(1) -$286,176
(2)
+$286,176
+137,590
+$137,590
(3)
+$68,480
Issued stock
+$68,480
LO 1 BT: AP Difficulty: Medium TOT: 3 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-4
(a) (b) (c) (d) (e) (f)
Accounts Payable Advertising Expense Service Revenue Accounts Receivable Retained Earnings Dividends
Debit Effect
Credit Effect
Normal Balance
Decrease Increase Decrease Increase Decrease Increase
Increase Decrease Increase Decrease Increase Decrease
Credit Debit Credit Debit Credit Debit
LO 2 BT: K Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
BRIEF EXERCISE 0-5
June 1 2 3 12
Account Debited Cash Equipment Rent Expense Accounts Receivable
Account Credited Common Stock Accounts Payable Cash Service Revenue
LO 2 BT: C Difficulty: Medium TOT: 3 min. AACSB: None AICPA FC: Reporting
BRIEF EXERCISE 0-6 June
1
2
Cash ................................................................................... Common Stock ..................................................................
5,000
Equipment .......................................................................... Accounts Payable..............................................................
1,100
5,000
1,100
3
12
Rent Expense ..................................................................... Cash ...........................................................................
740
Accounts Receivable ........................................................ Service Revenue .......................................................
700
740
700
LO 2 BT: AP Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-7 (a)
Basic Analysis
(b)
Debit-Credit Analysis
Aug. 1
The asset Cash is increased; the stockholders’ equity account Common Stock is increased.
Debits increase assets: debit Cash $10,000. Credits increase stockholders’ equity: credit Common Stock $10,000.
4
The asset Prepaid Insurance is increased; the asset Cash is decreased.
Debits increase assets: debit Prepaid Insurance $1,500. Credits decrease assets: credit Cash $1,500.
16
The asset Cash is increased; the revenue Service Revenue is increased.
Debits increase assets: debit Cash $900. Credits increase revenues: credit Service Revenue $900.
27
The expense Salaries and Wages Expense is increased; the asset Cash is decreased.
Debits increase expenses: debit Salaries and Wages Expense $620. Credits decrease assets: credit Cash $620.
LO 2 BT: C Difficulty: Medium TOT: 8 min. AACSB: None AICPA FC: Reporting
BRIEF EXERCISE 0-8 Aug.
1
4
Cash .................................................................................... Common Stock ..........................................................
10,000
Prepaid Insurance .............................................................. Cash ...........................................................................
1,500
10,000
1,500
16
27
Cash .................................................................................... Service Revenue........................................................
900
Salaries and Wages Expense ............................................ Cash ...........................................................................
620
LO 2 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
900
620
BRIEF EXERCISE 0-9 Cash 5/12 5/15
5/5
Service Revenue
1,600 2,000
Accounts Receivable 3,800 5/12
5/5 5/15
3,800 2,000
1,600
LO 3 BT: AP Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-10 PEETE COMPANY Trial Balance June 30, 2017
Cash ........................................................................................... Accounts Receivable ................................................................ Equipment ................................................................................. Accounts Payable ..................................................................... Common Stock ......................................................................... Dividends................................................................................... Service Revenue ....................................................................... Salaries and Wages Expense .................................................. Rent Expense ............................................................................
Debit $ 5,400 3,000 13,000
Credit
$ 1,000 18,000 1,200 8,600 4,000 1,000 $27,600
(Total of debit account balances = Total of credit account balances) LO 4 BT: AP Difficulty: Medium TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
$27,600
BRIEF EXERCISE 0-11 BIRELLIE COMPANY Trial Balance December 31, 2017
Cash ........................................................................................... Prepaid Insurance ..................................................................... Accounts Payable ..................................................................... Unearned Service Revenue...................................................... Common Stock ......................................................................... Retained Earnings .................................................................... Dividends................................................................................... Service Revenue ....................................................................... Salaries and Wages Expense .................................................. Rent Expense ............................................................................
Debit $20,800 3,500
Credit
$ 2,500 1,800 10,000 6,600 5,000 25,600 14,600 2,600 $46,500
$46,500
(Assets, expenses, and dividends have debit balances) LO 4 BT: AN Difficulty: Medium TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-12
(a) (b) (c) (d) (e) (f)
Cash $–100 0 0 +800 –2,500 0
Net Income $0 –20 +1,300 0 0 –600
LO 5 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
BRIEF EXERCISE 0-13 (a)
Prepaid Insurance—to recognize insurance expired during the period.
(b)
Depreciation Expense—to allocate the cost of an asset to expense during the current period.
(c)
Unearned Service Revenue—to account for unearned revenue for which services were provided during the period.
(d)
Interest Payable—to recognize interest accrued but unpaid on notes payable during the current period.
LO 5 BT: C Difficulty: Medium TOT: 4 min. AACSB: None AICPA FC: Reporting
BRIEF EXERCISE 0-14 Item
(1) Type of Adjustment
(2) Accounts Before Adjustment
(a)
Prepaid Expenses
Assets Overstated Expenses Understated
(b)
Accrued Revenues
Assets Understated Revenues Understated
(c)
Accrued Expenses
Expenses Understated Liabilities Understated
(d)
Unearned Revenues
Liabilities Overstated Revenues Understated
LO 5 BT: AN Difficulty: Hard TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-15 Dec. 31
12/31 Bal.
Supplies Expense ......................................................... Supplies ............................................................... Supplies 8,800 12/31 1,100
7,700
12/31
7,700
Supplies Expense 7,700
LO 5 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
7,700
BRIEF EXERCISE 0-16 Dec. 31
Depreciation Expense .................................................. Accumulated Depreciation— Equipment ........................................................
2,750
Accumulated Depreciation— Equipment 12/31 2,750
Depreciation Expense 2,750
12/31
2,750
Balance Sheet: Equipment ................................................................................ Less: Accumulated depreciation—equipment .....................
$22,000 2,750
$19,250
LO 5 BT: AP Difficulty: Medium TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-17 July
1
Dec. 31
Prepaid Insurance ........................................................ Cash......................................................................
12,400
Insurance Expense ($12,400 X 6/24) ........................... Prepaid Insurance ...............................................
3,100
Prepaid Insurance 7/1 12,400 12/31 12/31 Bal. 9,300
3,100
12/31
12,400
Insurance Expense 3,100
LO 5 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
3,100
BRIEF EXERCISE 0-18 July
1
Dec. 31
Cash .............................................................................. Unearned Service Revenue ................................
12,400
Unearned Service Revenue ......................................... Service Revenue ($12,400 X 6/24) ......................
3,100
Unearned Service Revenue 12/31 3,100 7/1 12,400 12/31 Bal. 9,300
12,400
3,100
Service Revenue 12/31
3,100
LO 5 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-19 (a)
(b)
(c)
Dec. 31
31
31
Interest Expense .................................................. Interest Payable ..........................................
300
Accounts Receivable .......................................... Service Revenue .........................................
1,700
Salaries and Wages Expense ............................. Salaries and Wages Payable .....................
780
300
LO 5 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
1,700
780
BRIEF EXERCISE 0-20 (1) Type of Adjustment
Account
(2) Related Account
(a)
Accounts Receivable
Accrued Revenues
Service Revenue
(b)
Prepaid Insurance
Prepaid Expenses
Insurance Expense
(c)
Equipment
Not required
Not required
(d)
Accum. Depreciation— Equipment
Prepaid Expenses
Depreciation Expense
(e)
Notes Payable
Not required
Not required
(f)
Interest Payable
Accrued Expenses
Interest Expense
(g)
Unearned Service Revenue
Unearned Revenues
Service Revenue
LO 6 BT: AN Difficulty: Hard TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-21 LEVIN CORPORATION Income Statement For the Year Ended December 31, 2017 Revenues Service revenue .................................................................. Expenses Salaries and wages expense.............................................. Rent expense....................................................................... Insurance expense .............................................................. Supplies expense ................................................................ Depreciation expense .........................................................
$32,000 $14,000 3,900 1,800 1,500 1,000
Total expenses ............................................................................. Net income ................................................................................... [Revenues – Expenses = Net income or (loss)] LO 7 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
22,200 $ 9,800
BRIEF EXERCISE 0-22 LEVIN CORPORATION Retained Earnings Statement For the Year Ended December 31, 2017 Retained earnings, January 1 ........................................................................... Add: Net income / (Loss) ................................................................................. Less: Dividends ................................................................................................ Retained earnings, December 31......................................................................
$17,200 10,400 27,600 6,000 $21,600
(Beginning retained earnings ± Changes to retained earnings = Ending retained earnings) LO 7 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
BRIEF EXERCISE 0-23 Account (a) (b) (c) (d) (e) (f) (g)
Accumulated Depreciation Depreciation Expense Retained Earnings (beginning) Dividends Service Revenue Supplies Accounts Payable
Balance Sheet Income Statement Retained Earnings Statement Retained Earnings Statement Income Statement Balance Sheet Balance Sheet
LO 7 BT: K Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
BRIEF EXERCISE 0-24 (a) Closing Entries July 31
Service Revenue .................................................. Income Summary ........................................ (To close revenue account)
16,000
Income Summary ................................................ Salaries and Wages Expense ..................... Maintenance and Repairs Expense........................................................ Income Tax Expense ................................... (To close expense accounts)
11,900
16,000
8,400 2,500 1,000
Income Summary ................................................ Retained Earnings ....................................... (To close net income to retained earnings)
4,100
Retained Earnings ............................................... Dividends ..................................................... (To close dividends to retained earnings)
1,300
4,100
(Income statement accounts are closed to the Income Summary account) (b) Retained Earnings 1,300
7/1 Bal. 7/31 Bal.
20,000 4,100 22,800
LO 8 BT: AP Difficulty: Medium TOT: 8 min. AACSB: Analytic AICPA FC: Reporting
1,300
BRIEF EXERCISE 0-25 The accounts that will appear in the post-closing trial balance are: Accumulated Depreciation Retained Earnings (ending) Supplies Accounts Payable LO 9 BT: K Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
SOLUTIONS TO DO IT! REVIEW EXERCISES DO IT! 0-1 Assets = Accounts Cash + Receivable = (1) (2)
Liabilities Accounts Payable
+
Common Stock
+$20,000 +$20,000
Stockholders’ Equity Retained Earnings + Revenues – Expenses – Dividends +$20,000
–20,000
(3) (4)
+
–$1,800
+$1,800 –3,000
–$3,000
LO 1 BT: AP Difficulty: Medium TOT: 3 min. AACSB: Analytic AICPA FC: Reporting
DO IT! 0-2 Boyd would likely need the following accounts in which to record the transactions necessary to ready his photography studio for opening day: Cash (debit balance) Supplies (debit balance) Notes Payable (credit balance)
Equipment (debit balance) Accounts Payable (credit balance) Common Stock (credit balance)
LO 2 BT: C Difficulty: Easy TOT: 2 min. AACSB: None AICPA FC: Reporting
DO IT! 0-3 Each transaction that is recorded is entered in the general journal. The three activities would be recorded as follows: 1. 2.
3.
Cash ....................................................................................... Common Stock ..............................................................
8,000
Supplies ............................................................................... Accounts Payable ......................................................... Cash ...............................................................................
950
No entry because no transaction has occurred.
LO 2 BT: AP Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA FC: Reporting
8,000 550 400
DO IT! 0-4
4/1 4/3 4/30
Cash 1,900 4/16 3,400 4/20 4,500
500 300
LO 3 BT: AP Difficulty: Easy TOT: 3 min. AACSB: Analytic AICPA FC: Reporting
DO IT! 0-5 CHILLIN’ COMPANY Trial Balance December 31, 2017
Cash ........................................................................................... Accounts Receivable ................................................................ Supplies ..................................................................................... Equipment ................................................................................. Notes Payable ........................................................................... Accounts Payable ..................................................................... Salaries and Wages Payable .................................................... Common Stock.......................................................................... Dividends ................................................................................... Service Revenue ....................................................................... Rent Expense ............................................................................ Salaries and Wages Expense...................................................
Debit $ 6,000 8,000 5,000 76,000
Credit
$ 20,000 9,000 3,000 25,000 8,000 86,000 2,000 38,000 $143,000
(Liabilities, Common stock, and Revenues have credit balances) LO 4 BT: AP Difficulty: Medium TOT: 8 min. AACSB: Analytic AICPA FC: Reporting
$143,000
DO IT! 0-6 1. (d)
2. (e)
3. (h)
4. (c)
LO 5 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
DO IT! 0-7 1.
2.
3.
4.
Insurance Expense ....................................................................... Prepaid Insurance ................................................................. (To record insurance expired)
300
Supplies Expense ......................................................................... Supplies ................................................................................. (To record supplies used)
1,600
Depreciation Expense .................................................................. Accumulated Depreciation—Equipment ............................ (To record monthly depreciation)
200
Unearned Service Revenue .......................................................... Service Revenue .................................................................... (To record revenue for services provided)
4,000
300
1,600
200
4,000
LO 5 BT: AP Difficulty: Medium TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
DO IT! 0-8 1.
2.
3.
Salaries and Wages Expense....................................................... Salaries and Wages Payable ................................................ (To record accrued salaries)
1,100
Interest Expense ($20,000 X .09 X 1/12) ...................................... Interest Payable ..................................................................... (To record accrued interest)
150
Accounts Receivable ................................................................... Service Revenue .................................................................... (To record revenue for service provided)
1,600
LO 5 BT: AP Difficulty: Medium TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
1,100
150
1,600
DO IT! 0-9a Income statement: Service Revenue, Utilities Expense Balance sheet: Accounts Receivable, Accumulated Depreciation, Notes Payable, Common Stock. LO 7 BT: C Difficulty: Easy TOT: 3 min. AACSB: None AICPA FC: Reporting
DO IT! 0-10a Dec. 31
Dec. 31
Dec. 31
Dec. 31
Service Revenue ..................................................................... 108,000 Income Summary ........................................................... (To close revenue to income summary)
108,000
Income Summary.................................................................... Salaries and Wages Expense ........................................ Rent Expense .................................................................. Utilities Expense ............................................................. Supplies Expense ........................................................... (To close expenses to income summary)
72,000 40,000 18,000 8,000 6,000
Income Summary.................................................................... Retained Earnings .......................................................... (To close net income to retained earnings)
36,000
Retained Earnings .................................................................. Dividends ........................................................................ (To close dividends to retained earnings)
22,000
36,000
LO 8 BT: AP Difficulty: Medium TOT: 6 min. AACSB: Analytic AICPA FC: Reporting
22,000
SOLUTIONS TO EXERCISES EXERCISE 0-1 1. 2. 3. 4. 5. 6. 7. 8. 9.
Increase in assets and increase in stockholders’ equity. Decrease in assets and decrease in stockholders’ equity. Increase in assets and increase in stockholders’ equity. Increase in assets and increase in stockholders’ equity. Decrease in assets and decrease in stockholders’ equity. Increase in liabilities and decrease in stockholders’ equity. Increase in assets and decrease in assets. Increase in assets and decrease in assets. Increase in assets and increase in liabilities.
LO 1 BT: C Difficulty: Medium TOT: 5 min. AACSB: None AICPA FC: Reporting
EXERCISE 0-2 Assets Cash (1)
+
=
Liabilities
+
Accounts Receivable + Equipment =
Accounts Payable
+
+$40,000 +$30,000
Issued Stock
+$30,000
–4,000
(4)
–$4,000 +$19,000
(5)
+5,000
(6)
–8,000
(7)
–30,000
Rent Expense
+$19,000
Service Revenue
+5,000
Service Revenue –8,000
Utilities Expense
–1,300
Advertising Expense
–30,000
(8) (9)
Common Retained Earnings Stock + Revenues – Expenses +$40,000
(2) (3)
Stockholders’ Equity
+1,300 +12,000
–12,000
$15,000 +
$7,000
$52,000
+
$30,000
=
$ 1,300
+
$40,000 +
$24,000 –
$13,300
$52,000
LO 1 BT: AP Difficulty: Medium TOT: 8 min. AACSB: Analytic AICPA FC: Reporting
Exercise 0-3
Cash (1)
+$100,000
(2)
+45,000
(3)
–60,000
(4)
+16,000
Assets Accounts + Receivable + Supplies +
Equipment
Liabilities Accounts Bonds = Payable + Payable
+ Common + Stock
Stockholders’ Equity Retained Earnings + Revenues – Expenses – Dividends
+$100,000
Issued Stock
+$45,000 +$60,000 +$16,000
(5) (6)
=
+$4,700
+$4,700
–5,200
(7)
–$5,200 +$10,000
(8)
–28,000
(9)
–11,000 $ 56,800 +
Service Revenue
Rent Expense
+10,000
Service Revenue –28,000
Salaries and Wages Expense –$11,000
$10,000
+
$4,700
$131,500
+
$60,000
$4,700
+
$45,000 +
$100,000 +
+$26,000 –
$131,500
LO 1 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
$33,200
–
$11,000
Dividends
EXERCISE 0-4 (Essay) 1.
Stockholders invested $20,000 cash in the business. 2. Purchased equipment for $5,000, paying $1,000 in cash and the balance of $4,000 on account. 3. Paid $750 cash for supplies. 4. Earned $9,500 in revenue, receiving $4,100 cash and $5,400 on account. 5. Paid $1,500 cash on accounts payable. 6. Paid $2,000 cash dividends to stockholders. 7. Paid $800 cash for rent. 8. Collected $450 cash from customers on account. 9. Paid salaries of $3,000. 10. Incurred $300 of utilities expense on account.
EXERCISE 0-4 (b)
Issued common stock ............................................................................. Service revenue ....................................................................................... Dividends .................................................................................................. Rent expense............................................................................................ Salaries and wages expense................................................................... Utilities expense ....................................................................................... Increase in stockholders’ equity ............................................................
$20,000 9,500 (2,000) (800) (3,000) (300) $23,400
[Revenues – Expenses = Net income or (loss)] (Changes in stockholders’ equity = Additional investment – dividends ± Net income or Loss) (c)
Service revenue ....................................................................................... Rent expense............................................................................................ Salaries and wages expense................................................................... Utilities expense ....................................................................................... Net income................................................................................................
$9,500 (800) (3,000) (300) $ 5,400
LO 1 BT: AP Difficulty: Medium TOT. 12 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-5 Account
SM
(a) Normal Balance Debit or Credit
.., Solutions Manual
(b) Balance Sheet or Income Statement
(For Instructor Use Only)
3-21
Accounts payable Accounts receivable Common stock Depreciation expense Interest expense Interest income Inventories Prepaid expenses Property and equipment Revenues
Credit Debit Credit Debit Debit Credit Debit Debit Debit Credit
Balance sheet Balance sheet Balance sheet Income statement Income statement Income statement Balance sheet Balance sheet Balance sheet Income statement
LO 2 BT: K Difficulty: Easy TOT: 5 min. AACSB: None AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-22
EXERCISE 0-06
3-18
(a) SM
Account Debited (b) (c) Specific Account Effect
(d) Normal Balance
(a) Basic Type
Account Credited (b) (c) Specific Account Effect
.., Solutions Manual
Transaction
(a) Basic Type
(d) Normal Balance
1.
Asset
Cash
Increase
Debit
Stockholders’ Equity
Common Stock
Increase
Credit
2.
Asset
Equipment
Increase
Debit
Asset
Cash
Decrease
Debit
3.
Asset
Supplies
Increase
Debit
Liability
Accounts Payable
Increase
Credit
4.
Asset
Accounts Receivable
Increase
Debit
Stockholders’ Equity
Service Revenue
Increase
Credit
5.
Stockholders’ Equity
Advertising Expense
Increase
Debit
Asset
Cash
Decrease
Debit
6.
Asset
Cash
Increase
Debit
Asset
Accounts Receivable
Decrease
Debit
7.
Liability
Accounts Payable
Decrease
Credit
Asset
Cash
Decrease
Debit
8.
Stockholders’ Equity
Dividends
Increase
Debit
Asset
Cash
Decrease
Debit
(For Instructor Use Only
EXERCISE 0-6 (Continued) (b) General Journal Trans. 1.
2.
3.
4.
5.
6.
Account Titles Cash Common Stock ......................................................
Debit 15,000
Equipment ....................................................................... Cash ........................................................................
10,000
Supplies .......................................................................... Accounts Payable ..................................................
300
Accounts Receivable ..................................................... Service Revenue ....................................................
3,700
Advertising Expense ...................................................... Cash ........................................................................
200
15,000
Cash
10,000
300
3,700
200 1,100
Accounts Receivable ............................................ 7.
8.
Credit
1,100
Accounts Payable........................................................... Cash ........................................................................
300
Dividends ........................................................................ Cash ........................................................................
400
300
400
LO 2 BT: AP Difficulty: Medium TOT: 15 AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-7 Oct. 1
SM
Debits increase assets: debit Cash $30,000. Credits increase stockholders’ equity: credit Common Stock $30,000.
2
No accounting transaction.
3
Debits increase assets: debit Equipment $3,800. Credits increase liabilities: credit Accounts Payable $3,800.
.., Solutions Manual
(For Instructor Use Only)
3-24
EXERCISE 0-7 (Continued) Oct. 6
Debits increase assets: debit Accounts Receivable $10,800. Credits increase revenues: credit Service Revenue $10,800.
10
Debits increase assets: debit Cash $140. Credits increase revenues: credit Service Revenue $140.
27
Debits decrease liabilities: debit Accounts Payable $700. Credits decrease assets: credit Cash $700.
30
Debits increase expenses: debit Salaries and Wages Expense $3,000. Credits decrease assets: credit Cash $3,000.
LO 2 BT: C Difficulty: Medium TOT: 10 min. AACSB: None AICPA FC: Reporting
EXERCISE 0-8 General Journal Date Oct. 1
Account Titles Cash Common Stock .....................................................
Debit 30,000
30,000
2
No entry.
3
Equipment ..................................................................... Accounts Payable ................................................
3,800
Accounts Receivable .................................................... Service Revenue ..................................................
10,800
6
10
Cash
3,800
10,800 140
Service Revenue .................................................. 27
30
Credit
140
Accounts Payable ......................................................... Cash ......................................................................
700
Salaries and Wages Expense ....................................... Cash ......................................................................
3,000
700
3,000
LO 2 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-25
EXERCISE 0-9 General Journal Date May 4
7
8
9
17
22
29
Account Titles Accounts Payable ......................................................... Cash ......................................................................
Debit 700
Accounts Receivable .................................................... Service Revenue ..................................................
6,800
Supplies ......................................................................... Accounts Payable ................................................
850
Equipment ..................................................................... Cash ......................................................................
1,000
Salaries and Wages Expense ....................................... Cash ......................................................................
530
Maintenance and Repairs Expense ............................. Accounts Payable ................................................
900
Prepaid Insurance ......................................................... Cash ......................................................................
1,200
Credit 700
6,800
850
1,000
530
900
1,200
LO 2 BT: AP Difficulty: Medium TOT: 8 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-26
EXERCISE 0-10 General Journal Date March
1
3
5
Account Titles Rent Expense ................................................................. Cash .......................................................................
Debit 1,200
Accounts Receivable ..................................................... Service Revenue ...................................................
140
Cash
75
1,200
140
Service Revenue ................................................... 8
12
75
Equipment ...................................................................... Cash ....................................................................... Accounts Payable .................................................
600
Cash
140
80 520
Accounts Receivable ............................................ 14
22
24
140
Salaries and Wages Expense ....................................... Cash .......................................................................
525
Utilities Expense ............................................................ Cash .......................................................................
72
Cash
525
72 1,500
Notes Payable ....................................................... 27
28
30
Credit
1,500
Maintenance and Repairs Expense .............................. Cash .......................................................................
220
Accounts Payable .......................................................... Cash .......................................................................
520
Prepaid Insurance.......................................................... Cash .......................................................................
1,800
220
520
1,800
LO 2 BT: AP Difficulty: Medium TOT: 8 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-11
SM
.., Solutions Manual
(For Instructor Use Only)
3-27
Trans. 1.
2.
Account Titles Cash Common Stock ...................................................... Cash
Debit 24,000
24,000 7,000
Notes Payable ........................................................ 3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
7,000
Equipment ....................................................................... Cash ........................................................................
11,000
Rent Expense .................................................................. Cash ........................................................................
1,200
Supplies .......................................................................... Cash ........................................................................
1,450
Advertising Expense ...................................................... Accounts Payable ..................................................
600
Cash Accounts Receivable ..................................................... Service Revenue ....................................................
2,000 16,000
Dividends ........................................................................ Cash ........................................................................
400
Utilities Expense ............................................................. Cash ........................................................................
2,000
Accounts Payable........................................................... Cash ........................................................................
600
Interest Expense ............................................................. Cash ........................................................................
40
Salaries and Wages Expense ........................................ Cash ........................................................................
6,400
Cash
12,000
11,000
1,200
1,450
600
18,000
400
2,000
600
40
6,400
Accounts Receivable ............................................ 14.
Credit
Income Tax Expense ...................................................... Cash ........................................................................
12,000 1,500 1,500
LO 2 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-28
EXERCISE 0-12 (a) Assets
=
Accounts Cash
+
Sept. 1
+$20,000
5
–3,000
8
Receivable
Liabilities Accounts
+ Equipment =
Payable
Stockholders’ Equity
+
Retained Earnings
Common +
Stock
–1,200
25
–4,000
30
–500 $ 11,300 +
Exp.
–
Div.
+$20,000 +$9,000
Issued stock
+$ 6,000
+$18,000
14
–
+ Revenues
+$18,000
Ser. Rev. –$1,200
Salar. Exp.
–4,000 –$500 $18,000 $38,300
+
$9,000
=
$ 2,000+
+
$20,000
..
+
–
$18,000
$1,200
–
Dividends
$500
$38,300
(b) General Journal Date Sept. 1
5
8
14
25
30
SM
J1
Account Titles Cash Common Stock ..................................................
Debit 20,000
Equipment ................................................................... Accounts Payable .............................................. Cash ....................................................................
9,000
Accounts Receivable ................................................. Service Revenue ................................................
18,000
Salaries and Wages Expense .................................... Cash ....................................................................
1,200
Accounts Payable....................................................... Cash ....................................................................
4,000
Dividends .................................................................... Cash ....................................................................
500
.., Solutions Manual
Credit 20,000
6,000 3,000
18,000
1,200
4,000
(For Instructor Use Only)
500
3-29
EXERCISE 0-12 (Continued) (c)
Bal.
Cash 20,000 9/5 9/14 9/25 9/30 11,300
9/8 Bal.
Accounts Receivable 18,000 18,000
9/1
9/5 Bal.
9/25
SM
Common Stock 9/1 Bal.
3,000 1,200 4,000 500 9/30 Bal.
Dividends 500 500 Service Revenue 9/8 Bal.
Equipment 9,000 9,000
20,000 20,000
18,000 18,000
Salaries and Wages Expense 9/14 1,200 Bal. 1,200
Accounts Payable 4,000 9/5 Bal.
6,000 2,000
.., Solutions Manual
(For Instructor Use Only)
3-30
LO 3 BT: AP Difficulty: Hard TOT:20 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-13 (a) Oct. 1 10 Bal.
Oct. 6 Bal.
Oct. 3 Bal.
Cash 30,000 Oct. 27 140 30 26,440
700 3,000
Oct. 27
Accounts Payable 700 Oct. 3 Bal.
3,800 3,100
Common Stock Oct. 1 Bal.
30,000 30,000
Service Revenue Oct. 6 10 Bal.
10,800 140 10,940
Accounts Receivable 10,800 10,800 Equipment 3,800 3,800
Salaries and Wages Expense Oct. 30 3,000 Bal. 3,000
(b)
MCCALL REAL ESTATE AGENCY Trial Balance October 31, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Equipment......................................................................... Accounts Payable ............................................................ Common Stock ................................................................. Service Revenue .............................................................. Salaries and Wages Expense ..........................................
Debit $26,440 10,800 3,800
3,000 $44,040
Credit
$ 3,100 30,000 10,940 . $44,040
(Total of debit account balances = Total of credit account balances) LO 4, BT: AP Difficulty: Medium TOT: 12 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-31
EXERCISE 0-14 (a) Date Apr.
1
4
7
12
General Journal Account Titles and Explanation Cash Common Stock ..................................................... (Issued stock for cash)
Debit 15,000
15,000
Supplies ......................................................................... Accounts Payable ................................................ (Purchased supplies on account)
5,200
Accounts Receivable .................................................... Service Revenue .................................................. (Billed clients for services rendered)
3,400
Cash
5,200
3,400
700 Service Revenue .................................................. (Received cash for revenue earned)
15
25
29
700
Salaries and Wages Expense ....................................... Cash ...................................................................... (Paid salaries)
800
Accounts Payable ......................................................... Cash ...................................................................... (Paid creditors on account)
3,500
Cash
800
3,500
800 Accounts Receivable ........................................... (Received cash in payment of account)
30
Cash
800
900 Unearned Service Revenue ................................. (Received cash for future services)
SM
Credit
.., Solutions Manual
(For Instructor Use Only)
900
3-32
EXERCISE 0-14 (Continued) (b)
SALVADOR’s GARDENING COMPANY, INC. Trial Balance April 30, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Supplies ............................................................................ Accounts Payable ............................................................ Unearned Service Revenue ............................................. Common Stock ................................................................. Service Revenue .............................................................. Salaries and Wages Expense ..........................................
Debit $13,100 2,600 5,200
Credit
$ 1,700 900 15,000 4,100 800 $21,700
$21,700
(Assets and Expenses have debit balances) LO 4 BT: AN Difficulty: Medium TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-33
EXERCISE 0-15 (a) Aug. 1 10 31 Bal.
Cash 8,000 Aug. 12 1,700 600 9,100
1,200
Accounts Receivable Aug. 25 3,400 Aug. 31 Bal. 2,800
Aug. 12 Bal.
(b)
Notes Payable Aug. 12 Bal.
5,000 5,000
Common Stock Aug. 1 Bal.
8,000 8,000
Service Revenue Aug. 10 25 Bal.
1,700 3,400 5,100
600
Equipment 6,200 6,200
BAYLEE INC. Trial Balance August 31, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Equipment......................................................................... Notes Payable................................................................... Common Stock ................................................................. Service Revenue ..............................................................
Debit $ 9,100 2,800 6,200
$18,100
Credit
$ 5,000 8,000 5,100 $18,100
(Liabilities, Common stock, and Revenues have credit balances) LO 4, BT: AP Difficulty: Medium TOT: 12 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-34
EXERCISE 0-16 (a)
Oct.
1
10
10
20
20
SM
Cash ............................................................................ Common Stock .................................................. (Issued stock for cash)
7,000
Cash ............................................................................ Service Revenue ................................................ (Received cash for services provided)
980
Cash ............................................................................ Notes Payable .................................................... (Issued note payable for cash)
8,000
Cash ............................................................................ Accounts Receivable ........................................ (Received cash in payment of account)
700
Accounts Receivable ................................................. Service Revenue ................................................ (Billed clients for services provided)
920
.., Solutions Manual
7,000
980
8,000
700
(For Instructor Use Only)
920
3-35
EXERCISE 0-16 (Continued) (b)
KRISCOE CO. Trial Balance October 31, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Supplies ............................................................................ Equipment......................................................................... Notes Payable................................................................... Accounts Payable ............................................................ Common Stock ................................................................. Dividends .......................................................................... Service Revenue .............................................................. Salaries and Wages Expense .......................................... Supplies Expense ............................................................ Rent Expense ...................................................................
Debit $15,730 1,020 220 3,000
Credit
$ 8,000 1,500 9,000 300 2,700 500 180 250 $21,200
$21,200
(Liabilities, Common stock, and Service revenues have credit balances) LO 4 BT: AN Difficulty: Medium TOT: 12 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-36
EXERCISE 0-17 (a) Date Oct.
1
Account Titles Cash Common Stock .....................................................
Debit 66,000
66,000
2
No entry
4
Rent Expense ................................................................. Cash .......................................................................
2,000
Equipment ...................................................................... Cash ....................................................................... Accounts Payable .................................................
18,000
Advertising Expense ..................................................... Cash .......................................................................
500
Maintenance and Repairs Expense .............................. Accounts Payable .................................................
390
Accounts Receivable ..................................................... Service Revenue ...................................................
3,200
Supplies .......................................................................... Accounts Payable .................................................
410
Accounts Payable .......................................................... Cash .......................................................................
14,000
Utilities Expense ............................................................ Cash .......................................................................
148
7
8
10
12
16
21
24
27
Cash
2,000
4,000 14,000
500
390
3,200
410
14,000
148 3,200
Accounts Receivable ............................................ 31
SM
Credit
Salaries and Wages Expense ....................................... Cash .......................................................................
.., Solutions Manual
3,200 5,100
(For Instructor Use Only)
5,100
3-37
EXERCISE 0-17 (Continued) (b)
Bal.
Cash 66,000 10/4 3,200 10/7 10/8 10/21 10/24 10/31 43,452
10/12
Accounts Receivable 3,200 10/27
10/1 10/27
10/16 Bal.
Supplies 410 410
10/7 Bal.
Equipment 18,000 18,000
10/21
SM
Service Revenue 10/12 Bal.
2,000 4,000 500 14,000 148 5,100
10/8 Bal.
3,200
Salaries and Wages Expense 10/31 5,100 Bal. 5,100
3,200 3,200
Advertising Expense 500 500
Maintenance & Repairs Expense 10/10 390 Bal. 390
Accounts Payable 14,000 10/7 10/10 10/16 Bal.
14,000 390 410 800
Common Stock 10/1 Bal.
66,000 66,000
.., Solutions Manual
10/4 Bal.
Rent Expense 2,000 2,000
10/24 Bal.
Utilities Expense 148 148
(For Instructor Use Only)
3-38
EXERCISE 0-17 (Continued) (c)
BEYERS CORPORATION Trial Balance October 31, 2017 Debit $43,452 410 18,000
Cash .................................................................................. Supplies ............................................................................ Equipment......................................................................... Accounts Payable ............................................................ Common Stock ................................................................. Service Revenue .............................................................. Advertising Expense ........................................................ Salaries and Wages Expense .......................................... Maintenance and Repairs Expense ................................ Rent Expense ................................................................... Utilities Expense ..............................................................
Credit
$800 66,000 3,200 500 5,100 390 2,000 148 $70,000
$70,000
(Total of debit account balances = Total of credit account balances) LO 4 BT: AP Difficulty: Hard TOT: 20 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-18
Error 1. 2. 3. 4. 5. 6.
(a) In Balance No Yes Yes No Yes No
(b) Difference $400 — — $300 — $36
(c) Larger Column Debit — — Credit — Credit
LO 4 BT: AN Difficulty: Hard TOT: 12 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-39
EXERCISE 0-19 The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. (a)
Since the sales effort is not complete until the flight actually occurs, revenue should not be recognized until December. Southwest Airlines should recognize the revenue in December when the customer has been provided with the flight.
(b)
Sales revenue should be recognized at the time of delivery.
(c)
Revenue should be recognized on a per game basis over the season from April through October.
(d)
Interest revenue should be accrued and recognized by RBC evenly over the term of the loan.
(e)
Revenue should be recognized when the sweater is shipped to the customer in September.
LO 5 BT: C Difficulty: Medium TOT: 10 min. AACSB: None AICPA FC: Measurement
EXERCISE 0-20 (a) (b) (c) (d) (e) (f) (g) (h)
8. 1. 7. 3. 6. 4. 2. 5.
Going concern assumption. Economic entity assumption. Full disclosure principle. Monetary unit assumption. Materiality. Periodicity assumption. Expense recognition principle. Historical cost principle.
LO 5 BT: K Difficulty: Easy TOT: 5 min. AACSB: None AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-40
EXERCISE 0-21 (a) (b) (c) (d) (e) (f)
Revenue recognition principle. Periodicity assumption. No violation. Going concern assumption. Historical cost principle. Economic entity assumption.
LO 5 BT: C Difficulty: Medium TOT: 10 min. AACSB: None AICPA FC: Reporting
EXERCISE 0-22 $ 33,640 + 3,400 – 2,800 + 1,300 – 1,460 – 2,000 + 2,400 – 1,400 + 1,100 $ 34,180
Cash basis earnings. Accounts receivable arise from sales that have been made, thus revenue must be recognized for balance outstanding at the end of the current year. Accounts receivable collected in current year, for sales made in previous year must be deducted from earnings. Supplies on hand at year end should be set up as an asset rather than expensed, this increases earnings. Supplies on hand at the end of the previous year should be expensed this year, this decreases earnings. Wages owing at the end of the current year should be accrued, thus reducing earnings. Wages owed at the end of the previous year should not be deducted from the current year’s earnings, thus increasing earnings. Other unpaid amounts owed at the end of the current year should be accrued, thus reducing earnings. Other unpaid amounts owed at the end of the previous year should not be deducted from the current year’s earnings, thus increasing earnings. Accrual basis earnings.
LO 5 BT: AP Difficulty: Hard TOT: 12 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-41
EXERCISE 0-23 (a) Service Revenue – Operating Expenses – Insurance Expense Net Income
(b)
Cash Basis $22,000 12,000 2,400 $ 7,600
Accrual Basis $28,000 15,800 — $12,200
The accrual basis of accounting provides more useful information for decision makers because it recognizes revenues when the performance obligation is satisfied and expenses when incurred.
LO 5 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-24 (a)
Event 180-day financing for customers
Cash Accounting Revenue is recorded as cash is received.
Accrual Accounting Revenue is recorded when the performance obligation is satisfied. BizCon records revenue (and a receivable) as soon as services are provided but may wait up to 180 days to receive cash.
Payment to equipment suppliers upon delivery of goods
Equipment expense is recorded as an expense as soon as equipment is received and paid for.
Equipment is recorded as an asset and depreciated.
Prepayment for 2 years of insurance coverage
Insurance expense is recorded as soon as payment is made.
Prepayment is recorded as an asset and recognized as an expense as time passes.
One month’s salaries owed at year-end
No salary expense is recorded until salaries are paid.
Salary expense is recorded as employees perform work. Amounts owed at year-end would be recorded as a liability.
Proper accrual accounting would require adjusting entries for depreciation, prepaid insurance, and accrued salaries. SM
.., Solutions Manual
(For Instructor Use Only)
4-42
EXERCISE 0-24 (Continued) (b) Accrual accounting rules require that revenue be recognized as a company performs services and expenses be matched with the revenue they help produce. Receipt or payment of cash does not influence the calculation of net income. BizCon has provided many services during the year and thus has positive net income. Since BizCon allowed its largest customers to take up to 180 days to pay, but was forced to pay cash for all purchases, it is likely that the company has very little cash at year-end. New companies frequently experience cash shortages because they extend credit to attract customers but are unable to receive credit from their suppliers. As time passes, the cash supply should increase as payments on accounts receivable come in and offset current purchases. LO 5 BT: C Difficulty: Hard TOT: 20 min. AACSB: Analytic AICPA FC: Measurement AICPA FC: Reporting
EXERCISE 0-25 Item
(1) Type of Adjustment
(2) Accounts Before Adjustment
(a)
Accrued Revenues
Assets Understated Revenues Understated
(b)
Prepaid Expenses
Assets Overstated Expenses Understated
(c)
Accrued Expenses
Expenses Understated Liabilities Understated
(d)
Unearned Revenues
Liabilities Overstated Revenues Understated
(e)
Accrued Expenses
Expenses Understated Liabilities Understated
(f)
Prepaid Expenses
Assets Overstated Expenses Understated
LO 5 BT: AN Difficulty: Hard TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-43
EXERCISE 0-26 1.
2.
3.
4.
5.
Mar. 31
31
31
31
31
Depreciation Expense ($280 X 3).............................. Accumulated Depreciation— Equipment .....................................................
840
Unearned Rent Revenue ........................................... Rent Revenue ($12,400 X 1/2) ..........................
6,200
Interest Expense ........................................................ Interest Payable ................................................
400
Supplies Expense ...................................................... Supplies ($3,000 – $850)...................................
2,150
Insurance Expense ($400 X 3) .................................. Prepaid Insurance .............................................
1,200
840
6,200
400
2,150
1,200
LO 5 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-27 1.
2.
3.
Jan. 31
31
31
31
4.
5.
31
31
Accounts Receivable ................................................. Service Revenue ...............................................
760
Utilities Expense ........................................................ Accounts Payable .............................................
450
Depreciation Expense ............................................... Accumulated Depreciation— Equipment .....................................................
400
Interest Expense ........................................................ Interest Payable ................................................
500
Insurance Expense ($24,000 ÷ 12) ............................ Prepaid Insurance .............................................
2,000
Supplies Expense ($1,750 – $550) ............................ Supplies .............................................................
1,200
760
450
400
500
2,000
1,200
LO 5 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-44
EXERCISE 0-28 1.
2.
3.
4.
5.
6.
7.
Oct. 31
31
31
31
31
31
31
Supplies Expense ...................................................... Supplies ($2,500 – $500)...................................
2,000
Insurance Expense .................................................... Prepaid Insurance .............................................
100
Depreciation Expense ............................................... Accumulated Depreciation— Equipment .....................................................
75
Unearned Service Revenue ...................................... Service Revenue ...............................................
800
Accounts Receivable ................................................. Service Revenue ...............................................
280
Interest Expense ........................................................ Interest Payable ................................................
70
Salaries and Wages Expense ................................... Salaries and Wages Payable............................
1,400
2,000
100
75
800
280
70
1,400
LO 5 BT: AP Difficulty: Medium TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-45
EXERCISE 0-29
Date July 31
31
31
31
31
31
31
Account Titles Debit Interest Receivable ($20,000 .06 1/12) .................... 100 Interest Revenue ...................................................
Credit 100
Supplies Expense ($24,000 – $18,600) ......................... 5,400 Supplies .................................................................
5,400
Rent Expense ($3,600 4) ............................................. Prepaid Rent ..........................................................
900
900
Salaries and Wages Expense........................................ 3,100 Salaries and Wages Payable ................................ Depreciation Expense ($6,000 12) ............................. Accumulated Depreciation—Buildings ...............
3,100
500 500
Unearned Service Revenue ........................................... 4,700 Service Revenue ...................................................
4,700
Maintenance and Repairs Expense .............................. 2,300 Accounts Payable .................................................
2,300
LO 5 BT: AP Difficulty: Medium TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-46
EXERCISE 0-30 (a)
July 10
14
15
20
SM
Supplies ...................................................................... Cash ...................................................................
200
Cash ............................................................................ Service Revenue ...............................................
3,800
Salaries and Wages Expense ................................... Cash ...................................................................
1,000
Cash ............................................................................ Unearned Service Revenue..............................
600
.., Solutions Manual
200
3,800
1,000
(For Instructor Use Only)
600
4-47
EXERCISE 0-30 (Continued) (b)
July 31
31
31
31
Supplies Expense ...................................................... Supplies .............................................................
750
Accounts Receivable ................................................. Service Revenue ...............................................
500
Salaries and Wages Expense ................................... Salaries and Wages Payable............................
1,000
Unearned Service Revenue ...................................... Service Revenue ...............................................
900
750
500
1,000
900
LO 5 BT: AN Difficulty: Medium TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-31 Answer
Computation
(a)
Supplies balance = $1,350
Supplies expense Add: Supplies (1/31) Less: Supplies purchased Supplies (1/1)
(b)
Total premium = $6,240
Total premium = Monthly premium X 12; $520 X 12 = $6,240
Purchase date = May 1, 2016
Purchase date: On Jan. 31, there are 3 months coverage remaining ($520 X 3). Thus, the purchase date was 9 months earlier on May 1, 2016.
SM
.., Solutions Manual
(For Instructor Use Only)
$ 950) 700) (300) $1,350)
4-48
EXERCISE 0-31 (Continued) (c)
Salaries and wages payable = $1,760
Cash paid Salaries and wages payable (1/31/17)
$2,500 1,060 3,560
Less: Salaries and wages expense Salaries and wages payable (12/31/16) (d)
Unearned service revenue = $2,950
Service revenue Unearned revenue (1/31/17) Cash received in Jan. Unearned revenue (12/31/16)
1,800 $1,760
$4,000 750 4,750 1,800 $2,950
LO 5 BT: AN Difficulty: Hard TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
4-49
EXERCISE 0-32 Net Income
Total Assets
Total Liabilities
Stockholders’ Equity
Incorrect balances
$70,000
$150,000
$70,000
$80,000
Effects of: Salaries and Wages
(10,000)
10,000
(10,000)
Rent Revenue
4,000
(4,000)
4,000
Depreciation
(9,000)
(9,000)
$55,000
$141,000
Item
Correct balances
(9,000) $76,000
$65,000
(Revenues increase Net income and Stockholders’ equity and expenses do the opposite) LO 5 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-33 (a)
2017 June
Aug.
Sept.
Nov.
Dec.
SM
1
31
4
30
5
Prepaid Insurance................................................... Cash .................................................................
1,800
Prepaid Rent............................................................ Cash .................................................................
6,500
Cash ......................................................................... Unearned Service Revenue ...........................
3,600
Prepaid Cleaning .................................................... Cash .................................................................
2,000
Cash ......................................................................... Unearned Service Revenue ...........................
1,500
.., Solutions Manual
1,800
6,500
3,600
2,000
(For Instructor Use Only)
1,500
4-50
EXERCISE 0-33 (Continued) (b) 2017 Dec.
31
31
31
31
31
SM
Insurance Expense ................................................. Prepaid Insurance ........................................ ($1,800 × 7/12 months = $1,050)
1,050
Rent Expense .......................................................... Prepaid Rent ................................................. ($6,500 × 4/5 months = $5,200)
5,200
Unearned Service Revenue.................................... Service Revenue .......................................... ($3,600 × 4/9 months = $1,600)
1,600
Maintenance and Repairs Expense ....................... Prepaid Cleaning ..........................................
1,000
Unearned Service Revenue.................................... Service Revenue .......................................... ($1,500 – $475 not played = $1,025 played)
1,025
.., Solutions Manual
1,050
5,200
1,600
1,000
(For Instructor Use Only)
1,025
4-51
EXERCISE 0-33 (Continued) (c) Prepaid Insurance June 1 1,800 Dec. 31 Adj. Dec. 31 Bal. 750
1,050
Prepaid Rent 6,500 Dec. 31 Adj. 1,300
5,200
Aug. 31 Dec. 31 Bal.
Unearned Service Revenue Dec. 31 Adj. 1,600 Sept. 4 3,600 Dec. 31 Adj. 1,025 Dec. 5 1,500 Dec. 31 Bal. 2,475 Prepaid Cleaning Nov. 30 2,000 Dec. 31 Adj. Dec. 31 Bal. 1,000
1,000
Insurance Expense Dec. 31 Adj. 1,050
Dec. 31 Adj.
Rent Expense 5,200 Service Revenue Dec. 31 Adj. Dec. 31 Adj. Dec. 31 Bal.
1,600 1,025 2,625
Maintenance and Repairs Expense Dec. 31 Adj. 1,000
SM
.., Solutions Manual
(For Instructor Use Only)
4-52
Note: The Cash account has not been included in this solution, as per the instructions. LO 5 BT: AP Difficulty: Medium TOT: 20 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-34 (a)
2017 Dec.
31
31
31
31
31
(b)
2018 Jan.
11
4
1
4
2
Utilities Expense ..................................................... Accounts Payable ........................................
425
Salaries and Wages Expense ................................ Salaries and Wages Payable ....................... ($3,500 × 4/7 days = $2,000)
2,000
Interest Expense ..................................................... Interest Payable ........................................... ($45,000 × 5% × 2/12 months = $375 (rounded))
375
Accounts Receivable .............................................. Service Revenue ..........................................
300
Accounts Receivable .............................................. Rent Revenue ...............................................
6,000
Accounts Payable ................................................... Cash .................................................................
425
Salaries and Wages Payable.................................. Salaries and Wages Expense ................................ Cash .................................................................
2,000 1,500
Interest Payable ...................................................... Cash .................................................................
375
Cash ......................................................................... Accounts Receivable ......................................
300
Cash ......................................................................... Accounts Receivable ......................................
6,000
425
2,000
375
300
6,000
425
3,500
375
300
6,000
LO 5 BT: AP Difficulty: Medium TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-53
EXERCISE 0-35 Aug. 31
31
31
31
31
31
Accounts Receivable ................................................ Service Revenue .......................................................
600
Supplies Expense .............................................................. Supplies .....................................................................
2,000
Insurance Expense ............................................................ Prepaid Insurance .....................................................
1,500
Depreciation Expense ........................................................ Accumulated Depreciation—Equipment .................
1,200
Salaries and Wages Expense ............................................ Salaries and Wages Payable ....................................
1,100
Unearned Rent Revenue .................................................... Rent Revenue ............................................................
1,000
600
2,000
1,500
1,200
1,100
1,000
LO 6 BT: AN Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-36 (a)
FRANKEN COMPANY Income Statement For the Six Months Ended April 30, 2017 Revenues Service revenue ($32,150 + $540) ................................ Expenses Income tax expense...................................................... Salaries and wages expense ($2,600 + $420) ............. Depreciation expense [($9,200 ÷ 4) X 6/12]................. Rent expense ($1,225 – $175) ...................................... Utilities expense ........................................................... Advertising expense.....................................................
$32,690 $10,000 3,020 1,150 1,050 970 375
Total expenses ...................................................................... Net income .............................................................................
16,565 $16,125
[Revenues – Expenses = Net income or (loss)]
SM
.., Solutions Manual
(For Instructor Use Only)
3-54
EXERCISE 0-36 (Continued) (b)
FRANKEN COMPANY Balance Sheet April 30, 2017 Assets Current Assets Cash ............................................................................ Accounts receivable .................................................. Prepaid rent ................................................................ Total current assets........................................... Property, plant, and equipment Equipment .................................................................. Less: Accumulated depreciation—equipment ....................................... Total assets ........................................................
$27,780 540 175 $28,495 9,200 1,150
8,050 $36,545
Liabilities and Stockholders’ Equity Current Liabilities Salaries and wages payable .................................... Stockholders’ equity Common stock .......................................................... Retained earnings..................................................... Total stockholders’ equity ........................ Total liabilities and stockholders’ equity ..............................................................
$
420
$20,000 16,125 36,125 $36,545
(Assets = Liabilities + Stockholders’ equity) LO 7 BT: AP Difficulty: Hard TOT: 15 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-55
EXERCISE 0-37 NORSKI CO. Income Statement For the Month Ended July 31, 2017 Revenues Service revenue ($5,500 + $700) ........................................... Expenses Salaries and wages expense ($2,100 + $360) ...................... Supplies expense ($900 – $200) ........................................... Utilities expense ..................................................................... Insurance expense ................................................................. Depreciation expense ............................................................ Total expenses .............................................................. Net income ......................................................................................
$6,200 $2,460 700 500 350 150 4,160 $2,040
[Revenues – Expenses = Net income or (loss)] LO 7 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-38 RYAN COMPANY Income Statement For the Year Ended August 31, 2017 Revenues Service revenue .................................................................. Rent revenue ....................................................................... Total revenues ............................................................ Expenses Salaries and wages expense.............................................. Rent expense....................................................................... Supplies expense ................................................................ Insurance expense .............................................................. Depreciation expense ......................................................... Total expenses ........................................................... Net income ...................................................................................
SM
.., Solutions Manual
$34,600 13,100 $47,700 18,100 10,800 2,000 1,500 1,200 33,600 $14,100
(For Instructor Use Only)
3-56
EXERCISE 0-38 (Continued) RYAN COMPANY Retained Earnings Statement For the Year Ended August 31, 2017 Retained earnings, September 1, 2016 .......................................... Add: Net income ............................................................................ Less: Dividends .............................................................................. Retained earnings, August 31, 2017 ..............................................
$ 5,500 14,100 19,600 2,800 $16,800
RYAN COMPANY Balance Sheet August 31, 2017 Assets Current Assets Cash ...................................................................................... Accounts receivable ............................................................ Supplies ................................................................................ Prepaid insurance ................................................................ Total current assets .................................................... Equipment ............................................................................ Less: Accum. depreciation—equipment ............................. Total assets .................................................................
$10,900 9,400 500 2,500 $23,300 16,000 4,800
11,200 $34,500
Liabilities and Stockholders’ Equity Current Liabilities Accounts payable ................................................................ Salaries and wages payable................................................ Unearned rent revenue ........................................................ Total current liabilities ................................................ Stockholders’ equity Common stock ..................................................................... Retained earnings ................................................................ Total stockholders’ equity ..................................... Total liabilities and stockholders’ equity ..................
$ 5,800 1,100 800 $ 7,700 10,000 16,800 26,800 $34,500
(Ending retained earnings = Beginning retained earnings ± Changes to retained earnings) LO 7 BT: AP Difficulty: Medium TOT: 20 min. AACSB: Analytic AICPA FC: Reporting SM
.., Solutions Manual
(For Instructor Use Only)
3-57
EXERCISE 0-39 Jan. 31
31
31
Service Revenue ................................................................ Income Summary ......................................................
4,000
Income Summary ............................................................... Salaries and Wages Expense ................................... Supplies Expense ..................................................... Insurance Expense ...................................................
3,270
Income Summary ............................................................... Retained Earnings.....................................................
730
4,000
1,800 950 520
730
LO 8 BT: AP Difficulty: Medium TOT: 5 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-40 (a) Date Dec.
31
31
31
31
SM
Account Titles Debit Service Revenue ......................................................... 183,800 Rent Revenue .............................................................. 6,200 Income Summary ...............................................
190,000
Income Summary ........................................................ 109,300 Salaries and Wages Expense ............................ Depreciation Expense........................................ Rent Expense ..................................................... Supplies Expense ..............................................
91,100 13,200 3,600 1,400
Income Summary ........................................................ 80,700 Retained Earnings .............................................
80,700
Retained Earnings ...................................................... 26,300 Dividends ............................................................
26,300
.., Solutions Manual
Credit
(For Instructor Use Only)
3-58
EXERCISE 0-40 (Continued) (b) Dec. 31
Retained Earnings 26,300 Jan. 1 Dec. 31 Bal.
61,800 80,700 116,200
LO 8 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
EXERCISE 0-41 Aug. 31
31
31
31
Service Revenue .......................................................... Rent Revenue ............................................................... Income Summary ................................................
34,600 13,100
Income Summary ......................................................... Salaries and Wages Expense ............................. Rent Expense ...................................................... Supplies Expense ............................................... Insurance Expense ............................................. Depreciation Expense .........................................
33,600
Income Summary ......................................................... Retained Earnings...............................................
14,100
Retained Earnings........................................................ Dividends .............................................................
2,800
47,700
18,100 10,800 2,000 1,500 1,200
14,100
2,800
LO 8 BT: AP Difficulty: Medium TOT: 10 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-59
WONDER TRAVEL AGENCY INC.
1.
+ Cash Accounts Receivable + Supplies + Equipment +$30,000
–900
3.
–3,400
=
Accounts Payable
+
Common Stock + +$30,000
Retained Earnings Revenues – Expenses –
Dividends
–$900
Rent Expense
–200
Advertising Expense
+$3,400
4.
+$200
(For Instructor Use Only)
5.
–500
+$500
6.
+3,000
7.
–400
8.
–200
9.
–1,800
10.
+9,000
–9,000
$34,800 +
$
+$9,000
+$12,000
Service Revenue
–$400
Dividends
–200
–1,800
0
+
$38,700
$500
+
$3,400
=
$
0
+
$30,000
+
$12,000
$38,700
–
$2,900
Salaries and Wages Expense
–
$400
OLUTIONS TO PROBLEMS PROBLEM 0-1A
.., Solutions Manual
2.
Stockholders’ Equity
= Liabilities +
Assets
SOLUTIONS TO PROBLEMS
Copyright © 2016 John Wiley & Sons, Inc.
(a)
3-39
PROBLEM 0-1A (Continued) (b)
Service Revenue .................................................................... Expenses Salaries and Wages Expense ....................................... Rent Expense ................................................................ Advertising Expense..................................................... Net Income ............................................................
$12,000 $1,800 900 200
2,900 $ 9,100
OR Revenues ............................................................................... Less: Expenses ..................................................................... Net Income..............................................................................
$12,000 2,900 $ 9,100
[Revenues – Expenses = Net Income or (Loss)] LO 1 BT: AP Difficulty: Hard TOT: 45 min. AACSB: Analytic AICPA FC: Reporting
PROBLEM 0-2A
Date Mar.
1
Account Titles and Explanation
Debit
Cash
50,000 Common Stock .................................................... (Issued stock for cash)
3
5
6
SM
50,000
Land Buildings....................................................................... Equipment .................................................................... Cash ..................................................................... (Purchased Snead’s Golf Land)
23,000 9,000 6,000
Advertising Expense.................................................... Cash ..................................................................... (Paid for advertising)
1,200
Prepaid Insurance ........................................................ Cash ..................................................................... (Paid for one-year insurance policy)
2,400
.., Solutions Manual
Credit
38,000
1,200
(For Instructor Use Only)
2,400
3-61
10
18
Equipment .................................................................... Accounts Payable ............................................... (Purchased equipment on account)
5,500
Cash
1,600
5,500
Service Revenue ................................................. (Received cash for revenue earned) 19
25
SM
1,600
Cash (100 X $25) .......................................................... Unearned Service Revenue ................................ (Received cash for coupon books sold)
2,500
Dividends ...................................................................... Cash ..................................................................... (Payment of cash dividend)
500
.., Solutions Manual
2,500
(For Instructor Use Only)
500
3-62
PROBLEM 0-2A (Continued) Date
Account Titles and Explanation
Mar. 30
Salaries and Wages Expense ...................................... Cash ..................................................................... (Paid salaries expense)
800
Accounts Payable ........................................................ Cash ..................................................................... (Paid creditor on account)
5,500
30
31
Debit
Cash
Credit 800
5,500
900 Service Revenue ................................................. (Received cash for revenue earned)
900
LO 2 BT: AP Difficulty: Medium TOT: 25 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-63
PROBLEM 0-3A (a) Date Apr.
1
Account Titles and Explanation Cash Common Stock.................................................... (Issued shares of stock for cash)
Debit 118,0000
18,000
1
No entry.
2
Rent Expense ............................................................... Cash ..................................................................... (Paid monthly office rent)
900
Supplies ........................................................................ Accounts Payable ............................................... (Purchased supplies on account from Burmingham Company)
1,300
Accounts Receivable ................................................... Service Revenue ................................................. (Billed clients for services rendered)
1,900
3
10
11
Cash
900
1,300
1,900
700 Unearned Service Revenue ................................ (Received cash advance for future service)
20
Cash
700
2,800 Service Revenue ................................................. (Received cash for service performed)
30
30
SM
Credit
2,800
Salaries and Wages Expense ..................................... Cash ..................................................................... (Paid monthly salary)
1,500
Accounts Payable ........................................................ Cash ..................................................................... (Paid Burmingham Company on account)
300
.., Solutions Manual
1,500
300
(For Instructor Use Only)
3-64
PROBLEM 0-3A (Continued) (b) 4/1 4/11 4/20 Bal.
Cash 18,000 4/2 700 4/30 2,800 4/30 18,800
900 1,500 300
4/10 Bal.
Accounts Receivable 1,900 1,900
4/3 Bal.
Supplies 1,300 1,300
4/30
SM
Salaries and Wages Expense 4/30 1,500 Bal. 1,500
4/2 Bal.
Accounts Payable 300 4/3 Bal.
1,300 1,000
Unearned Service Revenue 4/11 Bal.
700 700
Common Stock 4/1 Bal.
18,000 18,000
Service Revenue 4/10 4/20 Bal.
1,900 2,800 4,700
.., Solutions Manual
Rent Expense 900 900
(For Instructor Use Only)
3-65
PROBLEM 0-3A (Continued) (c)
AYALA ARCHITECTS INC. Trial Balance April 30, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Supplies ............................................................................ Accounts Payable ............................................................ Unearned Service Revenue ............................................. Common Stock ................................................................. Service Revenue .............................................................. Salaries and Wages Expense .......................................... Rent Expense ...................................................................
Debit $18,800 1,900 1,300
Credit
$ 1,000 700 18,000 4,700 1,500 900 $24,400
$24,400
(Assets and Expenses have debit balances) LO 4 BT: AP Difficulty: Hard TOT: 35 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-66
PROBLEM 0-4A
(a) & (c) 10/1 Bal. 10/5 10/17 Bal.
Cash 19,200 10/15 1,300 10/20 600 10/29 10/31 17,300
1,200 1,900 300 400
Accounts Receivable 10/1 Bal. 2,600 10/5 10/10 5,100 Bal. 6,400
10/1 Bal. Bal.
Supplies 2,100 2,100
10/1 Bal. Bal.
Equipment 8,000 8,000
10/20
1,300 10/29 Bal.
Common Stock 10/1 Bal. Bal.
15,000 15,000
Retained Earnings 10/1 Bal. Bal.
11,000 11,000
Dividends 300 300 Service Revenue 10/10 10/17 Bal.
5,100 600 5,700
Salaries and Wages Expense 10/15 1,200 Bal. 1,200
Accounts Payable 1,900 10/1 Bal. Bal.
4,800 2,900
10/31 Bal.
Utilities Expense 400 400
Unearned Service Revenue 10/1 Bal. 1,100 Bal. 1,100
SM
.., Solutions Manual
(For Instructor Use Only)
3-67
PROBLEM 0-4A (Continued) (b) Date
Account Titles and Explanation
Debit
Oct. 5
Cash
1,300 Accounts Receivable .......................................... (Received collections from customers on account)
10
15
17
1,300
Accounts Receivable ................................................... Service Revenue ................................................. (Billed customers for services performed)
5,100
Salaries and Wages Expense ...................................... Cash ..................................................................... (Paid employee salaries)
1,200
Cash
600
5,100
1,200
Service Revenue ................................................. (Performed services for customers) 20
29
31
SM
600
Accounts Payable ........................................................ Cash ..................................................................... (Paid creditors on account)
1,900
Dividends ...................................................................... Cash ..................................................................... (Payment of cash dividend)
300
Utilities Expense .......................................................... Cash ..................................................................... (Paid utilities)
400
.., Solutions Manual
Credit
1,900
300
(For Instructor Use Only)
400
3-68
PROBLEM 0-4A (Continued) (d)
LACEY COMPANY Trial Balance October 31, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Supplies ............................................................................ Equipment......................................................................... Accounts Payable ............................................................ Unearned Service Revenue ............................................. Common Stock ................................................................. Retained Earnings ............................................................ Dividends .......................................................................... Service Revenue .............................................................. Salaries and Wages Expense .......................................... Utilities Expense ..............................................................
Debit $ 17,300 6,400 2,100 8,000
Credit
$ 2,900 1,100 15,000 11,000 300 5,700 1,200 400 $35,700
$35,700
(Liabilities, Common stock, Retained earnings, and Service revenue have credit balances) LO 4 BT: AP Difficulty: Hard TOT: 45 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-69
PROBLEM 0-5A WASHBURN CO. Trial Balance June 30, 2017 Cash ($3,090 – $760 + $706) .............................. Accounts Receivable* ....................................... Supplies ($800 – $340) ....................................... Equipment ($3,000 + $340) ................................ Accounts Payable ($3,686 – $206 – $260) ........ Unearned Service Revenue ............................... Common Stock .................................................. Dividends ($800 + $600) .................................... Service Revenue ................................................ Salaries and Wages Expense ($3,600 + $700 – $600)..................................... Utilities Expense ................................................
Debit $ 3,036 4,054 460 3,340
Credit
$ 3,220 1,200 9,000 1,400 3,480 3,700 910 $16,900
$16,900
*$3,190 + $760 – $706 – $90 + $900 (Each journal entry must balance and reflect the actual amount of the transaction) LO 4 BT: AN Difficulty: Hard TOT: 35 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-70
PROBLEM 0-6A (a) & (c) 3/1 Bal. 3/9 3/20 3/31 3/31 Bal.
3/31 Bal.
3/1 Bal. Bal.
Cash 16,000 3/2 9,900 3/10 8,300 3/12 750 3/20 20,000 3/31 32,750 Accounts Receivable 750 750 Land 38,000 38,000
3/1 Bal. Bal.
Buildings 22,000 22,000
3/1 Bal. Bal.
Equipment 16,000 16,000
3/10
SM
2,000 10,900 500 5,000 3,800
Accounts Payable 10,900 3/1 Bal. 3/2 Bal.
12,000 8,000 9,100
.., Solutions Manual
Common Stock 3/1 Bal. Bal.
80,000 80,000
Service Revenue 3/9 3/20 3/31 Bal.
9,900 8,300 20,000 38,200
Sales Revenue 3/31 Bal.
1,500 1,500
3/12 Bal.
Advertising Expense 500 500
3/2 3/20 Bal.
Rent Expense 10,000 5,000 15,000
Salaries and Wages Expense 3/31 3,800 Bal. 3,800
(For Instructor Use Only)
3-71
PROBLEM 0-6A (Continued) (b) Date
Account Titles and Explanation
Debit
Mar. 2
Rent Expense ............................................................... Accounts Payable ............................................... Cash ..................................................................... (Rented films for cash and on account)
10,000
3
No entry—not a transaction.
9
Cash
8,000 2,000
9,900 Service Revenue ................................................. (Received cash for admissions)
10
Accounts Payable ($8,000 + $2,900) .......................... Cash ..................................................................... (Paid creditors on account)
11
No entry—not a transaction.
12
Advertising Expense ................................................... Cash ..................................................................... (Paid advertising expenses)
20
Cash
9,900
10,900 10,900
500 500
8,300 Service Revenue ................................................. (Received cash for admissions)
20
31
SM
Credit
8,300
Rent Expense ............................................................... Cash ..................................................................... (Paid film rental)
5,000
Salaries and Wages Expense ..................................... Cash ..................................................................... (Paid salaries expense)
3,800
.., Solutions Manual
5,000
(For Instructor Use Only)
3,800
3-72
PROBLEM 0-6A (Continued) Date Mar. 31
31
Account Titles and Explanation Cash Accounts Receivable ................................................... Sales Revenue (15% X $10,000) .............................. (Received cash and balance on account for concessions)
Debit 750 750
Cash
20,000
Credit
1,500
Service Revenue .................................................. (Received cash for admissions) (d)
20,000
TRIQUEL THEATER INC. Trial Balance March 31, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Land .................................................................................. Buildings ........................................................................... Equipment......................................................................... Accounts Payable ............................................................ Common Stock ................................................................. Service Revenue .............................................................. Sales Revenue .................................................................. Advertising Expense ........................................................ Rent Expense ................................................................... Salaries and Wages Expense ..........................................
Debit $ 32,750 750 38,000 22,000 16,000
Credit
$
500 15,000 3,800 $128,800
9,100 80,000 38,200 1,500
$128,800
(Assets and Expenses have debit balances) LO 4 BT: AP Difficulty: Hard TOT: 45 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-73
PROBLEM 0-7A (a) & (c) 7/31 8/3 8/5 8/7 8/18 8/26 Bal.
Cash 4,000 8/6 1,200 8/12 1,300 8/14 3,000 8/20 3,500 8/31 2,000 6,225
7/31 8/7 8/24 Bal.
Accounts Receivable 1,500 8/3 3,500 8/18 1,000 1,300
7/31 Bal.
Supplies 500 500
7/31 8/12 Bal.
Equipment 5,000 1,200 6,200
8/6
Common Stock 7/31 8/5 Bal. SM
2,700 400 4,675 500 500 8/20 Bal.
Dividends 500 500
Service Revenue 8/7 8/24 Bal.
1,200 3,500
3,400 3,400
6,500 1,000 7,500
Salaries and Wages Expense 8/14 3,500 Bal. 3,500
Accounts Payable 2,700 7/31 8/12 8/28 Bal. Notes Payable 8/26 Bal.
Retained Earnings 7/31 Bal.
4,100 800 275 2,475
2,000 2,000
3,500 1,300 4,800 .., Solutions Manual
8/14 Bal.
Rent Expense 900 900
8/14 Bal.
Advertising Expense 275 275
8/28 Bal.
Utilities Expense 275 275
8/31 Bal.
Income Tax Expense 500 500
(For Instructor Use Only)
3-74
PROBLEM 0-7A (Continued) (b) Date Aug. 3
5
Account Titles Debit Cash 1,200 Accounts Receivable ............................................. Cash
7
12
14
18
1,300
Accounts Payable ........................................................... Cash ........................................................................
2,700
Cash Accounts Receivable ...................................................... Service Revenue.....................................................
3,000 3,500
Equipment........................................................................ Cash ........................................................................ Accounts Payable ..................................................
1,200
Salaries and Wages Expense ......................................... Rent Expense .................................................................. Advertising Expense ....................................................... Cash ........................................................................
3,500 900 275
Cash
3,500
2,700
6,500
400 800
4,675
Accounts Receivable ............................................. 20
24
26
3,500
Dividends ......................................................................... Cash ........................................................................
500
Accounts Receivable ...................................................... Service Revenue.....................................................
1,000
Cash
2,000
500
1,000
Notes Payable .........................................................
SM
2,000
27
No entry
28
Utilities Expense ............................................................. Accounts Payable ..................................................
275
Income Tax Expense ....................................................... Cash ........................................................................
500
31
1,200
1,300 Common Stock .......................................................
6
Credit
.., Solutions Manual
275
(For Instructor Use Only)
500 3-75
PROBLEM 0-7A (Continued) (d)
HILLS LEGAL SERVICES INC. Trial Balance August 31, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Supplies ............................................................................ Equipment......................................................................... Accounts Payable ............................................................ Notes Payable................................................................... Common Stock ................................................................. Retained Earnings ............................................................ Dividends .......................................................................... Service Revenue .............................................................. Advertising Expense ........................................................ Salaries and Wages Expense .......................................... Rent Expense ................................................................... Utilities Expense .............................................................. Income Tax Expense ........................................................
Debit $ 6,225 1,300 500 6,200
Credit
$ 2,475 2,000 4,800 3,400 500 7,500 275 3,500 900 275 500 $20,175
$20,175
(Assets, Dividends, and Expenses have debit balances) LO 4 BT: AP Difficulty: Hard TOT: 55 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-76
PROBLEM 0-8A (a) & (c) Apr. 30 May 7 8 15 22 29
Bal.
Cash 5,000 May 1,500 1,200 800 1,000 1,700
1,000 1,100 1,200 1,000 400 50 1,200 150
5,100
Apr. 30 Bal.
Supplies 500 500
Apr. 30 Bal.
Equipment 24,000 24,000
May 4 May 21
1 4 14 21 25 31 31 31
Accounts Payable 1,100 Apr. 30 1,000 May 22 25 Bal. Notes Payable Apr. 30 Bal.
2,100 700 500 1,200
10,000 10,000
Unearned Service Revenue May 15 700 Apr. 30 1,000 29 600 May 7 1,500 Bal. 1,200
SM
.., Solutions Manual
Common Stock Apr. 30 Bal.
5,000 5,000
Retained Earnings Apr. 30 Bal.
11,400 11,400
Service Revenue May 8 15 15 22 29 29 Bal.
1,200 800 700 1,000 1,700 600 6,000
Salaries and Wages Expense May 14 1,200 31 1,200 Bal. 2,400
May 1 Bal.
Rent Expense 1,000 1,000
May 22 Bal.
Supplies Expense 700 700
May 25 Bal.
Advertising Expense 500 500
(For Instructor Use Only)
3-77
PROBLEM 0-8A (Continued)
May 25 Bal.
Utilities Expense 400 400
May 31 Bal.
Interest Expense 50 50
May 31 Bal.
Income Tax Expense 150 150
SM
.., Solutions Manual
(For Instructor Use Only)
3-78
PROBLEM 0-8A (Continued) (b) Date May 1
4
7
Account Titles Debit Rent Expense .................................................................. 1,000 Cash ........................................................................ Accounts Payable ........................................................... Cash ........................................................................
1,100
Cash
1,500
Cash
1,500 1,200
Service Revenue..................................................... 14
15
Salaries and Wages Expense ......................................... Cash ........................................................................ Cash
1,200 1,200 1,200 800
Service Revenue..................................................... 15
21
22
800
Unearned Service Revenue ............................................ Service Revenue.....................................................
700
Accounts Payable ........................................................... Cash ........................................................................
1,000
Cash
1,000
700
1,000
Service Revenue..................................................... 22
SM
1,000
1,100
Unearned Service Revenue ................................... 8
Credit
Supplies Expense ........................................................... Accounts Payable ..................................................
.., Solutions Manual
1,000 700
(For Instructor Use Only)
700
3-79
PROBLEM 0-8A (Continued) May
25
25
29
Advertising Expense ....................................................... Accounts Payable ..................................................
500
Utilities Expense ............................................................. Cash ........................................................................
400
Cash
500
400 1,700
Service Revenue..................................................... 29
31
31
31
SM
1,700
Unearned Service Revenue ............................................ Service Revenue.....................................................
600
Interest Expense ............................................................. Cash ........................................................................
50
Salaries and Wages Expense ......................................... Cash ........................................................................
1,200
Income Tax Expense ....................................................... Cash ........................................................................
150
.., Solutions Manual
600
50
1,200
(For Instructor Use Only)
150
3-80
PROBLEM 0-8A (Continued) (d)
PAMPER ME SALON INC. Trial Balance May 31, 2017
Cash .................................................................................. Supplies ............................................................................ Equipment......................................................................... Accounts payable ............................................................ Notes payable ................................................................... Unearned service revenue............................................... Common stock ................................................................. Retained earnings ............................................................ Service revenue ................................................................ Salaries and wages expense ........................................... Rent expense .................................................................... Supplies expense ............................................................. Advertising expense ........................................................ Utilities expense ............................................................... Interest expense ............................................................... Income tax expense ......................................................... Totals.............................................................................
Debit $ 5,100 500 24,000
Credit
$ 1,200 10,000 1,200 5,000 11,400 6,000 2,400 1,000 700 500 400 50 150 $34,800
$34,800
(Assets and Expenses have debit balances) LO 4 BT: AP Difficulty: Hard TOT: 55 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-81
PROBLEM 0-9A
Error
(a) In Balance
(b) Difference
(c) Larger Column
1.
No
$600
Debit
2.
Yes
None
N/A
3.
Yes
None
N/A
4.
No
$680
Credit
5.
Yes
None
N/A
6.
Yes
None
N/A
7.
No
$900
Debit
8.
Yes
None
N/A
LO 4 BT: AN Difficulty: Hard TOT: 35 min. AACSB: Analytic AICPA FC: Reporting
SM
.., Solutions Manual
(For Instructor Use Only)
3-82
PROBLEM 0-10A (a) 1. 2. 3.
Cash ................................................................................... Accounts Receivable .................................................
19,000
Unearned Sales Revenue ................................................. Sales Revenue ............................................................
23,000
Cash ................................................................................... Unearned Sales Revenue ..........................................
44,000
Unearned Sales Revenue ($44,000 – $20,000)......................................................... Sales Revenue ............................................................ 4. 5. (b)
19,000 23,000 44,000 24,000 24,000
Accounts Receivable ........................................................ Service Revenue ........................................................
151,000
Cash ................................................................................... Accounts Receivable ($151,000 – $15,000) ................
136,000
151,000 136,000
Cash received with respect to fees and dues 1. 3. 5.
1. 3. 5. 2017 Bal.
Collection of 2016 dues Sale of tickets Collection of 2017 dues
Cash 19,000 44,000 136,000 199,000
Accounts Receivable 2016 Bal. 19,000 4. 151,000 1. 19,000 5. 136,000 2017 Bal. 15,000
$ 19,000 44,000 136,000 $199,000
2. 3.
Unearned Sales Revenue 2016 Bal. 23,000 23,000 3. 44,000 24,000 2017 Bal. 20,000 Service Revenue 4. 2017 Bal.
151,000 151,000
Sales Revenue 2. 3. 2017 Bal.
23,000 24,000 47,000
LO 5 BT: AP Difficulty: Medium TOT: 30 min. AACSB Analytic AICPA FC: Reporting
PROBLEM 0-11A 1.
2.
3.
4.
Dec. 31
Dec. 31
Dec. 31
Dec. 31
Insurance Expense .................................................... Prepaid Insurance ............................................. [($9,600 ÷ 3) = $3,200 [($7,200 X 12/18) = 4,800 $8,000]
8,000
Unearned Rent Revenue ........................................... Rent Revenue .................................................... [[Nov. 5 X $5,000 X 2 = 50,000 [Dec. 4 X $8,500 X 1 = 34,000 $84,000]
84,000
Interest Expense ........................................................ Interest Payable ($40,000 X 7% X 3/12).....................................
700
Salaries and Wages Expense ................................... Salaries and Wages Payable............................ [5 X $600 X 3/5 = $1,800 [3 X $700 X 3/5 = 1,260 $3,060]
3,060
8,000
84,000
700
3,060
LO 5 BT: AP Difficulty: Medium TOT: 40 min. AACSB: Analytic AICPA FC: Reporting
PROBLEM 0-12A (a)
1.
2.
3.
Date 2017
Account Titles
Debit
June 30
Supplies Expense ................................................. Supplies ($2,000 – $720)..............................
1,280
Utilities Expense ................................................... Accounts Payable ........................................
180
Insurance Expense ...............................................
240
30
30
Credit
1,280
180
Prepaid Insurance ($2,880 ÷ 12 months)................................ 4.
5.
6.
7.
30
30
30
30
240
Unearned Service Revenue.................................. Service Revenue ..........................................
4,100
Salaries and Wages Expense .............................. Salaries and Wages Payable .......................
1,250
Depreciation Expense .......................................... Accumulated Depreciation— Equipment ................................................
250
Accounts Receivable ............................................ Service Revenue ..........................................
3,900
4,100
1,250
250
3,900
(b)
6/30 Bal.
Cash 6,850
Accounts Receivable 6/30 Bal. 7,000 6/30 3,900 6/30 Bal. 10,900
6/30 Bal. 6/30 Bal.
Supplies 2,000 6/30 720
1,280
6/30 Bal. 6/30 Bal.
Prepaid Insurance 2,880 6/30 2,640
240
PROBLEM 0-12A (Continued)
6/30 Bal.
Equipment 15,000
6/30 Bal.
Accumulated Depreciation— Equipment 6/30 250 6/30 Bal. 250
Accounts Payable 6/30 Bal. 6/30 6/30
4,230 180 4,410
Salaries and Wages Payable 6/30 1,250 6/30 Bal. 1,250
6/30
Unearned Service Revenue 4,100 6/30 Bal. 5,200 6/30 Bal. 1,100
Common Stock 6/30 Bal.
22,000
Service Revenue 6/30 Bal. 6/30 6/30 6/30 Bal.
8,300 4,100 3,900 16,300
Salaries and Wages Expense 6/30 Bal. 4,000 6/30 1,250 6/30 Bal. 5,250
Rent Expense 2,000
Depreciation Expense 6/30 250 6/30 Bal. 250
Insurance Expense 6/30 240 6/30 Bal. 240
6/30 6/30 Bal.
Utilities Expense 180 180
6/30 6/30 Bal.
Supplies Expense 1,280 1,280
PROBLEM 0-12A (Continued) (c)
KUMAR CONSULTING Adjusted Trial Balance June 30, 2017
Cash .................................................................................. Accounts Receivable ....................................................... Supplies ............................................................................ Prepaid Insurance ............................................................ Equipment......................................................................... Accumulated Depreciation—Equipment ........................ Accounts Payable ............................................................ Salaries and Wages Payable ........................................... Unearned Service Revenue ............................................. Common Stock ................................................................. Service Revenue .............................................................. Salaries and Wages Expense .......................................... Rent Expense ................................................................... Depreciation Expense ...................................................... Insurance Expense .......................................................... Utilities Expense .............................................................. Supplies Expense ............................................................
Debit $ 6,850 10,900 720 2,640 15,000
Credit
$
5,250 2,000 250 240 180 1,280 $45,310
(Total debits = Total credits) LO 6 BT: AP Difficulty: Medium TOT: 50 min. AACSB: Analytic AICPA FC: Reporting
250 4,410 1,250 1,100 22,000 16,300
$45,310
PROBLEM 0-13A
(a) 1.
2.
3.
4.
5.
6.
7.
June
30
30
30
30
30
30
30
Rent Revenue ............................................. Unearned Rent Revenue ................
57,000
Supplies Expense ...................................... Supplies ($8,200 – $1,800) .............
6,400
57,000
6,400
Insurance Expense ($14,400 X 3/12) ....................................... Prepaid Insurance...........................
3,600
Maintenance and Repairs Expense ..................................... Utilities Expense ........................................ Advertising Expense.................................. Accounts Payable ...........................
4,450 215 110
Salaries and Wages Expense ($300 X 4) ................................................. Salaries and Wages Payable ......................................... Interest Expense ($14,000 X 6% X 2/12) .............................. Interest Payable ............................. Income Tax Expense.................................. Income Taxes Payable ...................
3,600
4,775
1,200 1,200
140 140 13,400 13,400
PROBLEM 0-13A (Continued) (b)
ROADSIDE TRAVEL COURT Income Statement For the Quarter Ended June 30, 2017 Revenues Rent revenue ($212,000 – $57,000)..................................... Expenses Salaries and wages expense ($80,500 + $1,200) ............................................................. Income tax expense ............................................................ Maintenance and repairs expense ($4,300 + $4,450) ............................................................... Supplies expense ................................................................ Advertising expense ($3,800 + $110) ................................. Insurance expense .............................................................. Depreciation expense ............................................. 2,700 Utilities expense ($900 + $215) ........................................... Interest expense .................................................................. Total expenses..................................................................... Net income ...........................................................................
$155,000
$ 81,700 13,400 8,750 6,400 3,910 3,600 1,115 140 121,715 $ 33,285
(Revenues are recognized when a service has been provided and expenses are recognized when an asset has been used up or a service incurred.)
PROBLEM 0-13A (Continued) (c)
The generally accepted accounting principles pertaining to the income statement not recognized by Betty were the revenue recognition principle and the expense recognition principle. The revenue recognition principle states that revenue is recognized when the performance obligation is satisfied. The cash payments of $57,000 for summer rentals have not been earned and, therefore, should not be reported as income for the quarter ended June 30. The expense recognition principle dictates that efforts (expenses) be matched with accomplishments (revenue) whenever it is reasonable and practicable to do so. This means that the expenses should include amounts incurred in June but not paid until July, and any other costs related to the operations of the business during the period April–June. The difference in reported expenses was $29,515 ($121,715 – $92,200). The overstatement of revenues ($57,000) plus the understatement of expenses ($29,515) equals the difference in reported income of $86,515 ($119,800 – $33,285).
LO 7 BT: AN Difficulty: Hard TOT: 40 min. AACSB: Analytic AICPA FC: Measurement AICPA FC: Reporting
PROBLEM 0-14A (a), (c) & (e)
11/1 Bal. 11/10 11/12 11/29 11/30 Bal.
Cash 2,790 11/8 1,800 11/20 3,700 11/22 750 11/25 3,840
Accounts Receivable 11/1 Bal. 2,910 11/10 11/27 900 11/30 Bal. 2,010
11/1 Bal. 11/17 11/30 Bal.
Supplies 1,120 11/30 1,300 1,100
11/1 Bal. 11/15 11/30 Bal.
Equipment 10,000 3,600 13,600
1,220 2,500 480 1,000
1,800
1,320
Accumulated Depreciation—Equipment 11/1 Bal. 500 11/30 250 11/30 Bal. 750
11/20
11/30
Accounts Payable 2,500 11/1 Bal. 11/15 11/17 11/30 Bal.
2,300 3,600 1,300 4,700
Unearned Service Revenue 500 11/1 Bal. 11/29 11/30 Bal.
400 750 650
Salaries and Wages Payable 11/8 620 11/1 Bal. 11/30 11/30 Bal.
620 480 480
Common Stock 11/1 Bal. 11/30 Bal.
10,000 10,000
Retained Earnings 11/1 Bal. 11/30 Bal.
3,000 3,000
PROBLEM 0-14A (Continued) Service Revenue 11/12 11/27 11/30 11/30 Bal. Depreciation Expense 11/30 250 11/30 Bal. 250 Supplies Expense 11/30 1,320 11/30 Bal. 1,320
3,700 900 500 5,100
Salaries and Wages Expense 11/8 600 11/25 1,000 11/30 480 11/30 Bal. 2,080
11/22 11/30 Bal.
Rent Expense 480 480
PROBLEM 0-14A (Continued) (b) General Journal Date Nov.
8
10
Account Titles Salaries and Wages Payable ....................................... Salaries and Wages Expense ...................................... Cash ......................................................................
Debit 620 600
Cash
1,800
1,220
Accounts Receivable .......................................... 12
Cash
1,800 3,700
Service Revenue .................................................. 15
17
20
22
25
27
29
Credit
3,700
Equipment ..................................................................... Accounts Payable................................................
3,600
Supplies ........................................................................ Accounts Payable................................................
1,300
Accounts Payable......................................................... Cash ......................................................................
2,500
Rent Expense ................................................................ Cash ......................................................................
480
Salaries and Wages Expense ...................................... Cash ......................................................................
1,000
Accounts Receivable ................................................... Service Revenue ..................................................
900
Cash
750 Unearned Service Revenue ................................
3,600
1,300
2,500
480
1,000
900
750
PROBLEM 0-14A (Continued) (d) & (f)
SOHO EQUIPMENT REPAIR Trial Balances November 30, 2017 Before Adjustment
Cash ..................................................... Accounts Receivable .......................... Supplies ............................................... Equipment ........................................... Accumulated Depreciation— Equipment Accounts Payable ............................... Unearned Service Revenue ................ Salaries and Wages Payable .............. Common Stock .................................... Retained Earnings............................... Service Revenue ................................. Depreciation Expense ......................... Supplies Expense .............................. Salaries and Wages Expense ............ Rent Expense ......................................
Dr. $ 3,840 2,010 2,420 13,600
Cr.
$
After Adjustment Dr. $ 3,840 2,010 1,100 13,600
500 4,700 1,150
$
10,000 3,000 4,600
1,600 480 $23,950
$23,950
Cr.
250 1,320 2,080 480 $24,680
750 4,700 650 480 10,000 3,000 5,100
$24,680
PROBLEM 0-14A (Continued) (e) Nov. 30
30
30
30
(g)
Supplies Expense ....................................................... Supplies ($2,420 – $1,100) ................................
1,320
Salaries and Wages Expense .................................... Salaries and Wages Payable ............................
480
Depreciation Expense ................................................ Accumulated Depreciation-Equipment............
250
Unearned Service Revenue ....................................... Service Revenue ................................................
500
1,320
480
250
500
SOHO EQUIPMENT REPAIR Income Statement For the Month Ended November 30, 2017 Revenues Service revenue ........................................................... Expenses Salaries and wages expense ....................................... Supplies expense ......................................................... Rent expense ................................................................ Depreciation expense .................................................. Total expenses .................................................... Net income.............................................................................
( $5,100) $2,080 1,320 480 250 4,130) $ 970
SOHO EQUIPMENT REPAIR Retained Earnings Statement For the Month Ended November 30, 2017 Retained earnings, November 1 ......................................... Add: Net income .................................................................. Retained earnings, November 30 .......................................
$3,000 970 $3,970
PROBLEM 0-14A (Continued) SOHO EQUIPMENT REPAIR Balance Sheet November 30, 2017 Assets Current assets Cash ................................................................................. Accounts receivable ....................................................... Supplies ........................................................................... Total current assets ............................................... Property, plant and equipment Equipment ....................................................................... Less: Accumulated depreciation— equipment .......................................................... Total assets ............................................................
$ 3,840 2,010 1,100 $ 6,950 13,600 750
12,850 $19,800
Liabilities and Stockholders’ Equity Current liabilities Accounts payable ........................................................... Unearned service revenue ............................................. Salaries and wages payable ........................................... Total current liabilities ........................................... Stockholders’ equity Common stock ................................................................ Retained earnings ........................................................... Total stockholders’ equity ................................ Total liabilities and stockholders’ equity ...................................................................
$ 4,700 650 480 $ 5,830 10,000 3,970
(Ending retained earnings = Beginning retained earnings ± Changes to retained earnings) LO 7 BT: AP Difficulty: Hard TOT: 70 min. AACSB: Analytic AICPA FC: Reporting
13,970 $19,800
PROBLEM 0-15A
(a)
1.
2.
3.
May 31
31
31
31
4.
5.
6.
31
31
31
Insurance Expense ............................................. Prepaid Insurance ......................................
450
Supplies Expense ............................................... Supplies ($2,600 – $1,050) .........................
1,550
Depreciation Expense ($3,600 X 1/12) ................................................. Accumulated Depreciation— Building................................................... Depreciation Expense ($3,000 X 1/12) ................................................. Accumulated Depreciation— Equipment ..............................................
450
1,550
300 300
250 250
Interest Expense ................................................. Interest Payable [($36,000 X 6%) X 1/12] ..........................
180
Unearned Rent Revenue .................................... Rent Revenue .............................................
2,500
Salaries and Wages Expense............................. Salaries and Wages Payable .....................
900
180
2,500
900
(b) 5/31 Bal.
Cash 2,500
5/31 Bal. 5/31 Bal.
Supplies 2,600 5/31 1,050
5/31 Bal. 5/31 Bal. 1,550 5/31 Bal.
Prepaid Insurance 1,800 5/31 1,350 Land 15,000
450
PROBLEM 0-15A (Continued)
5/31 Bal.
Building 70,000
Accumulated Depreciation— Building 5/31 300 5/31 Bal. 300
5/31 Bal.
Equipment 16,800
Accumulated Depreciation— Equipment 5/31 250 5/31 Bal. 250 Accounts Payable 5/31 Bal.
5/31
4,700
Salaries and Wages Payable 5/31 5/31 Bal. Interest Payable 5/31 5/31 Bal.
3,300 800
36,000
Common Stock 5/31 Bal.
60,000
Rent Revenue 5/31 Bal. 5/31 5/31 Bal.
9,000 2,500 11,500
Salaries and Wages Expense 5/31 Bal. 3,000 5/31 900 5/31 Bal. 3,900
5/31 Bal. Unearned Rent Revenue 2,500 5/31 Bal. 5/31 Bal.
Mortgage Payable 5/31 Bal.
Utilities Expense 800
Advertising Expense 5/31 Bal. 500 Interest Expense 180 180
900 900
5/31 5/31 Bal.
180 180
Insurance Expense 5/31 450 5/31 Bal. 450
PROBLEM 0-15A (Continued)
5/31 5/31 Bal.
Supplies Expense 1,550 1,550
Depreciation Expense 5/31 300 5/31 250 5/31 Bal. 550
(c)
MOTO HOTEL Adjusted Trial Balance May 31, 2017
Cash .................................................................................. Supplies ............................................................................ Prepaid Insurance ............................................................ Land .................................................................................. Building ............................................................................. Accumulated Depreciation—Building ............................ Equipment......................................................................... Accumulated Depreciation—Equipment ........................ Accounts Payable ............................................................ Unearned Rent Revenue .................................................. Salaries and Wages Payable ........................................... Interest Payable ................................................................ Mortgage Payable ............................................................ Common Stock ................................................................. Rent Revenue ................................................................... Salaries and Wages Expense .......................................... Utilities Expense .............................................................. Advertising Expense ........................................................ Interest Expense .............................................................. Insurance Expense .......................................................... Supplies Expense ............................................................ Depreciation Expense ......................................................
(Total debits = Total credits)
Debit $ 2,500 1,050 1,350 15,000 70,000
Credit
$
300
16,800 250 4,700 800 900 180 36,000 60,000 11,500 3,900 800 500 180 450 1,550 550 $114,630
$114,630
PROBLEM 0-15A (Continued) (d)
MOTO HOTEL Income Statement For the Month Ended May 31, 2017 Revenues Rent revenue................................................................ Expenses Salaries and wages expense ...................................... Supplies expense ........................................................ Utilities expense .......................................................... Depreciation expense ................................................. Advertising expense ................................................... Insurance expense ...................................................... Interest expense .......................................................... Total expenses ................................................... Net income ............................................................................
$11,500 $3,900 1,550 800 550 500 450 180 7,930 $ 3,570
MOTO HOTEL Retained Earnings Statement For the Month Ended May 31, 2017 Retained earnings, May 1 .................................................... Add: Net income ................................................................. Retained earnings, May 31 ..................................................
$
0 3,570 $3,570
PROBLEM 0-15A (Continued) MOTO HOTEL Balance Sheet May 31, 2017 Assets Current Assets Cash ............................................................. $ 2,500 Supplies ....................................................... Prepaid insurance ....................................... Total current assets ........................... Property, plant, and equipment Land ............................................................. 15,000 Building ........................................................ $70,000
1,050 1,350 $
4,900
Less: Accumulated deprec.—Building .................................... Equipment.................................................... Less: Accumulated deprec.—equipment ................................. Total assets ........................................
300 16,800
69,700
250
16,550
101,250 $106,150
Liabilities and Stockholders’ Equity Current Liabilities Accounts payable ........................................................ $ 4,700 Salaries and wages payable ....................................... 900 Unearned rent revenue ................................................ 800 Interest payable ........................................................... 180 Total current liabilities ........................................ $ 6,580 Long-term Liabilities Mortgage payable ........................................................ 36,000 Total liabilities ..................................................... 42,580 Stockholders’ equity Common stock ............................................................. 60,000 Retained earnings ........................................................ 3,570 Total stockholders’ equity ......................... 63,570 Total liabilities and stockholders’ equity ............................................................... $106,150 (Ending retained earnings = Beginning retained earnings ± Changes to retained earnings)
PROBLEM 0-15A (Continued) (e)
The following accounts would be closed: Rent Revenue, Salaries and Wages Expense, Utilities Expense, Advertising Expense, Interest Expense, Insurance Expense, Supplies Expense, Depreciation Expense.
LO 8 BT: AP Difficulty: Hard TOT: 60 min. AACSB: Analytic AICPA FC: Reporting
PROBLEM 0-16A (a)
Sept. 30
30
30
30
30
30
30
(b)
Accounts Receivable ................................................ Service Revenue...............................................
600
Rent Expense............................................................. Prepaid Rent .....................................................
900
Supplies Expense...................................................... Supplies ............................................................
1,020
Depreciation Expense ............................................... Accum. Depreciation—Equipment..................
350
Interest Expense........................................................ Interest Payable ................................................
50
Unearned Rent Revenue ........................................... Rent Revenue ...................................................
200
Salaries and Wages Expense ................................... Salaries and Wages Payable ...........................
600
600
900
1,020
350
50
200
600
SALT CREEK GOLF INC. Income Statement For the Quarter Ended September 30, 2017 Revenues Service revenue ........................................................... Rent revenue................................................................ Total revenues .................................................... Expenses Salaries and wages expense ...................................... Rent expense ............................................................... Supplies expense ........................................................ Utilities expense .......................................................... Depreciation expense ................................................. Interest expense .......................................................... Total expenses ................................................... Net income ............................................................................
$14,700 900 $15,600 9,400 1,800 1,020 470 350 50 13,090 $ 2,510
PROBLEM 0-16A (Continued) SALT CREEK GOLF INC. Retained Earnings Statement For the Quarter Ended September 30, 2017 Retained earnings, July 1, 2017 .................................................................. Add: Net income......................................................................................... Less: Dividends ........................................................................................... Retained earnings, September 30, 2017 .....................................................
$
0 2,510 2,510 600 $1,910
SALT CREEK GOLF INC. Balance Sheet September 30, 2017 Assets Current Assets Cash ............................................................................ Accounts receivable .................................................. Supplies ...................................................................... Prepaid rent ................................................................ Total current assets .......................................... Property, Plant and Equipment Equipment ................................................................... Less: Accumulated depreciation— equipment ...................................................... Total assets ........................................................
$ 6,700 1,000 180 900 $ 8,780 15,000 350
14,650 $23,430
Liabilities and Stockholders’ Equity Current Liabilities Notes payable ............................................................. Accounts payable ....................................................... Unearned rent revenue .............................................. Salaries and wages payable ...................................... Interest payable .......................................................... Total current liabilities ...................................... Stockholders’ equity Common stock ........................................................... Retained earnings ...................................................... Total stockholders’ equity ............................ Total liabilities and stockholders’ equity ..............................................................
$ 5,000 1,070 800 600 50 $ 7,520 14,000 1,910 15,910 $23,430
(Ending retained earnings = Beginning retained earnings ± Changes to retained earnings)
PROBLEM 0-16A (Continued) (c) The following accounts would be closed: Service Revenue, Rent Revenue, Salaries and Wages Expense, Rent Expense, Utilities Expense, Depreciation Expense, Supplies Expense, Interest Expense, Dividends. (d)
Interest of 12% per year equals a monthly rate of 1%; monthly interest
is $50 ($5,000 X 1%). Since total interest payable is $50, the note has been outstanding one month. LO 8 BT: AP Diffciulty: Hard TOT: 50 min. AACSB: Analytic AICPA FC: Reporting
Chapter 1 Financial Accounting and Accounting Standards Assignment Classification Table (By Topic) Topics
Questions
1.
Environment of accounting, principles, objectives, standards, accounting theory.
2.
7. 8.
Authoritative 5,6, 7,8 pronouncements and rule-making bodies. Conceptual framework9, 10 general, objective of financial reporting. Qualitative characteristics of 11,12, 13, 14, accounting. 15, 16,17 Elements of 18, 19 financial statements. Basic assumptions and 20, 21, 22, 23, principles. 24, 25, 26, 27, 28, 29, 30,31 Cost constraint. 32,33,34 Role of pressure groups. 35, 36
9.
Ethical issues.
3.
4. 5.
6.
1,2, 3,4
37, 38,39,40
Brief Exercises
Exercises
Critical Thinking
1
1
1
2
2
2
3
3,4
3,4, 5, 6, 7
4,5,6
5, 10
8, 9
7
10, 11, 12, 13, 14
4, 8, 9, 10, 11, 12
6, 7, 8, 9, 11
12, 14, 15, 16, 17 13
Assignment Classification Table (By Learning Objective) Learning Objectives
Questions
Brief Exercises
Exercises
Critical Thinking
1.
Describe the financial reporting environment, major standardsetting bodies, and the meaning of generally accepted accounting principles (GAAP).
1, 2, 3, 4, 5, 6, 7, 8
1, 2
1, 2
2.
Describe the components and usefulness of the conceptual framework.
9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19
3, 5, 6, 7, 8,9
3, 4, 5, 6, 7
2,3,4, 5, 10
3.
Discuss the basic assumptions and principles of accounting.
4, 10, 11, 12, 13, 14
8, 9, 10, 11, 12
6, 7, 8, 9, 11, 12
4.
Identify the major challenges in the financial reporting environment.
20, 21, 22, 23, 24, 25, 26, 27, 28, 29, 31, 32, 33, 34 30, 35, 36, 37, 38, 39,40
2
11, 13, 14, 15, 16
1
Assignment Characteristics Table (Time on Task) Item
Description
Level of Difficulty
Time (minutes)
E1.1 E1.2 E1.3 E1.4
Simple Simple Simple Simple
15-20 15-20 15-20 15-20
E1.5 E1.6 E1.7 E1.8 E1.9 E1.10 E1.11 E1.12
Need for GAAP. Financial reporting and accounting standards. Usefulness, objective of financial reporting. Usefulness, objective of financial reporting, qualitative characteristics. Qualitative characteristics. Qualitative characteristics. Elements of financial statements. Assumptions, principles, and constraint. Assumptions, principles, and constraint. Full disclosure principle. Accounting principles and assumptionscomprehensive. Accounting principles-comprehensive.
Moderate Simple Simple Simple Moderate Complex Moderate Moderate
20-30 15-20 15-20 15-20 20-25 20-25 20-25 20-25
CT1.1 CT1.2 CT1.3 CT1.4 CT1.5 CT1.6 CT1.7 CT1.8 CT1.9 CT1.10 CT1.11 CT1.12 CT1.13 CT1.14 CT1.15 CT1.16
Securities and Exchange Commission. Conceptual framework-general. Conceptual framework-general. Objective of financial reporting. Qualitative characteristics. Revenue recognition principle. Expense recognition principle. Expense recognition principle. Expense recognition principle. Qualitative characteristics. Expense recognition principle. Cost Constraint. Rule-making Issues. Models for setting GAAP. Economic consequences. GAAP and economic consequences.
Moderate Simple Simple Moderate Moderate Complex Complex Moderate Moderate Moderate Moderate Moderate Complex Simple Moderate Moderate
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Answers to Questions 1.
If a company’s financial performance is measured accurately, fairly, and on a timely basis, the right managers and companies can attract investment capital. Unreliable and irrelevant information leads to poor capital allocation, which adversely affects the efficiency of the securities market.
LO: 1, Bloom: K, Difficulty: Simple, Time: 1-3, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
2.
The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity through equity investments and loans or other forms of credit. Information that is decision-useful to capital providers (investors) may also be useful to other users of financial reporting who are not investors.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
3.
Investors are interested in financial reporting because it provides information that is useful for making decisions (referred to as the decision-usefulness approach). When making these decisions, investors are interested in assessing the company’s (1) ability to generate net cash inflows and (2) management’s ability to protect and enhance the capital providers’ investments. Financial reporting should therefore help investors assess the amounts, timing, and uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans. For investors to make these assessments, the economic resources of an enterprise, the claims to those resources, and the changes in them must be understood.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
4.
A common set of financial accounting and reporting standards applied by all businesses and entities should produce financial statements which are reasonably comparable. Without a common set of standards, each enterprise could, and would, develop a theory structure and set of practices, resulting in noncomparability among the financial statements of enterprises.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
5.
The SEC has the power to prescribe, in whatever detail it desires, the accounting practices and principles to be employed by companies that fall within its jurisdiction. Because the SEC receives audited financial statements from nearly all companies that issue securities to the public or are listed on stock exchanges, it is greatly interested in the content, accuracy, and credibility of the statements. For many years, the SEC relied on the AICPA to regulate the profession and develop and enforce accounting principles. Lately, the SEC has assumed a more active role in the development of accounting standards, especially in the area of disclosure requirements. In December 1973, in ASR No. 150, the SEC said the FASB’s statements would be presumed to carry substantial authoritative support and anything contrary to them to lack such support. It thereby supports the development of accounting principles in the private sector.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
6.
The explanation should note that generally accepted accounting principles or standards have “substantial authoritative support.” They consist of accounting practices, procedures, concepts, and methods that are recognized by a large majority of practicing accountants as well as other members of the business and financial community. Statements issued by the Financial Accounting Standards Board constitute “substantial authoritative support.”
LO: 1, Bloom: K, Difficulty: Simple, 5-10, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 1 (Continued) 7.
The FASB Accounting Standards Codification (Codification) is a compilation of all GAAP in one place. Its purpose is to integrate and synthesize existing GAAP, not to create new GAAP. It creates one level of GAAP which is considered authoritative. The FASB Codification Research Systems (CRS) is an online real-time database that provides easy access to the Codification. The Codification and the related CRS provide a topically organized structure that is subdivided into topics, subtopics, sections, and paragraphs.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
8.
It is hoped that the Codification will help users to better understand what GAAP is. If this occurs, companies will be more likely to comply with GAAP and the time to research accounting issues will be substantially reduced. In addition, through the electronic web-based format, GAAP can be easily updated which will help users stay current.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
9.
A conceptual framework is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements. A conceptual framework is necessary for financial accounting for the following reasons: (1) It enables the FASB to issue more useful and consistent standards in the future. (2) New issues will be more quickly solvable by reference to an existing framework of basic theory. (3) It increases financial statement users’ understanding of and confidence in financial reporting. (4) It enhances comparability among companies’ financial statements.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
10. The objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
11. “Qualitative characteristics of accounting information” are those characteristics that contribute to the quality or value of the information. The overriding qualitative characteristic of accounting information is usefulness for decision-making. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
12. Relevance and faithful representation are the two fundamental qualities of useful accounting information. For information to be relevant, it should be capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations. Faithful representation rests on whether the numbers and descriptions match what really existed or happened. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 1 (Continued) 13. The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure, proper presentation of financial position, and the results of operations. Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size enter into its evaluation. An accounting misstatement is said to be material if knowledge of the misstatement could affect the decisions of the average informed reader of the financial statements. Financial statements are misleading if they omit a material fact or include so many immaterial matters as to be confusing. In the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative risk and disregards immaterial items. The relevant criteria for assessing materiality will depend upon the circumstances and the nature of the item and will vary greatly among companies. For example, an error in current assets or current liabilities will be more important for a company with a flow of funds problem than for one with adequate working capital. The effect upon net income (or earnings per share) is the most commonly used measure of materiality. This reflects the prime importance attached to net income by investors and other users of the statements. The effects upon assets and equities are also important, as are misstatements of individual accounts and subtotals included in the financial statements. The FASB defines materiality to be consistent with the legal concept of materiality, as established in the securities laws. Specifically, information is material “if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information.” There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality has been variously estimated at 5% of net income, but the determination will vary based upon the individual case and might not fall within these limits. Certain items, such as a questionable loan to a company officer, may be considered material even when minor amounts are involved. In contrast, a large misclassification among expense accounts may not be deemed material if there is no misstatement of net income. LO: 2, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
14. The enhancing characteristics are comparability, verifiability, timeliness, and understandability. Enhancing qualities are qualitative characteristics that are complementary to the fundamental qualitative characteristics. These characteristics distinguish more useful information from less useful information. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
15. In providing information to users of financial statements, the FASB relies on general-purpose financial statements. The intent of such statements is to provide the most useful information possible at minimal cost to various user groups. Underlying these objectives is the notion that a user needs a reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important. It means that in the preparation of financial statements, a level of reasonable competence for the user can be assumed; this has an impact on the way and the extent to which information is reported. LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: AICPA AC: Reporting, AICPA PC: Communication
16. Comparability facilitates comparisons between information about two different enterprises at a particular point in time. Consistency, a type of comparability, facilitates comparisons between information about the same enterprise at two different points in time. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 1 (Continued) 17. The accounting literature contains many terms that have specific meanings. Some of these terms have been in use for a long time, and their meanings have changed over time. Since the elements of financial statements are the building blocks with which the statements are constructed, it is necessary to develop a basic definitional framework for them. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
18. Distributions to owners differ from expenses and losses in that they represent transfers to owners, and they do not arise from activities intended to produce income. Expenses differ from losses in that they arise from the entity’s ongoing major or central operations. Losses arise from peripheral or incidental transactions. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
19. Investments by owners differ from revenues and gains in that they represent transfers by owners to the entity, and they do not arise from activities intended to produce income. Revenues differ from gains in that they arise from the entity’s ongoing major or central operations. Gains arise from peripheral or incidental transactions. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
20. The four basic assumptions that underlie the financial accounting structure are: (1) The economic entity assumption. (2) The going concern assumption. (3) The monetary unit assumption. (4) The periodicity assumption. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
21. (a) In accounting, it is generally agreed that any measures of the success of an enterprise for periods less than its total life are at best provisional and subject to correction. Measurement of progress and status for arbitrary time periods is a practical necessity to serve those who must make decisions. It is not the result of postulating specific time periods as measurable segments of total life. (b) The practice of periodic measurement has led to many of the most difficult accounting problems, such as inventory pricing, depreciation of long-term assets, and the necessity for revenue recognition tests. The accrual system calls for associating related revenues and expenses. This becomes difficult for an arbitrary time period with incomplete transactions in process at both the beginning and the end of the period. Many accounting practices such as adjusting entries or the reporting of corrections of prior periods result directly from efforts to make each period’s calculations as accurate as possible and yet recognizing that they are only provisional. LO: 3, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
22. The monetary unit assumption assumes that the unit of measure (the dollar) remains reasonably stable so that dollars of different years can be added without any adjustment. When the value of the dollar fluctuates greatly over time, the monetary unit assumption loses its validity. The FASB in Concept No. 5 indicated that it expects the dollar unadjusted for inflation or deflation to be used to measure items recognized in financial statements. Only if circumstances change dramatically will the FASB consider a more stable measurement unit. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 1 (Continued) 23. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is, therefore, a market-based measure. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: AICPA PC: None
24. The fair value hierarchy provides insight into the priority of valuation techniques that are used to determine fair value. The fair value hierarchy is divided into three broad levels. Fair Value Hierarchy Level 1: Observable inputs that reflect quoted prices for identical assets or liabilities in active markets.
Least Subjective
Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3: Unobservable inputs (for example, a company’s own data or assumptions).
Most Subjective
As indicated, Level 1 is the most reliable because it is based on quoted prices, such as a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. At the least-reliable level, Level 3, much judgment is needed based on the best information available to arrive at a relevant and representationally faithful fair value measurement. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
25. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case of selling a product, the performance obligation is met when the product is delivered. Companies follow a five-step process to analyze revenue arrangements to determine when revenue should be recognized: (1) Identify the contract(s) with the customer; (2) Identify the separate performance obligations in the contract; (3) Determine the transaction price; (4) Allocate the transaction price to separate performance obligations, and; (5) Recognize revenue when each performance obligation is satisfied. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
26. A performance obligation is a promise to deliver a product or provide a service to a customer. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case of selling a product, the performance obligation is met when the product is delivered. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
Questions Chapter 1 (Continued) 27. The five steps in the revenue recognition process are: Step 1
Identify the contract(s) with the customer. A contract is an agreement between two parties that creates enforceable rights or obligations.
Step 2
Identify the separate performance obligations in the contract. A performance obligation is either a promise to provide a service or deliver a product, or both.
Step 3. Determine the transaction price. The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring a good or service. Step 4. Allocate the transaction price to separate performance obligations. This is usually done by estimating the value of consideration attributable to each product or service. Step 5. Recognize revenue when each performance obligation is satisfied. This occurs when the service is provided or the product is delivered. Note that many revenue transactions pose few problems because the transaction is initiated and completed at the same time. LO: 3, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
28. Revenues are recognized when a performance obligation is satisfied–in the case of services, revenue is recognized when the services are performed. Therefore, revenue for Selane Eatery should be recognized at the time the luncheon is served. LO: 3, Bloom: AN, Difficulty: Simple, Time: 3-5, Analytic, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
29. The cause and effect relationship can seldom be conclusively demonstrated, but many costs appear to be related to particular revenues, and recognizing them as expenses accompany recognition of the revenue. Examples of expenses that are recognized by associating cause and effect are sales commissions and the cost of products sold or services provided. Systematic and rational allocation means that in the absence of a direct means of associating cause and effect, and where the asset provides benefits for several periods, its cost should be allocated to the periods in a systematic and rational manner. Examples of expenses that are recognized in a systematic and rational manner are depreciation of plant assets, amortization of intangible assets, and allocation of rent and insurance. Some costs are immediately expensed because the costs have no discernible future benefits or the allocation among several accounting periods is not considered to serve any useful purpose. Examples include officers’ salaries, most selling costs, amounts paid to settle lawsuits, and costs of resources used in unsuccessful efforts. LO: 3, Bloom: AN, Difficulty: Simple, Time: 5-7, Analytic, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
30. (a) To be recognized in the main body of financial statements, an item must meet the definition of an element. In addition, the item must have been measured, recorded in the books, and passed through the double-entry system of accounting. (b) Information provided in the notes to the financial statements amplifies or explains the items presented in the main body of the statements and is essential to an understanding of the performance and position of the enterprise. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. (c) Supplementary information includes information that presents a different perspective from that adopted in the financial statements. It also includes management’s explanation of the financial information and a discussion of the significance of that information. LO: 4, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
Questions Chapter 1 (Continued)
31. The general guide followed with regard to the full disclosure principle is to disclose in the financial statements any facts of sufficient importance to influence the judgment of an informed reader. The fact that the amount of outstanding common stock doubled in January of the subsequent reporting period probably should be disclosed because such a situation is of importance to present stockholders. Even though the event occurred after December 31, 2025 (referred to as a subsequent event), it should be disclosed on the balance sheet as of December 31, 2025, in order to make adequate disclosure. (The major point that should be emphasized throughout the entire discussion on full disclosure is that there is normally no “black” or “white” but varying shades of grey and it takes experience and good judgment to arrive at an appropriate answer). LO: 3, Bloom: AN, Difficulty: Simple, Time: 3-5, Analytic, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
32. Accounting information is subject to the cost constraint. Information should not be provided unless the benefits exceed the costs of preparing it. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, Analytic, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
33. The costs of providing accounting information include costs of collecting and processing, disseminating, auditing, potential litigation, disclosure to competitors, and analysis and interpretation. Benefits to preparers may include greater management control and access to capital at a lower cost. Users may receive better information for allocation of resources, tax assessment, and rate regulation. Occasionally new accounting standards require the presentation of information that is not readily assembled by the accounting systems of most companies. A determination should be made as to whether the incremental or additional costs of providing the proposed information exceed the incremental benefits to be obtained. This determination requires careful judgment since the benefits of the proposed information may not be readily apparent. LO: 3, Bloom: AN, Difficulty: Simple, Time: 3-5, Analytic, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
34. In general, conservatism should not be the basis for determining the accounting for transactions because it conflicts with the conceptual framework quality of neutrality. (a) Acceptable if reasonably accurate estimation is possible. To the extent that warranty costs can be estimated accurately, they should be recorded when an obligation exists, usually in the period of the sale. (b) Not acceptable. Most accounts are collectible, or the company will be out of business very soon. Hence, sales can be recorded when made. Also, other companies record sales when made rather than when collected, so if accounts for Landowska Co. are to be compared with other companies, they must be kept on a comparable basis. However, estimates for uncollectible accounts should be recorded if there is a reasonably accurate basis for estimating bad debts. (c) Not acceptable. A provision for the possible loss can be made through an appropriation of retained earnings, but until judgment has been rendered on the suit or it is otherwise settled, entry of the loss usually represents anticipation. Recording it earlier is probably an unwise legal strategy as well. For the loss to be recognized at this point, the loss would have to be probable and reasonably estimable. (See FASB ASC 450-10-05 for additional discussion if desired.) Note disclosure is required if the loss is not recorded. LO: 3, Bloom: AN, Difficulty: Simple, Time: 3-5, Analytic, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
35. The sources of pressure are innumerable, but the most intense and continuous pressure to change or influence accounting principles or standards come from individual companies, industry associations, governmental agencies, practicing accountants, academicians, professional accounting organizations, and public opinion. LO: 4, Bloom: K, Difficulty: Simple, 5-10, AACSB: Communication, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 1 (Continued) 36. Economic consequences mean the impact of accounting reports on the wealth positions of issuers and users of financial information and the decision-making behavior resulting from that impact. In other words, accounting information impacts various users in many different ways, which leads to wealth transfers among these various groups. If politics plays an important role in the development of accounting rules, the rules will be subject to manipulation to further whatever policy prevails at the moment. No matter how well-intentioned the rule maker may be, if the information is designed to indicate that investing in a particular enterprise involves less risk than it actually does, or is designed to encourage investment in a particular segment of the economy, financial reporting will suffer an irreplaceable loss of credibility. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: Communication
37
Concern exists about fraudulent financial reporting because it can undermine the entire financial reporting process. Failure to provide accurate information to users can lead to inappropriate allocations of resources in our economy. In addition, failure to detect massive fraud can lead to additional governmental oversight of the accounting profession.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: Communication
38. The expectations gap is the difference between what people think accountants should be doing and what accountants think they can do. It is a difficult gap to close. The accounting profession recognizes it must play an important role in narrowing this gap. To meet the needs of society, the profession is continuing its efforts in developing accounting standards, such as numerous pronouncements issued by the FASB, to serve as guidelines for recording and processing business transactions in the changing economic environment. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
39. Some major challenges facing the accounting profession relate to the following items: Nonfinancial measurement—how to report significant key performance measurements such as customer satisfaction indexes, backlog information and reject rates on goods purchased. Forward-looking information—how to report more future-oriented information. Soft assets—how to report on intangible assets, such as market know-how, market dominance, and well-trained employees. Timeliness—how to report more real-time information. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
40. Accountants must perceive the ethical dimensions of some situations because GAAP does not define or cover all specific features that are to be reported in financial statements. In these instances, accountants must choose among alternatives. These accounting choices influence whether particular stakeholders may be harmed or benefited. Ethical decision-making involves awareness of potential harm or benefit and taking responsibility for the choices. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Ethics, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Ethical Conduct
Solutions to Brief Exercises Brief Exercise 1.1 1. 2. 3. 4.
True False. Any company claiming compliance with GAAP must comply with all standards and interpretations, including disclosure requirements. True False. In establishing financial accounting standards, the FASB relies on two basic premises: (1) the FASB should be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession, and (2) it should operate in full view of the public through a “due process” system that gives interested people ample opportunities to make their view known.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: None, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.2 (a) AICPA. American Institute of Certified Public Accountants. The national organization of practicing certified public accountants. (b) FAF. Financial Accounting Foundation. An organization whose purpose is to select members of the FASB and its Advisory Councils, fund their activities, and exercise general oversight. (c) FASAC. Financial Accounting Standards Advisory Council. An organization whose purpose is to consult with the FASB on issues, project priorities, and select task forces. (d) GAAP. Generally Accepted Accounting Principles. A common set of standards, principles, and procedures which have substantial authoritative support and have been accepted as appropriate because of universal application. (e) CPA. Certified Public Accountant. An accountant who has fulfilled certain education and experience requirements and passed a rigorous examination. Most CPAs offer auditing, tax, and management consulting services to the general public. (f)
FASB. Financial Accounting Standards Board. The primary body that currently establishes and improves financial accounting and reporting standards for the guidance of issuers, auditors, users, and others.
(g) SEC. Securities and Exchange Commission. An independent regulatory agency of the United States government which administers the Securities Acts of 1933 and 1934 and other acts. (h) IASB. International Accounting Standards Board. An international group, formed in 2001 (replacing a predecessor body that was formed in 1973), actively developing and issuing accounting standards that will have international appeal and hopefully support. LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-10, AACSB: None, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.3 (a) (b) (c) (d) (e)
5. Comparability 8. Timeliness 3. Predictive value 1. Relevance 7. Neutrality
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 1.4 (a) (b) (c) (d) (e)
5. Faithful representation 8. Confirmatory value 3. Free from error 2. Completeness 4. Understandability
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 1.5 (a)
If the company changed its method for inventory valuation, the consistency, and therefore the comparability, of the financial statements have been affected by a change in the method of applying the accounting principles employed. The change would require comment in the auditor’s report in an explanatory paragraph.
(b)
If the company disposed of one of its two subsidiaries that had been included in its consolidated statements for prior years, no comment as to consistency needs to be made in the CPA’s audit report. The comparability of the financial statements has been affected by a business transaction, but there has been no change in any accounting principle employed or in the method of its application. (The transaction would probably require informative disclosure in the financial statements).
BE 1.5 (Continued) (c)
If the company reduced the estimated remaining useful life of plant property because of obsolescence, the comparability of the financial statements has been affected. The change is not a matter of consistency; it is a change in accounting estimate required by altered conditions and involves no change in accounting principles employed or in their method of application. The change might be disclosed by a note in the financial statements if the effect was material. If commented upon in the audit report, it would be a matter of disclosure rather than consistency.
LO: 2, Bloom: AN, Difficulty: Hard, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Brief Exercise 1.6 (a) (b) (c) (d)
Verifiability Comparability Comparability (consistency) Timeliness
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.7 Companies and their auditors, for the most part, have adopted the general rule of thumb that anything under 5% of net income is considered not material. Recently, the SEC has indicated that it is okay to use this percentage for the initial assessment of materiality, but other factors must be considered. For example, companies can no longer fail to record items to meet consensus analyst’s earnings numbers, preserve a positive earnings trend, convert a loss to a profit or vice versa, increase management compensation, or hide an illegal transaction like a bribe. In other words, both quantitative and qualitative factors must be considered in determining when an item is material. (a)
Because the change was used to create a positive trend in earnings, the change is considered material.
(b)
Each item must be considered separately and not netted. Therefore, each transaction is considered material.
BE 1.7 (Continued) (c)
In general, companies that follow an “expense all capital items below a certain amount” policy are not in violation of the materiality concept. Because the same practice has been followed from year to year, Damon’s actions are acceptable.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.8 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j)
Equity Revenues Equity Assets Expenses Losses Liabilities Distributions to owners Gains Investments by owners
LO: 2, Bloom: K, Difficulty: Simple, Time: 7-10, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.9 (a)
Debit to the Land account, as it is a cost incurred in acquiring land.
(b)
Debit to an asset account, preferably Land Improvements. The driveway will last for many years, and therefore should be capitalized and depreciated.
(c)
Debit to an asset account, preferably Equipment, as the machine will last for a number of years and contribute to the operations of those years.
(d)
If the fiscal year ends December 31, this expenditure will be an expense of the current year so will be debited to an expense account. If financial statements are prepared on some date before December 31, part of this cost would be an expense and part would be an asset. Depending upon the circumstances, the original entry, as well as the adjusting entry for statement purposes, should take the financial statement date into account.
BE 1.9 (Continued) (e)
Debit to the Building account, as it is a part of the cost of that plant asset which will contribute to operations for many years.
(f)
Debit to an expense account, as the service has already been received; the contribution to operations occurred in this period.
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.10 (a) (b) (c) (d)
Periodicity Monetary unit Going concern Economic entity
LO: 3, Bloom: K, Difficulty: Moderate, Time: 5-10, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.11 (a)
Net realizable value.
(b)
Would not be disclosed.
(c)
Would not be disclosed. Depreciation would be inappropriate if the going concern assumption no longer applies.
(d)
Net realizable value.
(e)
Net realizable value (i.e., redeemable value).
LO: 3, Bloom: K, Difficulty Moderate, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.12 (a) (b) (c) (d)
Revenue recognition Expense recognition Full disclosure Measurement (historical cost)
LO: 3, Bloom: K, Difficulty: Moderate, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.13 Investment (1)—Level 3 Investment (2)—Level 1 Investment (3)—Level 2 LO: 3, Bloom: AN, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 1.14 (a) (b) (c)
Full disclosure Expense recognition Historical cost
LO: 3, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 1.1 It is not appropriate to abandon mandatory accounting rules and allow each company to voluntarily disclose the type of information it considers important. Without a coherent body of accounting theory and standards, each accountant or enterprise would have to develop its own theory structure and set of practices, and readers of financial statements would have to familiarize themselves with every company’s peculiar accounting and reporting practices. As a result, it would be almost impossible to prepare state-ments that could be compared. In addition, voluntary disclosure may not be an efficient way of disseminating information. A company is likely to disclose less information if it has the discretion to do so. Thus, the company can reduce its cost of assembling and disseminating information. However, an investor wishing additional information has to pay to receive additional information desired. Different investors may be interested in different types of information. Since the company may not be equipped to provide the requested information, it would have to spend additional resources to fulfill such needs; or the company may refuse to furnish such information if it is too costly to do so. As a result, investors may not get the desired information or they may have to pay a significant amount of money for it. Furthermore, redundancy in gathering and distributing information occurs when different investors ask for the same information at different points in time. To society as a whole, this would not be an efficient way of utilizing resources. LO: 1, 4, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Reflective Thinking, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: None
Exercise 1.2 1. 2. 3. 4. 5. 6. 7. 8.
(d) (d) (d) (a) (a) (b) (d) (b)
LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, AICPA BC: None, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: None
Exercise 1.3 (a) (b)
(c)
True. False – General-purpose financial reports help users who lack the ability to demand all the financial information they need from an entity and, therefore, must rely on, at least partly, the information in financial reports. False – Standard-setting based on personal conceptual frameworks will lead to different conclusions about identical or similar issues. As a result, standards will not be consistent with one another, and past decisions may not be indicative of future ones.
Exercise 1.3 (Continued) (d) (e) (f)
False – Information that is decision-useful to capital providers may also be useful to users of financial reporting who are not capital providers. False – An implicit assumption is that all users need reasonable knowledge of business and financial accounting matters to understand the information contained in the financial statements. True.
LO: 2 Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: None
Exercise 1.4 (a) (b) (c) (d) (e) (f)
False – The fundamental qualitative characteristics that make accounting information useful are relevance and faithful representation. False – Relevant information must also be material. False – Information that is relevant is characterized as having predictive or confirmatory value or both. False – Comparability also refers to comparisons of a firm over time (consistency). False – Verifiability is an enhancing characteristic that relates to both relevance and faithful representation. True.
LO: 2, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 1.5 (a) (b) (c) (d) (e) (f)
Confirmatory value. Cost. Neutrality. Comparability (Consistency). Neutrality. Relevance and Faithful representation.
(g) (h) (i) (j)
Timeliness. Relevance. Comparability. Verifiability.
LO: 2, Bloom: C, Difficulty: Moderate, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 1.6 (a) (b) (c) (d) (e) (f) (g)
Comparability. Confirmatory value. Comparability (Consistency). Neutrality. Verifiability. Relevance. Comparability, Verifiability, Timeliness, and Understandability.
(h) Materiality. (i) Faithful representation. (j) Relevance and Faithful representation. (k) Timeliness.
LO: 2, Bloom: C, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None Bloom:
Exercise 1.7 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)
Gains, losses. Liabilities. Investments by owners, comprehensive income. (also, possible would be revenues and gains). Distributions to owners. (Note to instructor: net effect is to reduce equity and assets). Comprehensive income (also, possible would be revenues and gains). Assets. Comprehensive income. Revenues, expenses. Equity. Revenues. Distributions to owners. Comprehensive income.
LO: 2, Bloom: C, Difficulty: Moderate, Time: 15-20, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 1.8 (a) (b) (c) (d) (e) (f) (g)
7. 5. 8. 2. 1. 4. 3.
Expense recognition principle. Measurement principle (historical cost.) Full disclosure principle. Going concern assumption. Economic entity assumption. Periodicity assumption. Monetary unit assumption.
LO: 3, Bloom: C, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 1.9 (a) Measurement principle (i) Expense recognition and (historical cost). revenue recognition principles. (b) Full disclosure principle. (j) Economic entity assumption. (c) Expense recognition principle. (k) Periodicity assumption. (d) Measurement (fair value) (l) Measurement principle, principle. Expense recognition principle. (e) Economic entity assumption. (m) Measurement principle (f) Full disclosure principle. (historical cost). (g) Revenue recognition principle. (n) Expense recognition principle. (h) Full disclosure principle. LO: 3, Bloom: C, Moderate, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 1.10 (a)
It is well established in accounting that revenues, expenses, and cost of goods sold must be disclosed in an income statement. It might be noted to students that such was not always the case. At one time, only net income was reported, but over time, we have evolved to the present reporting format.
(b)
The proper accounting for this situation is to report the equipment as an asset and the notes payable as a liability on the balance sheet. Offsetting is permitted in only limited situations where certain assets are contractually committed to pay off liabilities.
Exercise 1.10 (Continued) (c)
According to GAAP, the basis upon which inventory amounts are stated (lower of cost or market) and the method used in determining cost (LIFO, FIFO, average cost, etc.) should also be reported. The disclosure requirement related to the method used in determining cost should be emphasized, indicating that where possible alternatives exist in financial reporting, disclosure in some format is required.
(d)
Consistency requires that disclosure of changes in accounting principles be made in the financial statements. To do otherwise, would result in misleading financial statements. Financial statements are more useful if they can be compared with similar reports for prior years.
LO: 3, Bloom: C, Difficulty: Hard, Time: 20-25, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 1.11 (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 a performance obligation is satisfied. In this case, the obligation is not satisfied until goods are delivered to a customer.
(c)
The expense recognition principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high degree of uncertainty about whether the company will have to pay. GAAP 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 the guidance (FASB ASC 450; formerly 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.)
Exercise 1.11 (Continued) (d)
At present, accountants do not recognize price-level adjustments in the accounts. Hence, it is misleading to deviate from the measurement principle (historical cost) 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 value but are depreciated using 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)
The answer to this situation is the same as (b).
LO: 3, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 1.12 (a)
Depreciation is an allocation of cost, not an attempt to value assets. As a consequence, even if the fair value of the building increased, costs related to this building should be matched with revenues on the income statement, not as a charge against retained earnings.
(b)
Accountants follow the measurement principle (historical cost) approach and write-ups of assets are not permitted. It should also be noted that the revenue recognition principle states that revenue should not be recognized until a performance obligation is satisfied. In this case, revenue (gross profit) would not be recognized until the goods are delivered to the customer. Further, this is not a peripheral transaction so recording a gain is not appropriate.
Exercise 1.12 (Continued) (c)
Assets should be recorded at the fair value of what is given up or the fair value of what is received, whichever is more clearly evident. It should be emphasized that it is not a violation of the measurement principle (historical cost) to use the fair value of the stock. Recording the asset at the par value of the stock has no conceptual validity. Par value is merely an arbitrary amount usually set at the date of incorporation.
(d)
The gain should be recognized when the equipment is delivered to the customer. Deferral of the gain is not permitted, because the company has satisfied the performance obligation.
(e)
It appears from the information that the sale should be recorded in 2026 instead of 2025. Revenue should be recognized when a performance obligation is satisfied. In this case, the performance obligation is met when the order is delivered to the buyer. Accounts receivable and Sales revenue should be recorded in 2026. It should be noted that if the company is employing a perpetual inventory system in dollars and quantities, a debit to Cost of Goods Sold and a credit to Inventory is also necessary in 2026.
LO: 3, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Using Your Judgement UYJ 1.1 Financial Reporting Problem (a) From Note 1 – Summary of Significant Accounting Policies: Our revenue is primarily generated from the sale of the finished product to customers. Those sales predominantly contain a single performance obligation and revenue is recognized at a single point in time when ownership, risks, and rewards transfer, which can be on the date of shipment or the date of receipt by the customer. A provision for payment discounts and product return allowances is recorded as a reduction of sales in the same period the revenue is recognized. The revenue recorded is presented net of sales and other taxes we collect on behalf of governmental authorities. The revenue includes shipping and handling costs, which generally are included in the list price to the customer. Trade promotions, consisting primarily of customer pricing allowances, merchandising funds, and consumer coupons, are offered through various programs to customers and consumers. Sales are recorded net of trade promotion spending, which is recognized as incurred at the time of the sale. Most of these arrangements have terms of approximately one year. Accruals for expected payouts under these programs are included as accrued marketing and promotion in the Accrued and other liabilities line item in the Consolidated Balance Sheets. (b) Historical Cost Buildings, machinery, and equipment Property, plant, and equipment is recorded at cost reduced by accumulated depreciation. Fair Value Investments (U.S. government securities, corporate bond securities, other investments), derivatives (relating to foreign currency hedges, other foreign currency instruments, interest rates, net investment hedges) are reported at fair value. Certain financial instruments are required to be recorded at fair value. (c) On July 1, 2019, we adopted ASU 2016-02, "Leases (Topic 842)." The new accounting standard requires the recognition of right-of-use assets and lease liabilities for all long-term leases, including operating leases, on the balance sheet. In January 2017, the FASB issued ASU 2017-04, "Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment." We will adopt the standard effective July 1, 2020. The impact of the new standard will be dependent on the specific facts and circumstances of future individual impairments if any. (d) Accounting Policy Related to Advertising Advertising makes up a portion of Selling, general and administrative expense (SG&A). Selling, general and administrative expense is primarily comprised of marketing expenses, selling expenses, research and development costs, administrative and other indirect overhead costs, depreciation and amortization expense on non-manufacturing assets, and other miscellaneous operating items. Advertising costs, charged to expense as incurred, include worldwide television, print, radio, internet, and in-store advertising expenses and were $7.3 billion in 2020, $6.8 billion in 2019, and $7.1 billion in 2018. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement, Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 1.2 Comparative Analysis Case
(a)
Coca-Cola Comparative Analysis (a) Coca-Cola Operating Segments (Note 1) The Company's operating structure is the basis for our internal financial reporting. Our operating structure includes the following operating segments, which are sometimes referred to as "operating groups" or "groups": • Europe, Middle East and Africa • Latin America • North America • Asia Pacific • Global Ventures • Bottling Investments Our operating structure also includes Corporate, which consists of two components: (1) a center focused on strategic initiatives, policy and governance; and (2) an enabling services organization focused on both simplifying and standardizing key transactional processes and providing support to business units through global centers of excellence. They own or license and market numerous nonalcoholic beverage brands, which we group into the following category clusters: sparkling soft drinks; water, enhanced water and sports drinks; juice, dairy and plant-based beverages; tea and coffee; and energy drinks. They also own and market four of the world's top five nonalcoholic sparkling soft drink brands: Coca-Cola, Diet Coke, Fanta and Sprite. PepsiCo Our Divisions (Note 1) We are organized into seven reportable segments (also referred to as divisions), as follows: 1) FLNA, which includes our branded food and snack businesses in the United States and Canada; 2) QFNA, which includes our cereal, rice, pasta and other branded food businesses in the United States and Canada; 3) PBNA, which includes our beverage businesses in the United States and Canada; 4) LatAm, which includes all of our beverage, food and snack businesses in Latin America; 5) Europe, which includes all of our beverage, food and snack businesses in Europe;
UYJ 1.2 (Continued)
6) AMESA, which includes all of our beverage, food and snack businesses in Africa, the Middle East and South Asia; and 7) APAC, which includes all of our beverage, food and snack businesses in Asia Pacific, Australia and New Zealand and China region. Through our operations, authorized bottlers, contract manufacturers and other third parties, we make, market, distribute and sell a wide variety of convenient beverages, foods and snacks, serving customers and consumers in more than 200 countries and territories with our largest operations in the United States, Mexico, Russia, Canada, the United Kingdom, China and South Africa. (b)
Dominant Position - Beverage Sales: Coke or Pepsi Coca-Cola: Net operating revenues for 2020 were $33,014 million, comprised primarily of beverage sales. Pepsi: Net revenue for 2020 was $70,372 million, of which beverages are estimated at 45% ($31,667) million. Coca-Cola has the dominant position for beverage sales.
(c)
Inventories, cost allocation method, the effect on comparability. As indicated, the companies use essentially the same inventory valuation method. Therefore, comparability is not affected. Coca-Cola Inventories consist primarily of raw materials and packaging (which includes ingredients and supplies) and finished goods (which include concentrates and syrups in our concentrate operations and finished beverages in our finished product operations). Inventories are valued at the lower of cost or net realizable value. We determine cost on the basis of the average cost or first-in, first-out methods. PepsiCo Inventory (c) Inventories – Note 15. Inventories are valued at the lower of cost or net realizable value. Cost is determined using the averages; first-in first-out (FIFO); or, in limited instances, last-in, first-out (LIFO) methods.
UYJ 1.2 (Continued) (d)
Change in accounting policy Coca-Cola Recently Issued Accounting Pronouncements – Adopted In August 2017, the Financial Accounting Standards Board ("FASB") issued ASU 2017 -12, Targeted Improvements to Accounting for Hedging Activities ("ASU 2017-12"), which eliminates the requirement to separately measure and report hedge ineffectiveness and requires companies to recognize all elements of hedge accounting that impact earnings in the same line item in the statement of income where the hedged item resides. The amendments in this update include new alternatives for measuring the hedged item for fair value hedges of interest rate risk and ease the requirements for effectiveness testing, hedge documentation and applying the critical terms match method. We adopted ASU 2017-12 effective January 1, 2019 using the modified retrospective method. We recognized a cumulative-effect adjustment to decrease the opening balance of reinvested earnings as of January 1, 2019 by $12 million, net of tax. Refer to Note 5 for additional disclosures required by this ASU. In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income ("ASU 2018-02"), which permits entities to reclassify the disproportionate income tax effects of the Tax Cuts and Jobs Act of 2017 ("Tax Reform Act") on items within AOCI to reinvested earnings. These disproportionate income tax effect items are referred to as "stranded tax effects." The amendments in this update only relate to the reclassification of the income tax effects of the Tax Reform Act. Other accounting guidance that requires the effect of changes in tax laws or rates to be included in net income is not affected by this update. We adopted ASU 2018-02 effective January 1, 2019. We recognized a cumulative effect adjustment to increase the opening balance of reinvested earnings as of January 1, 2019 by $558 million related to the effect that the change in the income tax rate had on the gross deferred tax amount s of items remaining in AOCI. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. ASU 2014-09, and its amendments, were primarily included in ASC 606,Revenue from Contracts with Customers, which we adopted effective January 1, 2018 using the modified retrospective method. We recognized a cumulative effect adjustment to decrease the opening balance of reinvested earnings as of January 1, 2018 by $257 million, net of tax.
UYJ 1.2 (Continued)
In January 2016, the FASB issued ASU 2016-01, which addresses certain aspects of the recognition, measurement, presentation and disclosure of financial instruments. ASU 201601 was effective for the Company beginning January 1, 2018, and we are now recognizing any changes in the fair value of certain equity investments in net income as prescribed by the new standard rather than in other comprehensive income ("OCI"). We recognized a cumulative effect adjustment to increase the opening balance of reinvested earnings as of January 1, 2018 by $409 million, net of tax. In October 2016, the FASB issued ASU 2016-16, Intra-Entity Transfers of Assets Other Than Inventory ("ASU 2016-16"), which requires the Company to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. ASU 2016-16 was effective for the Company beginning January 1, 2018 and was adopted using a modified retrospective basis. We recorded a $2.9 billion cumulative effect adjustment to increase the opening balance of reinvested earnings as of January 1, 2018, with the majority of the offset being recorded in the line item deferred income tax assets in our consolidated balance sheet. In March 2018, the FASB issued ASU 2018-05, Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118. The amendments in this update provide guidance on when to record and disclose provisional amounts for certain income tax effects of the Tax Reform Act. The amendments also require any provisional amounts or subsequent adjustments to be included in net income. Additionally, this ASU discusses required disclosures that an entity must make with regard to the Tax Reform Act. This ASU is effective immediately as new information is available to adjust provisional amoun ts that were previously recorded. The Company adopted this standard and subsequently finalized the accounting based on the guidance, interpretations and data available as of December 31, 2018.
Pepsico Recently Issued Accounting Pronouncements - Adopted In 2016, the Financial Accounting Standards Board (FASB) issued guidance that changes the impairment model used to measure credit losses for most financial assets. Under the new model we are required to estimate expected credit losses over the life of our trade receivables, certain other receivables and certain other financial instruments. The new model replaced the existing incurred credit loss model and generally results in earlier recognition of allowances for credit losses. We adopted this guidance in the first quarter of 2020 and the adoption did not have a material impact on our consolidated financial statements or disclosures. On initial recognition, we recorded an after-tax cumulative effect decrease to retained earnings of $34 million ($44 million pre-tax) as of the beginning of 2020.
UYJ 1.2 (Continued)
Recently Issued Accounting Pronouncements - Not Yet Adopted In 2019, the FASB issued guidance to simplify the accounting for income taxes. The guidance primarily addresses how to (1) recognize a deferred tax liability after we transition to or from the equity method of accounting, (2) evaluate if a step-up in the tax basis of goodwill is related to a business combination or is a separate transaction, (3) recognize all of the effects of a change in tax law in the period of enactment, including adjusting the estimated annual tax rate, and (4) Include the amount of tax based on income in the income tax provision and any incremental amount as a tax not based on income for hybrid tax regimes. The guidance is effective in the first quarter of 2021 with early adoption permitted. We will adopt the guidance when it becomes effective in the first quarter of 2021. The guidance is not expected to have a material impact on our consolidated financial statements or related disclosures. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 1.3 Accounting, Analysis, and Principles Accounting Caddie Shack Driving Range Statement of Financial Position May 31, 2025 Assets Cash Building Equipment
Total Assets
***$15,100 6,000 800
$21,900
Liabilities Advertising payable Utilities payable
$
Owners’ Equity Owners’ capital Total Liabilities Equity
*21,650
150 100
& $21,900
Accrual income = $4,700 – $1,000 – $750 – $400 – $100 = $2,450**** Owners’ capital balance = $20,000** + $2,450 – $800 = $21,650* Murray might conclude that his business earned a profit of $1,650 ($21,650* $20,000**) because of the difference between his ending Owner’s Capital and beginning Owner's Capital. The conclusion that his business lost $4,900 ($20,000* - $15,100***) might come from the change in the business’s cash balance, which started at $20,000** and ended the month at $15,100***. Analysis The income measure of $2,450**** is most relevant for assessing the future profitability and hence the payoffs to the owners. For example, charging the cost of the building and equipment to expense in the first month of operations understates income in the first month. These costs should be allocated to future periods of benefit through depreciation expense. Similarly, although not paid, the utilities were used to generate revenues, so they should be recognized when incurred, not when paid.
UYJ 1.3 (Continued) Principles GAAP income is the accrual income computed above as $2,450 (excluding depreciation expense.) The key concept illustrated in the difference between the loss of $4,900 and profit of $1,650 is the expense recognition principle, which calls for recognition of expenses when incurred, not when paid. Excluding the cash withdrawal from the measurement of income [the difference between income measures in parts (c) and (d)] is an application of the definition of basic elements. Cash withdrawals are distributions to owners, not an element of income (expenses or losses). LO: 2, 3, 4, Bloom: AN, Difficulty, Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Solutions to Critical Thinking Cases CT 1.1 (a) The Securities and Exchange Commission (SEC) is an independent federal agency that receives its authority from federal legislation enacted by Congress. The Securities and Exchange Act of 1934 created the SEC. (b) As a result of the Securities and Exchange Act of 1934, the SEC has legal authority relative to accounting practices. The U.S. Congress has given the SEC broad regulatory power to control accounting principles and procedures to fulfill its goal of full and fair disclosure. (c) There is no direct relationship as the SEC was created by Congress and the Financial Accounting Standards Board (FASB) was created by the private sector. However, the SEC historically has followed a policy of relying on the private sector to establish financial accounting and reporting standards known as generally accepted accounting principles (GAAP). The SEC does not necessarily agree with all of the pronouncements of the FASB. In cases of unresolved differences, the SEC rules take precedence over FASB rules for companies within SEC jurisdiction. LO: 2, Bloom: K, Difficulty: Moderate, Time: 30-40, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 1.2 (a) A conceptual framework is a coherent system of concepts that flow from an objective. Some compare it to a constitution. Its objective is to provide a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements. A conceptual framework is necessary so that standard-setting is useful, i.e., standard-setting should build on and relate to an established body of concepts and objectives. A well-developed conceptual framework should enable the FASB to issue more useful and consistent standards in the future. Specific benefits that may arise are: (1) A coherent set of standards and rules should result. (2) New and emerging practical problems should be more quickly soluble by reference to an existing framework. (3) It should increase financial statement users’ understanding of and confidence in financial reporting. (4) It should enhance comparability among companies’ financial statements. (5) It should provide guidance on identifying the boundaries of judgment in preparing financial statements. (6) It should provide guidance to the body responsible for establishing accounting standards. (b) The FASB has issued eight Statements of Financial Accounting Concepts (SFAC) that relate to business enterprises. Their titles and a brief description of the focus of seven of these Statements are as follows: (1) SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” presents the goals and purposes of accounting (superseded by SFAC No. 8, Chapter 1.) (2) SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines the characteristics that make accounting information useful (SFAC No. 8, Chapter 3.) (3) SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” provides definitions of items in financial statements such as assets, liabilities, revenues, and expenses. (4) SFAC No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises,” sets forth fundamental recognition and measurement criteria and guidance on what information should be formally incorporated into financial statements and when. (5) SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” and expands its scope to include not-for-profit organizations. (6) SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” provides a framework for using expected future cash flows and present values as a basis for measurement. (7) SFAC No. 8, Chapter 1, “The Objective of General Purpose Financial Reporting,” Chapter 3, “Qualitative Characteristics of Useful Financial Information,” replaces SFAC No. 1 and No. 2, and Chapter 8: Notes to Financial Statements. LO: 2, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
CT 1.3 (a) FASB’s Conceptual Framework should provide benefits to the accounting community such as: (1) A coherent set of standards and rules should result. (2) New and emerging practical problems should be more quickly soluble by reference to an existing framework.
CT 1.3 (Continued) (b) The most important quality of accounting information is its usefulness for decision-making. Relevance and faithful representation are the primary qualities leading to this decision-usefulness. Usefulness is the most important quality because, without usefulness, there would be no benefits from information to set against its costs. (c) There are a number of key characteristics or qualities that make accounting information useful for decision-making. The importance of three of these characteristics or qualities is discussed below. (1) Understandability—information provided by financial reporting should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence. Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it, or who misuse it. (2) Relevance—the accounting information is capable of making a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct expectations (including materiality). (3) Faithful representation—the faithful representation of a measure rests on whether the numbers and descriptions matched what really existed or happened, including completeness, neutrality, and free from error. (Note to instructor: Other qualities might be discussed by the student, such as enhancing qualities. All of these qualities are defined in the textbook). LO: 2, Bloom: K, Difficulty: Simple, Time: 25-35, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 1.4 (a) The objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. (b) The purpose of this statement is to set forth fundamentals on which financial accounting and reporting standards may be based. Without some basic set of objectives that everyone can agree on, inconsistent standards will be developed. For example, some believe that accountability should be the primary objective of financial reporting. Others argue that the prediction of future cash flows is more important. It follows that individuals who believe that accountability is the primary objective may arrive at different financial reporting standards than others who argue for the prediction of cash flow. Only by establishing some consistent starting point can accounting ever achieve some underlying consistency in establishing accounting principles. It should be emphasized to the students that the FASB itself is likely to be the major user and thus the most direct beneficiary of the guidance provided by this pronouncement. However, knowledge of the objectives and concepts the FASB uses should enable all who are affected by or interested in financial accounting standards to better understand the content and limitations of the information provided by financial accounting and reporting, thereby furthering their ability to use that information effectively and enhancing confidence in financial accounting and reporting. That knowledge, if used with care, may also provide guidance in resolving new or emerging problems of financial accounting and reporting in the absence of applicable authoritative pronouncements. LO: 2, Bloom: C, Difficulty: Simple, Time: 25-35, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
CT 1.5 (a) (1) Relevance is one of the two primary decision-specific characteristics of useful accounting information. Relevant information is capable of making a difference in a decision. Relevant information helps users to make predictions about the outcomes of past, present, and future events, or to confirm or correct prior expectations. Only material information is considered to be relevant and therefore, must be disclosed. If the information is not likely to make a difference to a decision-maker, then it need not be disclosed. Information must also be timely to be relevant. (2) Faithful representation is one of the two primary decision-specific characteristics of useful accounting information. Faithful representation means that numbers and descriptions match what really existed or happened. Representational faithfulness is correspondence or agreement between accounting information and the economic phenomena it is intended to represent stemming from completeness, neutrality, and free from error. (3)
Understandability is a user-specific characteristic of information. Information is understandable when it permits reasonably informed users to perceive its significance. Understandability is a link between users, who vary widely in their capacity to comprehend or utilize the information, and the decision-specific qualities of information.
(4) Comparability means that information about enterprises has been prepared and presented in a similar manner. Comparability enhances comparisons between information about two different enterprises at a particular point in time. (5) Consistency means that unchanging policies and procedures have been used by an enterprise from one period to another. Consistency enhances comparisons between information about the same enterprise at two different points in time. (b) (Note to instructor: Many answers are possible here. The suggestions below are intended to serve as examples). (1)
Forecasts of future operating results and projections of future cash flows may be highly relevant to some decision-makers. However, they would not be as free from error as historical cost information about past transactions. (2) Proposed new accounting methods may be more relevant to many decision-makers than existing methods. However, if adopted, they would impair consistency and make trend comparisons of an enterprise’s results over time difficult or impossible. (3) There presently exists much diversity among acceptable accounting methods and procedures. In order to facilitate comparability between enterprises, the use of only one accepted accounting method for a particular type of transaction could be required. However, consistency would be impaired for those firms changing to the new required methods. (4) Occasionally, relevant information is exceedingly complex. Judgment is required in determining the optimum trade-off between relevance and understandability. Information about the impact of general and specific price changes may be highly relevant but not understandable by all users. (c) Although trade-offs result in the sacrifice of some desirable quality of information, the overall result should be information that is more useful for decision-making. LO: 2, Bloom: C, Difficulty: Moderate, Time: 30-35, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
CT 1.6 (a)
Recognition when cash is received is not appropriate unless the magazines are delivered to the customer at the same time. The revenue recognition principle indicates that companies recognize revenue when each performance obligation is satisfied. This occurs when the products are delivered – in this case, the magazines.
(b)
Recognition when the magazines are published each month is not appropriate. The revenue recognition principle indicates that companies recognize revenue as each performance obligation is satisfied. This occurs when the product is delivered – publication of the magazines is a necessary step in the process, but until the magazines are delivered, the performance obligation has not been satisfied.
(c)
Recognition over time, as the magazines are delivered to customers, is appropriate. The revenue recognition principle indicates that companies recognize revenue as each performance obligation is satisfied. This occurs when the product is delivered, which is the case when the magazines are delivered to customers each month. When the customer pays for the annual subscription, the company has a performance obligation (a liability – Unearned Revenue) that is satisfied over time as magazines are published and delivered to customers.
(Note to instructor: CT 1.6 might also be assigned in conjunction with Chapter 17.) LO: 3, Bloom: AP, Difficulty: Hard, Time: 25-30, AACSB: Analytic, Knowledge, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
CT 1.7 (a) Some costs are recognized as expenses on the basis of a presumed direct association with specific revenue. This presumed direct association has been identified both as “associating cause and effect” and as “matching (expense recognition principle).” Direct cause-and-effect relationships can seldom be conclusively demonstrated, but many costs appear to be related to particular revenue, and recognition of them as expenses accompanies recognition of the revenue. Generally, the expense recognition principle requires that the revenue recognized and the expenses incurred to produce the revenue be given concurrent period recognition in the accounting records. Only if the effort is properly related to accomplishment will the results, called earnings, have useful significance concerning the efficient utilization of business resources. Thus, applying the expense recognition principle is recognition of the cause-and-effect relationship that exists between expense and revenue. Examples of expenses that are usually recognized by associating cause and effect are sales commissions, freight-out on merchandise sold, and cost of goods sold or services provided. (b) Some costs are assigned as expenses to the current accounting period because: (1) their incurrence during the period provides no discernible future benefits; (2) they are measures of assets recorded in previous periods from which no future benefits are expected or can be discerned; (3) they must be incurred each accounting year, and no build-up of expected future benefits occurs; (4) by their nature, they relate to current revenues even though they cannot be directly associated with any specific revenues; (5) the amount of cost to be deferred can be measured only in an arbitrary manner or great uncertainty exists regarding the realization of future benefits or both; (6) and uncertainty exists regarding whether allocating them to current and future periods will serve any useful purpose.
CT 1.7 (Continued) Thus, many costs are called “period costs” and are treated as expenses in the period incurred because they have neither a direct relationship with revenue earned nor can their occurrence be directly shown to give rise to an asset. The application of this principle of expense recognition results in charging many costs to expense in the period in which they are paid or accrued for payment. Examples of costs treated as period expenses would include officers’ salaries, advertising, research and development, and auditors’ fees. (c) A cost should be capitalized, that is, recorded as an asset when it is expected that the expenditure will produce benefits in future periods. The important concept here is that the incurrence of the cost has resulted in the acquisition of an asset with future service potential. If a cost is incurred that resulted in the acquisition of an asset from which benefits are not expected beyond the current period, the cost may be expensed as a measure of the service potential that expired in producing the current period’s revenues. Not only should the incurrence of the cost result in the acquisition of an asset from which future benefits are expected, but also the cost should be measurable with a reasonable degree of objectivity, and there should be reasonable grounds for associating it with the asset acquired. Examples of costs that should be treated as measures of assets are the costs of merchandise on hand at the end of an accounting period, costs of insurance coverage relating to future periods, and the cost of self-constructed plant or equipment. (d) In the absence of a direct basis for associating asset cost with revenue and if the asset provides benefits for two or more accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner. Thus, when it is impractical, or impossible, to find a close cause-and-effect relationship between revenue and cost, this relationship is often assumed to exist. Therefore, the asset cost is allocated to the accounting periods by some method. The allocation method used should appear reasonable to an unbiased observer and should be followed consistently from period to period. Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of intangibles, and allocation of rent and insurance. (e) A cost should be treated as a loss when no revenue results. The matching of losses to specific revenue should not be attempted because, by definition, they are expired service potentials not related to revenue produced. That is, losses result from events that are not anticipated as necessary in the process of producing revenue. LO: 3, Bloom: AN, Difficulty: Hard, Time: 20-25, AACSB: Analytic, Knowledge, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Decision Making
CT 1.8 (a) Costs should be recognized as expiring in a given period if they are not chargeable to a prior period and do not apply to future periods. Recognition in the current period is required when any of the following conditions or criteria are present: (1) A direct association of charges with revenue of the period, such as goods shipped to customers. (2) An indirect association with the revenue of the period, such as insurance or rent. (3) A period charge where no association with revenue in the future can be made, so the expense is charged this period, such as officers’ salaries, or a measurable expiration of asset costs during the period, even though not associated with the production of revenue for the current period, such as a fire or casualty loss.
CT 1.8 (Continued) (b) (1) Although it is generally agreed that inventory costs should include all costs attributable to placing the goods in a salable state, receiving and handling costs are often treated as cost expirations in the period incurred because they are irregular or are not in uniform proportion to sales. The portion of the receiving and handling costs attributable to the unsold goods processed during the period should be inventoried. These costs might be more readily apportioned if they are assigned by some device such as an applied rate. Abnormally high receiving and handling costs should be charged off as a period cost. (2) Cash discounts on purchases are treated as “other revenues” in some financial statements in violation of the revenue and expense recognition principles. Revenue is not recognized when goods are purchased or cash disbursed. Furthermore, inventories valued at gross invoice price are recorded at an amount greater than their cash outlay resulting in a misstatement of inventory cost in the current period and inventory cost expirations in future periods. Close adherence to the expense recognition principle requires that cash discounts be recorded as a reduction of the cost of purchases and that inventories be priced at net invoice prices. Where inventories are priced at gross invoice prices for expediency, however, there is a slight distortion of the financial statements if the beginning and ending inventories are not materially different. LO: 3, Bloom: AP, Difficulty: Hard, Time: 20-25, AACSB: Analytic, Knowledge, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Decision Making
CT 1.9 (a) The preferable treatment of the costs of the sample display houses is expensing them over more than one period. These sample display houses are assets because they represent rights to future service potentials or economic benefits. (1) The alternative of expensing the costs of sample display houses in the period in which the expenditure is made is based primarily upon the expense recognition principle. These costs are of a promotional nature. Promotional costs often are considered expenses of the period in which the expenditures occur due to the uncertainty in determining the time periods benefited (do they meet the definition of an asset?). It is likely that no decision is made concerning the life of a sample display house at the time it is erected. Past experience may provide some guidance in determining the probable life. A decision to tear down or alter a house probably is made when sales begin to lag or when a new model with greater potential becomes available. There is uncertainty not only as to the life of a sample display house but also as to whether a sample display house will be torn down or altered. If it is altered rather than torn down, a portion of the cost of the original house may be attributable to the new model. (2) According to the expense recognition principle, the costs of service potentials should be amortized as the benefits are received. Thus, costs of the sample display houses should be matched with the revenue from the sale of the houses, which is receivable over a period of more than one year. As the sample houses are left on display for three to seven years, Daniel Barenboim apparently expects to benefit from the displays for at least that length of time. (b) There is uncertainty regarding the number of homes of a particular model which will be sold as a result of the display sample. The success of this amortization method is dependent upon accurate estimates of the number and selling price of shell houses to be sold. The estimate of the number of units of a particular model which will be sold as a result of a display model should include not only units sold while the model is on display but also units sold after the display house is torn down or altered.
CT 1.9 (Continued) (1) Cost amortization solely on the basis of time may be preferable when the life of the models can be estimated with a great deal more accuracy than can the number of units that will be sold. If unit sales and selling prices are uniform over the life of the sample, a satisfactory matching of costs and revenues may be achieved if the straight-line amortization procedure is used. (2) If all of the shell houses are to be sold at the same price, it may be appropriate to allocate the costs of the display houses on the basis of the number of shell houses sold. This allocation would be similar to the units-of-production method of depreciation and would result in a good matching of costs with revenues. On the other hand, if the shell houses are to be sold at different prices, it may be preferable to allocate costs on the basis of the revenue contribution of the shell houses sold. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic,, AICPA BC: Strategic Perspective, AICPA AC: Measurement, Reporting, AICPA PC: Decision Making
CT 1.10 Dear Uncle Carlos, I received the information on Neville Corp. and appreciate your interest in sharing this venture with me. However, I think that basing an investment decision on these financial statements would be unwise because they are neither relevant nor representationally faithful. One of the most important characteristics of accounting information is that it is relevant, i.e., it will make a difference in my decision. To be relevant, this information must be timely. Because Neville’s financial statements are a year old, they have lost their ability to influence my decision: a lot could have changed in that one year. Another element of relevance is predictive value. Once again, Neville’s accounting information proves irrelevant. Shown without reference to other years’ profitability, it cannot help me predict future profitability because I cannot see any trends developing. Closely related to predictive value is confirmatory value. These financial statements do not provide feedback on any strategies which the company may have used to increase profits. These financial statements are also not representationally faithful. To be representationally faithful, their assertions must be verifiable by several independent parties. Because no independent auditor has verified these amounts, there is no way of knowing whether or not they are represented faithfully. For instance, I would like to believe that this company earned $2,424,240 and that it had a very favorable debt-to-equity ratio. However, unaudited financial statements do not give me any reasonable assurance about these claims. Finally, the fact that Ms. Neville herself prepared these statements indicates a lack of neutrality. Because she is not a disinterested third party, I cannot be sure that she did not prepare the financial statements in favor of her husband’s business. I do appreciate the trouble you went through to get me this information. Under the circumstances, however, I do not wish to invest in the Neville bonds and would caution you against doing so. Before you make a decision in this matter, please call me. Sincerely, Your Nephew/Niece LO: 2, Bloom: C, Difficulty: Moderate, Time: 20-30, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
CT 1.11 (a) The stakeholders are investors, creditors, etc.; i.e., users of financial statements, current, and future. (b) Honesty and integrity of financial reporting, job protection, profit. (c) Applying the expense recognition principle and recording expense during the plant’s life, or not applying it. That is, record the mothball costs in the future. (d) The major question may be whether or not the expense of mothballing can be estimated properly so that the integrity of financial reporting is maintained. Applying the expense recognition principle will result in lower profits and possibly higher rates for consumers. Could this cost anyone his or her job? Will investors and creditors have more useful information? On the other hand, failure to apply the expense recognition principle means higher profits, lower rates, and greater potential job security. (e) Students’ recommendations will vary. Note: Other stakeholders possibly affected are present and future consumers of electric power. Delay in allocating the expense will benefit today’s consumers of electric power at the expense of future consumers. LO: 3, Bloom: E, Difficulty, Moderate, Time: 20-25, AACSB: Ethics, Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Professional Behavior, Decision Making
CT 1.12 1.
Information about competitors might be useful for benchmarking the company’s results but if management does not have expertise in providing the information, it could be highly subjective. In addition, it is likely costly for management to gather sufficiently verifiable information of this nature.
2.
While users of financial statements might benefit from receiving internal information, such as company plans and budgets, competitors might also be able to use this information to gain a competitive advantage relative to the disclosing company.
3.
To produce forecasted financial statements, management would have to make numerous assumptions and estimates, which would be costly in terms of time and data collection. Because of the subjectivity involved, the forecasted statements would not be faithful representations, thereby detracting from any potential benefits. In addition, while management’s forecasts of future profitability or balance sheet amounts could be of benefit, companies could be subject to shareholder lawsuits if the amounts in the forecasted statements are not realized.
4.
It would be excessively costly for companies to gather and report information that is not used in managing the business.
5.
Flexible reporting allows companies to “fine-tune” their financial reporting to meet the information needs of its varied users. In this way, they can avoid the cost of providing information that is not demanded by its users.
6.
Similar to number 3, concerning forecasted financial statements, if managers report forward-looking information, the company could be exposed to liability if investors unduly rely on the information in making investment decisions. Thus, if companies get protection from unwarranted lawsuits (called a safe harbor), then they might be willing to provide potentially beneficial forward-looking information.
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
CT 1.13 (a) Inclusion or omission of information that materially affects net income harms particular stakeholders. Accountants must recognize that their decision to implement (or delay) reporting requirements will have immediate consequences for some stakeholders. (b) Yes. Because the FASB rule results in a fairer representation, it should be implemented as soon as possible—regardless of its impact on net income. SEC Staff Bulletin No. 74 (December 30, 1987) requires a statement as to what the expected impact of the standard will be. (c) The accountant’s responsibility is to provide financial statements that present fairly the financial condition of the company. By advocating early implementation, Weller fulfills this task. (d) Potential lenders and investors, who read the financial statements and rely on their fair representation of the financial condition of the company have the most to gain by early implementation. A stockholder who is considering the sale of stock may be harmed by early implementation that lowers net income (and may lower the value of the stock). LO: 4, Bloom: K, Difficulty: Hard, Time: 20-25, AACSB: Ethics, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Professional Behavior, Decision Making
CT 1.14 (a) The public/private mixed approach is the way rules are established in the United States. In many respects, the FASB is a quasi-governmental agency in that its pronouncements are required to be followed because the SEC has provided support for this approach. The SEC has the ultimate power to establish GAAP but has chosen to permit the private sector to develop these rules. By accepting the standards established by the FASB as authoritative, it has granted much power to the FASB. (b) Publicly reported accounting numbers influence the distribution of scarce resources. Resources are channeled where needed at returns commensurate with perceived risk. Thus, reported accounting numbers have economic effects in that resources are transferred among entities and individuals as a consequence of these numbers. It is not surprising then that individuals affected by these numbers will be extremely interested in any proposed changes in the financial reporting environment. (c) The Accounting Standards Executive Committee (AcSEC of the AICPA), among other groups, has presented a potential challenge to the exclusive right of the FASB to establish accounting principles. Also, Congress has been attempting to legislate certain accounting practices, particularly to help struggling industries. Some possible reasons why other groups might wish to establish GAAP are: 1. As indicated in the previous answer, these rules have economic effects and therefore certain groups would prefer to make their own rules to ensure that they receive just treatment. 2. Some believe the FASB does not act quickly to resolve accounting matters, either because it is not that interested in the subject area or because it lacks the resources to do so. 3.
Some argue that the FASB does not have the competence to legislate GAAP in certain areas. For example, many have argued that the FASB should not legislate GAAP for not-for-profit enterprises because the problems are unique and not well understood by the FASB.
LO: 2, 4 Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: None
CT 1.15
(a) Considering the economic consequences of GAAP, it is not surprising that special interest groups become vocal and critical (some supporting, some opposing) when rules are being formulated. The FASB’s derivative accounting pronouncement is no exception. Many from the banking industry, for example, criticized the rule as too complex and leading to unnecessary earnings volatility. They also indicated that the proposal may discourage prudent risk management activities and in some cases could present misleading financial information. As a result, Congress is often approached to put pressure on the FASB to change its rulings. In the stock option controversy, industry was quite effective in going to Congress to force the FASB to change its conclusions. In the derivative controversy, Rep. Richard Baker introduced a bill that would force the SEC to formally approve each standard issued by the FASB. Not only would this process delay adoption, but could lead to additional politicization of the rule-making process. Dingell commented that Congress should stay out of the rule-making process and defended the FASB’s approach to establishing GAAP. (b) Attempting to set GAAP by a political process will probably lead to the following consequences: (a) Too many alternatives. (b) Lack of clarity that will lead to inconsistent application. (c) Lack of disclosure that reduces transparency. (d) Not comprehensive in scope. Without an independent process, GAAP will be based on political compromise. A classic illustration is what happened in the savings and loan industry. Applying generally accepted accounting principles to the S&L industry would have forced regulators to restrict activities of many S&Ls. Unfortunately, accounting principles were overridden by regulatory rules and the resulting lack of transparency masked the problems. William Siedman, former FDIC Chairman noted later that it was “the worst mistake in the history of government.” Another indication of the problem of government intervention is shown in the accounting standards used by some countries around the world. Completeness and transparency of information needed by investors and creditors are not available in order to meet or achieve other objectives. LO: 4, Bloom: C, Difficulty: Moderate, Time: 25-30, AACSB: None, AICPA BC: Governance Perspective, AICPA AC: Reporting, Research, AICPA PC: None
CT 1.16 (a) The “due process” system involves the following: 1. Identifying topics and placing them on the FASB’s agenda. 2. Research and analysis are conducted and preliminary views of pros and cons are issued. 3. A public hearing is often held. 4. The FASB evaluates research and public responses and issues exposure draft. 5. The FASB evaluates responses and changes the exposure draft if necessary. The final statement is then issued. (b) Economic consequences mean the impact of accounting reports on the wealth positions of issuers and users of financial information and the decision-making behavior resulting from that impact. (c) Economic consequences indicated in the letter are (1) concerns related to the potential impact on the capital markets, (2) the weakening of companies’ ability to manage risk, and (3) the adverse control implications of implementing costly and complex new rules imposed at the same time as other major initiatives, including the Year 2000 issues and a single European currency.
CT 1.16 (Continued) (d) The principal point of this letter is to delay the finalization of the derivatives standard. As indicated in the letter, the authors of this letter urge the FASB to expose its new proposal for public comment,
following the established due process procedures that are essential to acceptance of its standards and providing sufficient time for affected parties to understand and assess the new approach. (Authors note: The FASB indicated in a follow-up letter that all due process procedures had been followed and all affected parties had more than ample time to comment. In addition, the FASB issued a follow-up standard, which delayed the effective date of the standard, in part to give companies more time to develop the information systems needed for implementation of the standard). (e) The reason why the letter was sent to Congress was to put additional pressure on the FASB to delay or drop the issuance of a rule on derivatives. Unfortunately, in too many cases, when the business community does not like the answer proposed by the FASB, it resorts to lobbying members of Congress. The lobbying efforts usually involve developing some type of legislation that will negate the rule. In some cases, efforts involve challenging the FASB’s authority to develop rules in certain areas with additional Congressional oversight. LO: 4, Bloom: E, Difficulty: Moderate, Time: 25-30, AACSB: Communication, AICPA BC: Governance Perspective, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Codification Exercises CE1.1 The information at this link describes the elements offered in The FASB Accounting Standards Codification. As indicated, the website offers several resources to enhance your working knowledge of the Codification and the Codification Research System. This page includes links to help pages that describe specific functions and features of the Codification. Links to frequently asked questions, the FASB Learning Guide, and the Notice to Constituents are also available on this page. Help pages FAQ Learning Guide About the Codification—Notice of Constituents LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Technology, AICPA BC: None, AICPA AC: Research, Reporting, Technology and Tools, AICPA PC: Communication
CE1.2 The following information is provided at the Providing Feedback link: The Codification includes a feature that can be used to submit content-related feedback or general, system-related comments. The feedback system is not designed for comments on proposed Accounting Standards Updates. Content-related feedback As a registered user of the FASB Accounting Standards Codification Research System website, you are able and are encouraged to provide feedback, at the paragraph level, to the FASB about any contentrelated matters. For specific information about the Codification and the feedback process, please read the Notice to Constituents. To provide content-related feedback: Click the Submit feedback button beneath the paragraph for which you want to provide feedback. Enter or copy/paste your comments in the text box. Note that formatting (lists, bold, etc.) is not retained and there is a 4,000 character limit on feedback submissions. Click SUBMIT. Your comments are sent to the FASB and reviewed by FASB staff. You can also submit multiple comments for any given paragraph, if, for example, you determine that more information would be useful to the FASB staff. General feedback Click here to provide general feedback on the Codification in general, the Codification Research System website, and other system-related items that are not content-specific. LO: 3, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, Technology, AICPA BC: None, AICPA AC: Research, Reporting, Technology and Tools, AICPA PC: Communication
CE1.3 The “What’s New” page provides links to Codification content that has been recently issued. During the verification phase, updates may result from either the issuance of Codification update instructions that accompany new Standards or from changes to the Codification due to incorporation of constituent feedback. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BC: None, AICPA AC: Research, Reporting, Technology and Tools, AICPA PC: Communication
CE1.4 (a)
The master glossary provides three definitions of fair value that are found in GAAP: Fair Value—The amount at which an asset (or liability) could be bought (or incurred) or settled in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Fair Value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
(b)
Revenue—Revenue earned by an entity from its direct distribution, exploitation, or licensing of a film, before deduction for any of the entity’s direct costs of distribution. For markets and territories in which an entity’s fully or jointly-owned films are distributed by third parties, revenue is the net amounts payable to the entity by third-party distributors. Revenue is reduced by appropriate allowances, estimated returns, price concessions, or similar adjustments, as applicable. The glossary references a revenue definition for the SEC: (Revenue (SEC))—See paragraph 942.235-S599-1, Regulation S-X Rule 9-05(c)(2), for the definition of revenue for purposes of Regulation S-X Rule 9-05. This definition relates to segment reporting requirements for public companies.
(c)
Comprehensive Income is defined as the change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
LO: 2, 3, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, Technology, AICPA BC: None, AICPA AC: Research, Reporting, Technology and Tools, AICPA PC: Communication
CE1.5 The FASB Codification’s organization is closely aligned with the elements of financial statements, as articulated in the Conceptual Framework. This is apparent in the layout of the “Browse” section, which has primary links for Assets, Liabilities, Equity, Revenues, and Expenses. LO: 2, Bloom: K, Difficulty: Simple, Time: 5, AACSB: Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Solutions to Codification Research Case Search Strings: concept statement, “materiality”, “articulation” (a)
According to Concepts Statement 8 (CON 8, Chapter 3): Qualitative Characteristics of Accounting Information, “Glossary”: “Materiality is defined as the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information could have been changed or influenced by the omission or misstatement.”
(b)
CON 8 refers to several SEC cases which apply materiality. Students might also research SEC literature (e.g. Staff Accounting Bulletin No. 99), although SEC literature is not in the FARS database. CON 8, Chapter 3. provides the following examples of screens that might be used to determine materiality: a. An accounting change in circumstances that puts an enterprise in danger of being in breach of a covenant regarding its financial condition may justify a lower materiality threshold than if its position were stronger. b. A failure to disclose separately a nonrecurrent item of revenue may be material at a lower threshold than would otherwise be the case if the revenue turns a loss into a profit or reverses the trend of earnings from a downward to an upward trend. c. A misclassification of assets that would not be material in amount if it affected two categories of plant or equipment might be material if it changed the classification between a noncurrent and a current asset category. d. Amounts too small to warrant disclosure or correction in normal circumstances may be considered material if they arise from abnormal or unusual transactions or events.
Codification Research Case (Continued) However, the FASB notes that more than magnitude must be considered in evaluating materiality: The relative rather than the absolute size of a judgment item almost always determines whether it should be considered material in a given situation. Losses from bad debts or pilferage that could be shrugged off as routine by a large business may threaten the continued existence of a small one. An error in inventory valuation may be material in a small enterprise for which it cut earnings in half but immaterial in an enterprise for which it might make a barely perceptible ripple in the earnings. Some of the empirical investigations referred to in Appendix C throw light on the considerations that enter into materiality judgments. Some hold the view that the Board should promulgate a set of quantitative materiality guides or criteria covering a wide variety of situations that preparers could look to for authoritative support. That appears to be a minority view, however. The predominant view is that materiality judgments can properly be made only by those who have all the facts. The Board’s present position is that no general standards of materiality could be formulated to take into account all the considerations that enter into an experienced human judgment. (c)
SFAC No. 6, Paras. 20-21. The two classes of elements are related in such a way that (a) assets, liabilities, and equity are changed by elements of the other class and at any time are their cumulative result and (b) an increase (decrease) in an asset cannot occur without a corresponding decrease (increase) in another asset or a corresponding increase (decrease) in a liability or equity. Those relationships are sometimes collectively referred to as “articulation.” They result in financial statements that are fundamentally interrelated so that statements that show elements of the second class depend on statements that show elements of the first class and vice versa.
LO: 3, Bloom: C, Moderate, Time: 25-30, AACSB: Communication, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, Technology and Tools, AICPA PC: Communication
Chapter 2 The Accounting Information System Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises
Exercises
Problems
1.
Transaction Identification.
1, 2, 3, 5
1, 2
1, 2, 3, 4, 17
1
2.
Nominal Accounts.
4, 7
3.
Trial Balance.
6, 10
2, 3, 4
1
4.
Adjusting Entries.
8, 11, 13, 14
5, 6, 7, 8, 9, 10, 20
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 12
5.
Financial Statements.
11, 12, 15, 22, 23
1, 2, 4, 6, 7, 8
6.
Closing.
12
13, 14, 16
1, 4, 9, 10, 12
7.
Inventory And Cost Of Goods Sold.
9
8.
Comprehensive Accounting Cycle.
*9.
Cash Vs. Accrual Basis.
15, 16, 17
12
18, 19
*10.
Reversing Entries.
18
13
20
*11.
Worksheet.
19
3, 4, 5, 6, 7, 8, 9, 10
11
14, 15 1, 4, 12
*These topics are dealt with in an Appendix to the Chapter.
21, 22, 23
11
12
Assignment Classification Table (By Learning Objective) Learning Objectives
Questions
Brief Exercises
Exercises
Problems
1.
Explain the basic concepts of an accounting information system.
1, 2, 3, 4, 5, 7
2.
Record and summarize accounting transactions.
3, 6
1, 2, 3, 4, 5, 6,
1, 2, 3, 4, 9, 17
1, 9,10
3.
Identify and prepare adjusting entries.
8, 11, 13, 14
3, 4, 5, 6, 7, 8, 9, 10
5, 6, 7, 8, 9, 10, 20
2, 3, 4, 5, 6, 7, 8, 9, 10, 12
4.
Prepare financial statements from the adjusted trial balance and prepare closing entries.
10, 12
11
11, 12, 13, 14, 16
1, 2, 4, 6, 7, 8, 9, 10, 12
5.
Prepare financial statements for a merchandising company.
9
13, 15
4,
*6.
Differentiate the cash basis of accounting from the accrual basis of accounting.
15, 16, 17
12
18, 19
11
*7.
Identify adjusting entries that may be reversed.
18
13
20
*8.
Prepare a 10-column worksheet.
19
*These topics are dealt with in an Appendix to the Chapter.
21, 22, 23
12
Assignment Characteristics Table Level Of Difficulty
Time (Minutes)
Transaction Analysis–Service Company. Corrected Trial Balance. Corrected Trial Balance. Corrected Trial Balance. Adjusting Entries. Adjusting Entries. Analyze Adjusted Data. Adjusting Entries. Adjusting Entries. Adjusting Entries. Prepare Financial Statements. Prepare Financial Statements. Closing Entries. Closing Entries. Missing Amounts. Closing Entries for a Corporation. Transactions of a Corporation, Including Investment and Dividend. Cash to Accrual Basis. Cash and Accrual Basis. Adjusting and Reversing Entries. Worksheet. Worksheet and Balance Sheet Presentation. Partial Worksheet Preparation.
Simple Simple Simple Simple Moderate Moderate Complex Moderate Moderate Complex Moderate Moderate Simple Moderate Simple Moderate Moderate
15–20 10–15 15–20 10–15 10–15 10–15 15–20 10–15 15–20 25–30 20–25 20–25 10–15 10–15 10–15 10–15 10–15
Moderate Moderate Complex Simple Moderate Moderate
15–20 10–15 20–25 10–15 20–25 10–15
Transactions, Financial Statements–Service Company. Adjusting Entries and Financial Statements. Adjusting Entries. Financial Statements, Adjusting and Closing Entries. Adjusting Entries. Adjusting Entries and Financial Statements. Adjusting Entries and Financial Statements. Adjusting Entries and Financial Statements. Adjusting and Closing. Adjusting and Closing. Cash and Accrual Basis. Worksheet, Balance Sheet, Adjusting and Closing Entries.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex
25–35 35–40 25–30 40–50 15–20 25–35 25–35 25–35 30–40 30–35 35–40 40–50
Item
Description
E2.1 E2.2 E2.3 E2.4 E2.5 E2.6 E2.7 E2.8 E2.9 E2.10 E2.11 E2.12 E2.13 E2.14 E2.15 E2.16 E2.17 *E2.18 *E2.19 *E2.20 *E2.21 *E2.22 *E2.23 P2.1 P2.2 P2.3 P2.4 P2.5 P2.6 P2.7 P2.8 P2.9 P2.10 *P2.11 *P2.12
Answers to Questions 1.
Examples are: (a) Payment of accounts payable. (b) Collection of accounts receivable from a customer. Also, a purchase of supplies or equipment for cash. (c) Conversion of accounts payable to note payable.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA BB: Communication, AICPA FC: Reporting, AICPA PC: None
2.
Transactions (a), (b), (d) are considered business transactions and are recorded in the accounting records because a change in assets, liabilities, and/or owners’/stockholders’ equity has been effected as a result of a transfer of values from one party to another. Transactions (c) and (e) are not business transactions because a transfer of values has not resulted, nor can the event be considered financial in nature and capable of being expressed in terms of money.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA BB: Communication, AICPA FC: Reporting, AICPA PC: None
3.
Transaction (a): Transaction (b): Transaction (c): Transaction (d):
Accounts Receivable (debit), Service Revenue (credit). Cash (debit), Accounts Receivable (credit). Supplies (debit), Accounts Payable (credit). Delivery Expense (debit), Cash (credit).
LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA BB: Communication, AICPA FC: Reporting, AICPA PC: None
4.
Revenue and expense accounts are referred to as temporary or nominal accounts because each period they are closed out to Income Summary in the closing process. Their balances are reduced to zero at the end of the accounting period; therefore, the term temporary or nominal is given to these accounts.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA BB: Communication, AICPA FC: Reporting, AICPA PC: None
5.
Andrea is not correct. The double-entry system means that for every debit amount there must be a credit amount and vice-versa. At least two accounts are affected and debits must equal credits. It does not mean that each transaction must be recorded twice.
LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AICPA BB: Communication, AICPA FC: Reporting, AICPA PC: None
6.
Although it is not absolutely necessary that a trial balance be prepared periodically, it is customary and desirable. The trial balance accomplishes two principal purposes: (1) It tests the accuracy of the entries in that it proves that debits and credits of an equal amount are in the ledger. (2) It provides a list of ledger accounts and their balances, which may be used in preparing the financial statements and in supplying financial data about the concern.
LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AICPA BB: Communication, AICPA FC: Reporting, AICPA PC: None
7.
(a) Real account; balance sheet. (b) Real account; balance sheet. (c) Inventory is generally considered a real account appearing on the balance sheet. (Note: Inventory has the elements of a nominal account when the periodic inventory system is used. It may appear on the income statement when the multiple-step format is used under a periodic inventory system.) (d) Real account; balance sheet. (e) Real account; balance sheet. (f) Nominal account; income statement. (g) Nominal account; income statement. (h) Real account; balance sheet.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA BB: Communication, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 2 (Continued) 8.
At December 31, the three days’ wages due to the employees represent an accrued expense which creates a current liability, salaries and wages payable. The related expense must be recorded in this period to properly reflect the expense incurred.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA FC: Reporting, AICPA PC: None
9.
(a) In a service company, revenues are service revenues and expenses are operating expenses. In a merchandising company, revenues are sales revenues and expenses consist of cost of goods sold plus operating expenses. (b) The measurement process in a merchandising company consists of comparing the sales price of the merchandise inventory to the cost of goods sold and operating expenses.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA FC: Reporting, AICPA PC: None
10. (a) (b) (c) (d)
No change. Before closing, balances exist in these accounts; after closing, no balances exist. Before closing, balances exist in these accounts; after closing, no balances exist. Before closing, a balance exists in this account exclusive of any dividends or the net income or net loss for the period; after closing, the balance is increased or decreased by the amount of net income or net loss and decreased by dividends declared. (e) No change.
LO: 4, Bloom: C, Difficulty: Simple, Time: 3-5, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
11. Adjusting entries are prepared prior to the preparation of financial statements in order to bring the accounts up to date and are necessary (1) to achieve a proper recognition of revenues and expenses in measuring income and (2) to achieve an accurate presentation of assets, liabilities and stockholders’ equity. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
12. Closing entries are prepared to transfer the balances of nominal accounts to capital (retained earnings) after the adjusting entries have been recorded and the financial statements prepared. Closing entries are necessary to reduce the balances in nominal accounts to zero in order to prepare the accounts for the next period’s transactions. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
13. Cost – Salvage Value = Depreciable Cost: $4,000 – $0 = $4,000. Depreciable Cost ÷ Useful Life = Depreciation Expense for One Year $4,000 ÷ 5 years = $800 per year. The asset was used for 6 months (7/1 – 12/31), therefore 1/2-year of depreciation expense should be reported. Annual depreciation X 6/12 = amount to be reported on the 2025 income statement: $800 X 6/12 = $400. LO: 3, Bloom: AP, Difficulty: Simple, Time: 5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
14. December 31 Interest Receivable ........................................................................................... Interest Revenue ....................................................................................... (To record accrued interest revenue on loan)
10,000 10,000
Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company (the borrower) is an accrued revenue to another company (the lender). LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 2 (Continued) *15. Under the cash basis of accounting, revenue is recorded only when cash is received and expenses are recorded only when paid. Under the accrual basis of accounting, revenue is recognized when a performance obligation is satisfied and expenses are recognized when incurred, without regard to the time of the receipt or payment of cash. A cash-basis balance sheet and income statement are incomplete and inaccurate in comparison to accrual-basis financial statements. The accrual-basis matches effort (expenses) with accomplishment (revenues) in the income statement while the cash basis only presents cash receipts and cash disbursements. The accrual basis balance sheet contains receivables, payables, accruals, prepayments, and deferrals while a cash-basis balance sheet shows none of these. LO:6, Bloom: C, Difficulty: Simple, Time: 3-5, AICPA FC: Measurement, Reporting, AICPA PC: None
*16. Salaries and wages paid during the year will include the payment of any wages attributable to the prior year but unpaid at the end of the prior year. This amount is an expense of the prior year and not of the current year, and thus should be subtracted in determining salaries and wages expense. Similarly, salaries and wages paid during the year will not include any salaries and wages attributable to hours worked during the current year but not actually paid until the following year. This should be added in determining salaries and wages expense. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
*17. Although similar to the strict cash basis, the modified cash basis of accounting requires that expenditures for capital items be charged against income over all the periods to be benefited. This is done through conventional accounting methods, such as depreciation and amortization and inventory. Under the strict cash basis, expenditures would be recognized as expenses in the period in which the corresponding cash disbursements are made. LO:6, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
*18. Reversing entries are made at the beginning of the period to reverse accruals and some deferrals. Reversing entries are not required. They are made to simplify the recording of certain transactions that will occur later in the period that relate to previous adjustments. The same net results will be attained whether or not reversing entries are recorded. LO:7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*19. Disagree. A worksheet is not a permanent accounting record and its use is not required in the accounting cycle. The worksheet is an informal device for accumulating and sorting information needed for the financial statements. Its use is optional in helping to prepare financial statements. LO:8, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Solutions to Brief Exercises Brief Exercise 2.1 May
1 3 13 21
Cash ........................................................... Common Stock ..................................
4,000
Equipment ................................................. Accounts Payable ..............................
1,100
Rent Expense ............................................ Cash ....................................................
400
Accounts Receivable ................................ Service Revenue ................................
500
4,000 1,100 400 500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 2.2 Aug.
2
7 12
15 19
Cash ............................................................ Equipment................................................... Owner’s Capital ...................................
12,000 2,500
Supplies ...................................................... Accounts Payable ...............................
500
Cash ............................................................ Accounts Receivable ................................. Service Revenue .................................
1,300 670
Rent Expense .............................................. Cash ......................................................
600
Supplies Expense........................................ Supplies ($500 – $270) .........................
230
14,500 500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,970 600 230
Brief Exercise 2.3 July Dec.
1 31
Prepaid Insurance ....................................... Cash ......................................................
15,000
Insurance Expense ...................................... Prepaid Insurance ($15,000 X 6/12 X 1/3) .......................
2,500
15,000
2,500
LO: 2, 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 2.4 July Dec.
1 31
Cash ............................................................. Unearned Service Revenue .................
15,000
Unearned Service Revenue ............... 3,000 Service Revenue ($15,000 X 6/12 X 1/3) .......................
2,500
15,000
2,500
LO: 2, 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 2.5 Feb.
1
June 30
Prepaid Insurance ....................................... Cash ......................................................
720,000
Insurance Expense ...................................... Prepaid Insurance ($720,000 X 5/24)...............................
150,000
720,000
150,000
LO: 2, 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 2.6 Nov. Dec.
1 31
Cash ............................................................. Unearned Rent Revenue ......................
2,400
Unearned Rent Revenue ............................. Rent Revenue ($2,400 X 2/3) ....................................
1,600
2,400
LO: 2, 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
1,600
Brief Exercise 2.7 Dec.
Jan.
31
2
Salaries and Wages Expense .................... Salaries and Wages Payable ($8,000 X 3/5) ...................................
4,800
Salaries and Wages Payable ..................... Salaries and Wages Expense .................... Cash .....................................................
4,800 3,200
4,800
8,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 2.8 Dec. Feb.
31 1
Interest Receivable ..................................... Interest Revenue .................................
300
Cash ............................................................ Notes Receivable ................................ Interest Receivable ............................. Interest Revenue ($12,000 X 10% X1/12) .
12,400
300 12,000 300 100
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 2.9 Aug.
31 31 31 31
Interest Expense......................................... Interest Payable ..................................
300
Accounts Receivable ................................. Service Revenue .................................
1,400
Salaries and Wages Expense .................... Salaries and Wages Payable ..............
700
Bad Debt Expense ...................................... Allowance for Doubtful Accounts ......
900
300 1,400 700
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
900
Brief Exercise 2.10 Depreciation Expense .............................................. Accumulated Depreciation—Equipment .........
2,000
Equipment ................................................................ Less: Accumulated Depreciation—Equipment .....
$30,000 2,000
2,000 $28,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 2.11 Sales Revenue.......................................................... Interest Revenue ...................................................... Income Summary ..............................................
808,900 13,500
Income Summary ..................................................... Cost of Goods Sold .......................................... Administrative Expenses ................................. Income Tax Expense ........................................
780,300
Income Summary ($822,400 - $780,300) ................. Retained Earnings ............................................
42,100
Retained Earnings.................................................... Dividends ..........................................................
18,900
822,400 556,200 189,000 35,100 42,100 18,900
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
*Brief Exercise 2.12 (a)
(b)
Cash receipts .................................................. + Increase in accounts receivable ($18,600 – $13,000) .................................. Service revenue ..............................................
$142,000
Payments for operating expenses ................. – Increase in prepaid expenses ($23,200 – $17,500) .................................. Operating expenses ........................................
$ 97,000
5,600 $147,600
(5,700) $ 91,300
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 7-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
*Brief Exercise 2.13 (a) (b) (c)
Salaries and Wages Payable .............................. Salaries and Wages Expense .....................
4,200
Salaries and Wages Expense............................. Cash .............................................................
7,000
Salaries and Wages Payable .............................. Salaries and Wages Expense ($7,000 - $4,200). Cash .............................................................
4,200 2,800
4,200 7,000
LO: 7, Bloom: C, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
7,000
Solutions to Exercises Exercise 2.1 (15–20 Minutes) Apr.
2
Cash ............................................................. Equipment .................................................... Owner’s Capital ....................................
32,000 14,000 46,000
2
No Entry—Not A Transaction.
3
Supplies ....................................................... Accounts Payable ................................
700
Rent Expense ............................................... Cash ......................................................
600
Accounts Receivable .................................. Service Revenue ..................................
1,100
Cash ............................................................. Unearned Service Revenue .................
3,200
Cash ............................................................. Service Revenue ..................................
2,300
Insurance Expense ...................................... Cash ......................................................
110
Salaries And Wages Expense ..................... Cash ......................................................
1,160
Supplies Expense ........................................ Supplies ................................................
120
Equipment .................................................... Owner’s Capital ....................................
6,100
7 11 12 17 21 30 30 30
700 600 1,100 3,200 2,300 110 1,160 120
LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
6,100
Exercise 2.2 (10–15 minutes) Wanda Landowska Company Trial Balance April 30, 2025 Debit Cash ..................................................................... Accounts Receivable .......................................... Prepaid Insurance ($700 + $100) ........................ Equipment ........................................................... Accounts Payable ($4,500 – $100) ..................... Property Taxes Payable...................................... Owner’s Capital ($11,200 + $1,500) ........................ Owner’s Drawing ................................................. Service Revenue ................................................. Salaries and Wages Expense ............................. Advertising Expense ($1,100 + $300) ................ Property Tax Expense ($800 + $100) .................
Credit
$ 4,800 2,750 800 8,000 $ 4,400 560 12,700 1,500 6,690 4,200 1,400 900 $24,350
$24,350
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.3 (15–20 minutes) The ledger accounts are reproduced below, and corrections are shown in the accounts. Accounts Payable Bal.
7,044
Accounts Receivable Bal. 5,240 (1) 450 Bal, 4,790
Common Stock Bal.
8,000
Supplies 2,967
Retained Earnings Bal.
2,000
Bal. (1) Bal.
Bal.
Cash 5,912 (4) 450 6,172
190
(1) [$1,830 - $1,380] (4) [$95 + $95]
Exercise 2.3 (Continued)
Bal. (2) Bal.
Equipment 6,100 3,200 9,300
Service Revenue Bal. (3) (5) Bal. Bal. Bal.
5,200 2,025 80 7,305
Office Expense 4,320 (2) 1,120
3,200
(3)[$2,250 - $225] Blues Traveler Corporation Trial Balance (corrected) April 30, 2025 Debit Cash .............................................................................. .............................................................................. Accounts Receivable .......................................... Supplies ............................................................... Equipment ........................................................... Accounts Payable ............................................... Common Stock .................................................... Retained Earnings............................................... Service Revenue ................................................. Office Expense ....................................................
Credit
$ 6,172
4,790 2,967 9,300 $ 7,044 8,000 2,000 7,305 1,120 $24,349
LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$24,349
Exercise 2.4 (10–15 minutes) Watteau Co. Trial Balance June 30, 2025 Debit Cash ($2,870 + $180 – $65 – $65) ................................... Accounts Receivable ($3,231 – $180) ............................ Supplies ($800 – $500) .................................................... Equipment ($3,800 + $500) ............................................. Accounts Payable ($2,666 – $206 – $260) ..................... Unearned Service Revenue ($1,200 – $325) .................. Common Stock ............................................................... Dividends......................................................................... Retained Earnings .......................................................... Service Revenue ($2,380 + $801 [$890 – $89] + $325) .. Salaries and Wages Expense ($3,400 + $670 – $575) ... Office Expense ................................................................
Credit
$ 2,920 3,051 300 4,300 $ 2,200 875 6,000 575 3,000 3,506 3,495 940 $15,581
$15,581
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.5 (10–15 minutes) 1. 2. 3.
4. 5.
Depreciation Expense ($250 X 3) ............................ Accumulated Depreciation—Equipment .........
750
Unearned Rent Revenue ($9,300 X 1/3) .................. Rent Revenue ....................................................
3,100
Interest Expense ...................................................... Interest Payable ................................................
500
Supplies Expense .................................................... Supplies ($2,800 – $850)...................................
1,950
Insurance Expense ($300 X 3) ................................. Prepaid Insurance.............................................
900
750 3,100
500 1,950
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
900
Exercise 2.6 (10–15 minutes) 1. 2. 3.
4. 5.
Accounts Receivable ................................................... Service Revenue ...................................................
750
Utilities Expenses ........................................................ Accounts Payable .................................................
520
Depreciation Expense .................................................. Accumulated Depreciation – Equipment.............
400
Interest Expense .......................................................... Interest Payable ....................................................
500
Insurance Expense ($12,000 X 1/12) ........................... Prepaid Insurance .................................................
1,000
Supplies Expense ($1,600 – $500) .............................. Supplies .................................................................
1,100
750 520 400 500 1,000 1,100
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.7 (15–20 minutes) (a)
Ending balance of supplies Add: Adjusting entry Deduct: Purchases Beginning balance of supplies
(b)
Total prepaid insurance Amount used (6 X $400) Present balance
$700 950 850 $800 $4,800 2,400 $2,400
($400 X 12)
The policy was purchased six months ago (August 1, 2024) (c)
The entry in January to record salary and wages expense was Salaries and Wages Expense ............................. Salaries and Wages Payable .............................. Cash ...............................................................
1,800 700 2,500
Exercise 2.7 (Continued) The “T” account for salaries and wages payable is Salaries and Wages Payable Paid 700 Beg. Bal. ? January End Bal. 800 The beginning balance is therefore
(d)
Ending balance of salaries and wages payable Plus: Reduction of salaries and wages payable Beginning balance of salaries and wages payable
$ 800 700 $1,500
Service revenue Cash received Unearned revenue reduced
$2,000 (1,600) $ 400
Ending unearned revenue January 31, 2025 Plus: Unearned revenue reduced Beginning unearned revenue December 31, 2024
$ 750 400 $1,150
LO: 3, Bloom: AP, Difficulty: Complex, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.8 (10–15 minutes) 1. 2. 3. 4.
Salaries and Wages Expense ....................................... Salaries and Wages Payable .................................
1,900
Utilities Expenses ......................................................... Accounts Payable ..................................................
600
Interest Expense ($30,000 X 8% X 1/12) ...................... Interest Payable .....................................................
200
Telephone and Internet Expense ................................. Accounts Payable ..................................................
117
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,900 600 200 117
Exercise 2.9 (15–20 minutes) (a)
10/15
10/17
10/20
(b)
10/31
10/31
10/31
10/31
Salaries and Wages Expense ........................ Cash ......................................................... (To record payment of October 15 payroll)
800
Accounts Receivable ..................................... Service Revenue ..................................... (To record revenue for services performed for which payment has not yet been received)
2,400
Cash ................................................................ Unearned Service Revenue .................... (To record receipt of cash for services not yet performed)
650
Supplies Expense ........................................... Supplies ................................................... (To record the use of supplies during October)
470
Accounts Receivable ..................................... Service Revenue ..................................... (To record revenue for services performed for which payment has not yet been received)
1,650
Salaries and Wages Expense ........................ Salaries and Wages Payable .................. (To record liability for accrued payroll)
600
Unearned Service Revenue ........................... Service Revenue ..................................... (To reduce the Unearned Service Revenue account for service that has been performed)
400
800
2,400
650
470
1,650
600
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
400
Exercise 2.10 (25–30 minutes) (a)
1. Aug. 31 Insurance Expense ($4,500 X 3/12) .......... Prepaid Insurance .............................
1,125
2. Aug. 31 Supplies Expense ($2,600 – $450) ........... Supplies .............................................
2,150
3. Aug. 31 Depreciation Expense .............................. Accumulated Depreciation— Buildings ......................................... ($120,000 – $12,000* = $108,000; $108,000 X 4% = $4,320 per year; $4,320 X 3/12 = $1,080) *$120,000 X 10%
1,080
Aug. 31 Depreciation Expense .............................. Accumulated Depreciation— Equipment ....................................... ($16,000 – $1,600** = $14,400; $14,400 X 10% = $1,440; $1,440 X 3/12 = $360) **$16,000 X 10%
360
4. Aug. 31 Unearned Rent Revenue .......................... Rent Revenue ....................................
3,800
5. Aug. 31 Salaries and Wages Expense................... Salaries and Wages Payable ............
375
6. Aug. 31 Accounts Receivable ................................ Rent Revenue ....................................
800
7. Aug. 31 Interest Expense ....................................... Interest Payable ................................. [($60,000 X 8%) X 3/12]
1,200
1,125 2,150
1,080
360
3,800 375 800 1,200
Exercise 2.10 (Continued) (b)
Greco Resort Adjusted Trial Balance August 31, 2025 Debit
Cash ......................................................................... Accounts Receivable .............................................. Prepaid Insurance ($4,500 – $1,125) ...................... Supplies ($2,600 – $2,150) ...................................... Land ......................................................................... Buildings.................................................................. Accumulated Depreciation—Buildings ................. Equipment ............................................................... Accumulated Depreciation—Equipment ............... Accounts Payable ................................................... Unearned Rent Revenue ($4,600 – $3,800) ............ Salaries and Wages Payable .................................. Interest Payable ...................................................... Mortgage Payable ................................................... Common Stock ........................................................ Retained Earnings................................................... Dividends ................................................................. Rent Revenue ($76,200 + $3,800 + $800) ............... Salaries and Wages Expense ($44,800 + $375) ..... Utilities Expenses ................................................... Maintenance and Repair Expense ......................... Insurance Expense ................................................. Supplies Expense ................................................... Depreciation Expense ($1,080 + $360)................... Interest Expense .....................................................
Credit
$ 10,600 800 3,375 450 20,000 120,000 $
1,080
16,000 360 4,500 800 375 1,200 60,000 91,000 0 5,000 80,800 45,175 9,200 3,600 1,125 2,150 1,440 1,200 $240,115
LO: 3, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$240,115
Exercise 2.11 (20–25 minutes) (a)
OLIVER CO. Income Statement For the Year Ended December 31, 2025
Revenues Service revenue ................................................. Expenses Salaries and wages expense ............................ Rent expense ..................................................... Depreciation expense ....................................... Interest expense ................................................ Net Income ................................................................... (b)
$11,590 $6,840 2,260 145 83
OLIVER CO. Retained Earnings Statement For the Year Ended December 31, 2025
Retained earnings, January 1 ........................................................ Add: Net income ............................................................................. Less: Dividends .............................................................................. Retained earnings, December 31 ................................................... (c)
9,328 $ 2,262
$11,310 2,262 13,572 3,000 $10,572
OLIVER CO. Balance Sheet December 31, 2025
Assets Current Assets Cash .............................................................. Accounts receivable .................................... Prepaid rent .................................................. Total current assets ............................... Property, plant, and equipment Equipment .................................................... Accumulated depreciation – equipment ................................................... Total assets.................................................................
$19,472 6,920 2,280 28,672 $18,050 (4,895)
13,155 $41,827
Exercise 2.11 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable ................................................. Interest payable .............................................. Accounts payable .......................................... Total current liabilities ............................. Stockholders’ equity Common stock ............................................... Retained earnings .......................................... Total liabilities and stockholders’ equity ....................
$ 5,700 83 5,472 11,255 $20,000 10,572*
30,572 $41,827
*Beg. Balance + Net Income – Dividends = Ending Balance $11,310 + $2,262 – $3,000 = $10,572 LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.12 (20–25 Minutes) (a)
SANTO DESIGN Income Statement For the Year Ended December 31, 2025
Revenues Service revenue ................................................... Expenses Salaries and wages expense .............................. Depreciation expense.......................................... Rent expense ....................................................... Supplies expense ................................................ Insurance expense .............................................. Interest expense .................................................. Total expenses .............................................. Net income......................................................................
$61,500 $11,300 7,000 4,000 3,400 850 150 26,700 $34,800
SANTO DESIGN Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1 ......................................................... Add: Net income............................................................................... Retained earnings, December 31 .................................................... Exercise 2.12 (Continued)
$ 3,500 34,800 $38,300
(a) Continued
SANTO DESIGN Balance Sheet December 31, 2025
Assets Cash ................................................................................. Accounts receivable ....................................................... Supplies ........................................................................... Prepaid insurance ........................................................... Equipment ....................................................................... Less: Accumulated depreciation – equipment................... Total assets ...........................................................
$11,350 21,500 5,000 2,500 $60,000 35,000
25,000 $65,350
Liabilities and Stockholders’ Equity Liabilities Notes payable............................................................. Accounts payable ...................................................... Interest payable.......................................................... Unearned service revenue ........................................ Salaries and wages payable ...................................... Total liabilities ...................................................... Stockholders’ equity Common stock ........................................................... Retained earnings ...................................................... Total liabilities and stockholders’ equity ...........
$ 5,000 5,000 150 5,600 1,300 $17,050 $10,000 38,300
48,300 $65,350
(b) (1) Based on interest payable at December 31, 2025, interest is $25 per month ($150/6 months) or 0.5% of the note payable. 0.5% X 12 = 6% interest per year. (2) Salaries and Wages Expense, $11,300 less Salaries and Wages Payable 12/31/25, $1,300 = $10,000. Total payments, $17,500 – $10,000 = $7,500 Salaries and Wages Payable 12/31/24. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.13 (10–15 minutes) (a)
Sales revenue ...................................................... Less: Sales returns and allowances .................. Sales discounts......................................... Net sales ..............................................................
$800,000 $24,000 15,000
(b) Sales Revenue ..................................................... Income Summary .........................................
800,000
Income Summary ................................................ Sales Returns and Allowances ................... Sales Discounts ...........................................
39,000
39,000 $761,000 800,000 24,000 15,000
LO: 4, 5 Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.14 (10–15 minutes) Sales Revenue ..................................................... Income Summary .........................................
350,000
Income Summary ................................................ Cost of Goods Sold ..................................... Sales Returns and Allowances ................... Sales Discounts ........................................... Delivery Expense ......................................... Insurance Expense ...................................... Rent Expense ............................................... Salaries and Wages Expense ......................
329,000
Income Summary ($350,000 - $329,000) ............ Retained Earnings .......................................
21,000
350,000 208,000 13,000 8,000 7,000 12,000 20,000 61,000 21,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.15 (10–15 minutes) (a) $9,000 ($90,000 − $81,000) (b) $25,000 ($81,000 − $56,000) (c) $10,000 ($25,000 − $15,000)
(d) $100,000 ($95,000 + $5,000) (e) $57,000 ($95,000 − $38,000)
LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 2.16 (10–15 minutes) Sales Revenue........................................................ Cost of Goods Sold ........................................ Sales Returns and Allowances ...................... Sales Discounts .............................................. Selling Expenses ............................................ Administrative Expenses ............................... Income Tax Expense ...................................... Income Summary ............................................
410,000 225,700 12,000 15,000 16,000 38,000 30,000 73,300
(or) Sales Revenue........................................................ Income Summary ............................................
410,000
Income Summary ................................................... Cost of Goods Sold ........................................ Sales Returns and Allowances ...................... Sales Discounts .............................................. Selling Expenses ............................................ Administrative Expenses ............................... Income Tax Expense ......................................
336,700
Income Summary ($410,000 - $336,700) ............... Retained Earnings ..........................................
73,300
Retained Earnings ................................................. Dividends ........................................................
18,000
410,000 225,700 12,000 15,000 16,000 38,000 30,000 73,300
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
18,000
Exercise 2.17 (10–15 minutes) Date Mar.
Account Titles and Explanation 1 Cash
Ref.
Debit
J1 Credit
50,000 Common Stock (Investment of cash in business)
50,000
3 Land Buildings Equipment Cash (Purchased Michelle Wie’s Golf Land)
10,000 22,000 6,000
5 Advertising Expense Cash (Paid for advertising)
1,600
6 Prepaid Insurance Cash (Paid for one-year insurance policy)
1,480
10 Equipment Accounts Payable (Purchased equipment on account)
2,500
18 Cash
1,200
38,000
1,600
1,480
2,500
Service Revenue (Received cash for services performed)
1,200
25 Dividends Cash (Declared and paid a $500 cash dividend)
500
30 Salaries and Wages Expense Cash (Paid wages expense)
900
30 Accounts Payable Cash (Paid creditor on account)
500
900
2,500
31 Cash
2,500
750 Service Revenue (Received cash for services performed)
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
750
*Exercise 2.18 (15–20 minutes) Jill Accardo, M.D. Conversion of Cash Basis to Accrual Basis For the Year 2025 Excess of cash collected over cash disbursed ($142,600 – $55,470) Add increase in accounts receivable ($9,250 – $15, 927) Deduct increase in unearned service revenue ($2,840 – $4,111) Add decrease in accrued expenses ($3,435 – $2,108) Add increase in prepaid expenses ($1,917 – $3,232) Net income on an accrual basis
$87,130 6,677 (1,271) 1,327 1,315 $95,178
Alternate solution: Jill Accardo, M.D. Conversion of Income Statement Data from Cash Basis to Accrual Basis For the Year 2025 Cash Adjustments Basis Add Deduct Collections from customers:
$142,600
Accrual Basis $142,600
–Accounts receivable, Jan. 1
$9,250
($9,250)
+Accounts receivable, Dec. 31
$15,927
$15,927
+Unearned service revenue, Jan. 1
$2,840
$2,840
–Unearned service revenue, Dec. 31 Service revenue Disbursements for expenses:
$142,600
$18,767
$4,111
($4,111)
$13,361
$148,006
$55,470
–Accrued expenses, Jan. 1
$3,435
+Accrued expenses, Dec. 31
$2,108
+Prepaid expenses, Jan. 1
$1,917
–Prepaid expenses, Dec. 31
_______
_______
$3,232
Operating expenses
$55,470
$4,025
$ 6,667
Net income—cash basis
$ 87,130
Net income—accrual basis LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
52,828 $ 95,178
*Exercise 2.19 (10–15 minutes) (a)
Wayne Rogers Corp. Income Statement (Cash Basis) For the Year Ended December 31, 2024 $295,000 225,000 $ 70,000
Sales revenue Expenses Net income (b)
2025 $515,000 272,000 $243,000
Wayne Rogers Corp. Income Statement (Accrual Basis) For the Year Ended December 31,
Sales revenue* Expenses** Net income *2024: 2025: **2024: 2025:
2024 $485,000 277,000 $208,000
2025 $445,000 255,000 $190,000
$295,000 + $160,000 + $30,000 = $485,000 $355,000 + $90,000 = $445,000 $185,000 + $67,000 + $25,000 = $277,000 $40,000 + $160,000 + $55,000 = $255,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
*Exercise 2.20 (20–25 minutes) (a)
Adjusting Entries: 1. Dec. 31 Insurance Expense ($5,280 X 5/24).... Prepaid Insurance .......................... 2. 3. 4.
1,100 1,100
Dec. 31 Rent Revenue ($1,800 X 1/3) .............. Unearned Rent Revenue................
600
Dec. 31 Supplies .............................................. Advertising Expense .....................
290
Dec. 31 Interest Expense ................................. Interest Payable .............................
770
600 290 770
*Exercise 2.20 (Continued) (b)
Reversing Entries: 1. No reversing entry required. 2. 3. 4.
Unearned Rent Revenue .................................. Rent Revenue ............................................
600
Advertising Expense ........................................ Supplies .....................................................
290
Interest Payable ................................................ Interest Expense ........................................
770
600 290 770
LO: 7, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Exercise 2.21 (10–15 minutes)
Accounts Cash Inventory Sales Revenue Sales Returns and Allowances Sales Discounts Cost of Goods Sold
Adjusted Trial Balance
Income Statement
Dr. 9,000 80,000
Dr.
Cr.
450,000 10,000 5,000 250,000
Cr.
Balance Sheet Dr. 9,000 80,000
450,000 10,000 5,000 250,000
LO: 8, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Cr.
*Exercise 2.22 (20–25 minutes) Ed Bradley Co. Worksheet (partial) For the Month Ended April 30, 2025 Adjusted Trial Balance
Income Statement
Account Titles Cash Accounts Receivable Prepaid Rent Equipment Accum. Depreciation – Equipment Notes Payable Accounts Payable Common Stock Retained Earnings Dividends Service Revenue Salaries and Wages Expense Rent Expense Depreciation Expense Interest Expense Interest Payable
Dr. 24,522 6,920 2,280 18,050
Dr.
Totals Net income
63,700
Totals
Cr.
Cr.
Balance Sheet Dr. 24,522 6,920 2,280 18,050
4,895 5,700 4,472 34,960 1,000
Cr.
4,895 5,700 4,472 34,960 1,000
1,100
1,100 12,590
6,840 3,760 145 83
12,590 6,840 3,760 145 83
83
83
63,700 10,828 12,590 52,872 1,762
51,110 1,762
12,590 12,590 52,872
52,872
*Exercise 2.22 (Continued) Ed Bradley Co. Balance Sheet April 30, 2025 Assets Current Assets Cash
$24,522
Accounts receivable .................................... Prepaid rent .................................................. Total current assets ............................ Property, plant, and equipment Equipment..................................................... Accumulated depreciation – equipment ................................................... Total assets
Liabilities and Stockholders’ Equity Liabilities Notes payable ............................................... Accounts payable......................................... Interest payable ............................................ Total current liabilities ........................ Stockholders’ equity Common stock ............................................. Retained earnings ........................................ Total liabilities and Stockholders’ equity.................
6,920 2,280 $33,722 18,050 (4,895)
13,155 $46,877
$ 5,700 4,472 83 $10,255 34,960 1,662*
*Beg. Balance + Net Income – Dividends = Ending Balance $1,000 + $1,762 – $1,100 = $1,662 LO: 8, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
36,622 $46,877
*Exercise 2.23 (10–15 minutes) Jurassic Park Co. Worksheet (partial) For Month Ended February 28, 2025
Trial Balance Account Titles Supplies
Dr.
Adjustments
Cr.
Dr.
Cr.
1,756
Adjusted
Income
Balance
Trial Balance
Statementa
Sheet
Dr.
Dr.
Dr.
Cr.
Cr.
715
Cr.
(a)
1,041
715
6,939
(b)
257
7,196
7,196
150
(c)
50
200
200
Accumulated depreciation – equipment Interest payable Supplies expense
1,500
(a) 1,041
2,541
2,541
Depreciation expense
257
(b)
257
514
514
50
(c)
50
100
100
Interest expense
The following accounts and amounts would be shown in the February income statementa: Supplies expense Depreciation expense Interest expense
$2,541 514 100
LO: 8, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Time and Purpose of Problems Problem 2.1 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to post daily transactions to a “T” account ledger, prepare a trial balance, prepare an income statement, a balance sheet and a retained earnings statement, close the ledger, and prepare a post-closing trial balance. The problem deals with routine transactions of a professional service firm and provides a good integration of the accounting process. Problem 2.2 (Time 35–40 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries, and prepare financial statements (income statement, balance sheet, and retained earnings statement). The student also is asked to analyze two transactions to find missing amounts. Problem 2.3 (Time 25–30 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries. The adjusting entries are fairly complex in nature. Problem 2.4 (Time 40–50 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries and an adjusted trial balance and then prepare an income statement, a retained earnings statement, and a balance sheet. In addition, closing entries must be made and a post-closing trial balance prepared. Problem 2.5 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to determine what adjusting entries need to be made to specific accounts listed in a partial trial balance. The student is also required to determine the amounts of certain revenue and expense items to be reported in the income statement. Problem 2.6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare year-end adjusting entries from a trial balance and related information presented. The problem also requires the student to prepare an income statement, a balance sheet, and a retained earnings statement. The problem covers the basics of the end-of-period adjusting process. Problem 2.7 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to figure out the year-end adjusting entries that were made from a trial balance and an adjusted trial balance. The student is also required to prepare an income statement, a retained earnings statement, and a balance sheet. In addition, the student needs to answer a number of questions related to specific accounts. Problem 2.8 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to figure out the year-end adjusting entries that were made from a trial balance and an adjusted trial balance. The student is also required to prepare an income statement, a retained earnings statement, and a balance sheet. In addition, the student needs to answer a number of questions related to specific accounts. Problem 2.9 (Time 30–40 minutes) Purpose—to provide an opportunity for the student to prepare adjusting, and closing entries. This problem presents basic adjustments including a number of accruals and deferrals. It provides the student with an integrated flow of the year-end accounting process. Problem 2.10 (Time 30–35 minutes) Purpose—to provide an opportunity for the student to prepare adjusting and closing entries from a trial balance and related information. The student is also required to post the entries to “T” accounts.
Time and Purpose of Problems (Continued) *Problem 2.11 (Time 35–40 minutes) Purpose—to provide an opportunity for the student to prepare and compare (a) cash-basis and accrualbasis income statements, (b) cash-basis and accrual-basis balance sheets, and (c) to discuss the weaknesses of cash-basis accounting. *Problem 2.12 (Time 40–50 minutes) Purpose—to provide an opportunity for the student to complete a worksheet and then prepare a classified balance sheet. In addition, adjusting and closing entries must be made and a post-closing trial balance prepared.
Solutions to Problems Problem 2.1 (a)
(Explanations are omitted.) and (d)
Cash Sept. 1 20,000 Sept. 4 8 1,690 5 20 980 10 18 19 30 30 30 Bal 12,133
680 942 430 3,600 3,000 1,800 85
Sept.
2
Common Stock Sept.
Sept. 30 Accounts Receivable Sept. 14 5,82 Sept. 20 0
Bal. 30
Sept.
4
Sept. 5 Bal. 30
2,11 0 6,95 0
20,000
Bal. 30 Retained Earnings 3,000 Sept. 30 Bal. 30
20,000
19
Dividends 3,000 Sept.30
Sept.
30
18
Sept.
Sept.
10 30
2
17,280
Bal.
30
13,680
8 14 25
1,690 5,820 2,110 9,620
680
330
Office Expense 430 Sept. 30 85 515
515 515
Salaries and Wages Expense 30 1,800 Sept. 30 1,800
30
3,000
3,600 Sept.
Sept.
30
Service Revenue 9,620 Sept.
9,620
Sept.
6,007 3,007
Accounts Payable
Rent Expense 680 Sept. 30 Supplies 942 Sept. 612
1
980 Sept.
25
Equipment 17,280
Supplies Expense 330 Sept. 30
Problem 2.1 (Continued)
330
Accumulated Depreciation—Equipment Sept. 30 288
Depreciation Expense Sept.
30
288 Sept. 30
Income Summary 288
Sept.
30 30 30 30 30 30 Inc.
680 Sept. 515 1,800 330 288 6,007 9,620
(b)
30
9,620
9,620
YASUNARI KAWABATA, D.D.S. Trial Balance September 30 Debit Cash ................................................................................ ................................................................................ Accounts Receivable ............................................ Supplies ................................................................. Equipment ............................................................. Accumulated Depreciation—Equipment ............. Accounts Payable ................................................. Common Stock...................................................... Retained Earnings................................................. Dividends ............................................................... Service Revenue ................................................... Rent Expense ........................................................ Office Expense ...................................................... Salaries and Wages Expense ............................... Supplies Expense ................................................. Depreciation Expense........................................... Totals ...........................................................
Credit
$12,133
6,950 612 17,280 $ 288 13,680 20,000 0 3,000 9,620 680 515 1,800 330 288 $43,588
$43,588
Problem 2.1 (Continued) (c)
YASUNARI KAWABATA, D.D.S. Income Statement For the Month of September Service revenue ...................................................... Expenses: Salaries and wages expense .................. Rent expense ........................................... Supplies expense .................................... Depreciation expense ............................. Office expense ......................................... Total expenses .................................... Net income ..............................................................
$9,620 $1,800 680 330 288 515 3,613 $6,007
YASUNARI KAWABATA, D.D.S. Retained Earnings Statement For the Month of September Balance, September 1.......................................................... Add: Net income ................................................................ Less: Dividends ................................................................... Balance, September 30........................................................
$
0 6,007 6,007 3,000 $3,007
YASUNARI KAWABATA, D.D.S. Balance Sheet September 30 Assets Cash ............................. $12,133 Accounts receivable ... 6,950 Supplies....................... 612 Equipment. .................. 17,280 Accum. depreciation— equipment................ (288) Total assets ......... $36,687
Liabilities and Stockholders’ Equity Accounts payable ......... $13,680 Common Stock ................ 20,000 Retained earnings ........... 3,007 Total liabilities and stockholders’ equity .... $36,687
Problem 2.1 (Continued) (d)
YASUNARI KAWABATA, D.D.S. Post-Closing Trial Balance September 30 Debit Cash ..................................................................... ..................................................................... Accounts Receivable ................................. Supplies ...................................................... Equipment .................................................. Accumulated Depreciation—Equipment .. Accounts Payable ...................................... Common Stock ........................................... Retained Earnings...................................... Totals................................................
Credit
$12,133
6,950 612 17,280 $
$36,975
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
288 13,680 20,000 3,007 $36,975
Problem 2.2 (a) Dec. 31 Accounts Receivable ($23,500 − $20,000)............ 3,500 Service Revenue............................................. 3,500 31 Unearned Service Revenue ($7,000 − $5,600)...... 1,400 Service Revenue............................................. 1,400 31 Supplies Expense .................................................. 5,400 Supplies ($8,400 − $3,000) ............................. 5,400 31 Depreciation Expense ........................................... 5,000 Accumulated Depreciation— Equipment ($33,000 − $28,000) ................... 5,000 31 Interest Expense($500 − $350) .............................. Interest Payable ..............................................
150
31 Insurance Expense ................................................ Prepaid Insurance ($3,350 - $2,500) ..............
850
150 850
31 Salaries and Wages Expense ($11,300 − $10,000) 1,300 Salaries and Wages Payable ......................... 1,300 (b)
MASON ADVERTISING Income Statement For the Year Ended December 31, 2025 Revenues Service revenue ................................ Expenses Salaries and wages expense ............ Supplies expense .............................. Depreciation expense ....................... Rent expense..................................... Insurance expense ............................ Interest expense ................................ Total expenses ........................... Net income ...................................................
$63,500 $11,300 5,400 5,000 4,000 850 500 27,050 $36,450
Problem 2.2 (Continued) MASON ADVERTISING Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1 ................................ Add: Net income .................................................... Retained earnings, December 31...........................
$ 3,500 36,450 $39,950
MASON ADVERTISING Balance Sheet December 31, 2025 Assets Cash ........................................................................... Accounts receivable.................................................. Supplies ..................................................................... Prepaid insurance ..................................................... Equipment .................................................................. Less: Accumulated depreciation—equipment ....... Total assets .................................................
$11,000 23,500 3,000 2,500 $60,000 33,000
27,000 $67,000
Liabilities and Stockholders’ Equity Liabilities Notes payable .................................................. Accounts payable ............................................ Unearned service revenue .............................. Salaries and wages payable ........................... Interest payable ............................................... Total liabilities ........................................... Stockholders’ equity Common stock................................................. Retained earnings ........................................... Total liabilities and stockholders’ equity .....................................................
$ 5,000 5,000 5,600 1,300 150 $17,050 10,000 39,950
49,950 $67,000
(c) 1. Interest is $50 per month or 1% of the note payable. 1% X 12 = 12% interest per year. 2. Salaries and Wages Expense, $11,300 less Salaries and Wages Payable 12/31/25, $1,300 = $10,000. Total Payments, $12,500 – $10,000 = $2,500 Salaries and Wages Payable 12/31/24. LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 2.3 1.
Dec. 31 Salaries and Wages Expense........................ Salaries and Wages Payable.................. (5 X $700 X 2/5) = $1,400 (3 X $600 X 2/5) = 720 Total accrued salaries $2,120
2,120 2,120
2.
31 Unearned Rent Revenue ............................... 94,000 Rent Revenue ......................................... 94,000 (5 X $6,000 X 2) = $60,000 (4 X $8,500 X 1) = 34,000 Total rent recognized $94,000
3.
31 Advertising Expense ..................................... Prepaid Advertising ................................ (A650 – $500 ($6,000/12) per month for 8 months) = $4,000 (B974 – $300 per month ($7,200/24) for 3 months) = 900 Total advertising expense $4,900
4,900
31 Interest Expense ............................................ Interest Payable ($60,000 X 12% X 7/12) .......................
4,200
4.
4,900
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
4,200
Problem 2.4 (a) Nov. 30 Supplies Expense ($5,500 − $1,500) ..... Supplies...........................................
4,000
30 Depreciation Expense............................ Accumulated Depreciation— Equipment ...................................
15,000
30 Interest Expense .................................... Interest Payable ..............................
11,000
4,000
15,000 11,000
Problem 2.4 (Continued) (b)
BELLEMY FASHION CENTER Adjusted Trial Balance November 30, 2025
Dr. Cash ..................................................................... $ 28,700 Accounts Receivable .......................................... 33,700 Inventory .............................................................. 45,000 Supplies ($5,500 - $4,000) ................................... 1,500 Equipment ........................................................... 133,000 Accumulated Depr.— Equipment ($24,000 + $15,000) .................................. Notes Payable ..................................................... Accounts Payable ............................................... Common Stock .................................................... Retained Earnings............................................... Sales Revenue..................................................... Sales Returns and Allowances .......................... 4,200 Cost of Goods Sold ............................................. 495,400 Salaries and Wages Expense ............................. 140,000 Advertising Expense........................................... 26,400 Utilities Expenses ............................................... 14,000 Maintenance and Repairs Expense ................... 12,100 Delivery Expense ................................................ 16,700 Rent Expense ...................................................... 24,000 Supplies Expense ($0 + $4,000) ......................... 4,000 Depreciation Expense ($0 + $15,000)................. 15,000 Interest Expense ($0 + $11,000) ......................... 11,000 Interest Payable ($0 + $11,000) .......................... Totals ............................................................. $1,004,700
Cr.
$
39,000 51,000 48,500 90,000 8,000 757,200
11,000 $1,004,700
Problem 2.4 (Continued) (c)
BELLEMY FASHION CENTER Income Statement For the Year Ended November 30, 2025 Revenues Sales revenue................................... Less: Sales returns and allowances ............................ Net sales ........................................... Cost of goods sold ..................................... Gross profit................................................. Operating expenses Selling expenses Salaries and wages expense ($140,000 X 70%) ................. Advertising expense ............... Rent expense ($24,000 X 80%) ................... Delivery expense .................... Utilities expenses ($14,000 X 80%) ................... Depreciation expense ............. Supplies expense ................... Total selling expenses ..... Administrative expenses Salaries and wages expense ($140,000 X 30%) ................. Maintenance and repairs expense ................................ Rent expense ($24,000 X 20%) ................... Utilities expenses ($14,000 X 20%) ................... Total admin. expenses .... Total oper. expenses . Income from operations ........................... Other expenses and losses Interest expense .............................. Net loss .................................................
$757,200 4,200 753,000 495,400 257,600
$98,000 26,400 19,200 16,700 11,200 15,000 4,000 $190,500 42,000 12,100 4,800 2,800 61,700 252,200 5,400 ($5,000)
11,000 ($ 5,600)
Problem 2.4 (Continued) BELLEMY FASHION CENTER Retained Earnings Statement For the Year Ended November 30, 2025 Retained earnings, December 1, 2024 ........... Less: Net loss................................................. Retained earnings, November 30, 2025 .........
$8,000 5,600 $2,400
BELLEMY FASHION CENTER Balance Sheet November 30, 2025 Assets Current assets Cash .................................................................. Accounts receivable ................................ Inventory .................................................. Supplies ................................................... Total current assets ....................... Property, plant, and equipment Equipment ................................................ Less: Accumulated depreciation— equipment ....................................... Total assets.....................................
$28,700 33,700 45,000 1,500 $108,900 133,000 39,000
94,000 $202,900
Liabilities and Stockholders’ Equity Current liabilities Notes payable due next year .................. Accounts payable .................................... Interest payable ....................................... Total current liabilities ................... Long-term liabilities Notes payable ($51,000 - $30,000) .......... Total liabilities ................................ Stockholders’ equity Common stock ........................................ Retained earnings ................................... Total liabilities and stockholders’ equity...........................................
$30,000 48,500 11,000 $ 89,500 21,000 110,500 90,000 2,400
92,400 $202,900
Problem 2.4 (Continued) (d) Nov. 30 Sales Revenue............................................ Income Summary ................................
757,200
30 Income Summary ....................................... Sales Returns and Allowances .......... Cost of Goods Sold ............................ Salaries and Wages Expense............. Advertising Expense .......................... Utilities Expenses ............................... Maintenance and Repair Expense ..... Delivery Expense ................................ Rent Expense ...................................... Supplies Expense ............................... Depreciation Expense ........................ Interest Expense .................................
762,800
30 Retained Earnings ..................................... Income Summary ($757,200 - $762,800) .
5,600
(e)
757,200 4,200 495,400 140,000 26,400 14,000 12,100 16,700 24,000 4,000 15,000 11,000 5,600
BELLEMY FASHION CENTER Post-Closing Trial Balance November 30, 2025 Debit Cash ........................................................................... ........................................................................... Accounts Receivable ....................................... Inventory ........................................................... Supplies ................................................................ Equipment ........................................................ Accumulated Depreciation—Equipment ........ Notes Payable .................................................. Accounts Payable ............................................ Interest Payable................................................ Common Stock ................................................. Retained Earnings ............................................
Credit
$ 28,700
33,700 45,000 1,500 133,000
$241,900 LO: 3, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$ 39,000 51,000 48,500 11,000 90,000 2,400 $241,900
Problem 2.5 (a)
-1Dec. 31 Depreciation Expense ............................. Accum. Depreciation—Equipment (1/16 X [$192,000 − $24,000]) ............ -2Dec. 31 Interest Expense ...................................... Interest Payable ($90,000 X 8% X 72/360) ..................... -3Dec. 31 Admissions Revenue .............................. Unearned Admissions Revenue (2,000 X $30) .......................................
10,500 10,500 1,440* 1,440* 60,000 60,000
-4Dec. 31 Prepaid Advertising ................................. Advertising Expense .............................
1,100
-5Dec. 31 Salaries and Wages Expense ................. Salaries and Wages Payable ................
4,700
(b) 1. 2. 3. 4.
1,100
4,700
Interest expense, $2,840 ($1,400 + $1,440). Admissions revenue, $320,000 ($380,000 – $60,000). Advertising expense, $12,580 ($13,680 – $1,100). Salaries and wages expense, $62,300 ($57,600 + $4,700).
*Note to instructor: If 30-day months are assumed, interest expense = $1,400 ($90,000 X 8% X 70/360). LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 2.6 (a)
-1Dec. 31 Service Revenue ........................................ Unearned Service Revenue ....................
6,000
-2Dec. 31 Accounts Receivable ................................. Service Revenue.....................................
4,900
-3Dec. 31 Bad Debt Expense...................................... Allowance for Doubtful Accounts ..........
1,430
-4Dec. 31 Insurance Expense .................................... Prepaid Insurance ...................................
480
-5Dec. 31 Depreciation Expense ................................ Accumulated Depreciation—Equipment ($25,000 X 10%) ............................. -6Dec. 31 Interest Expense ........................................ Interest Payable ($7,200 X 10% X 30/360) .................
6,000
4,900
1,430
480 2,500 2,500 60 60
-7Dec. 31 Prepaid Rent ............................................... Rent Expense ..........................................
750
-8Dec. 31 Salaries and Wages Expense .................... Salaries and Wages Payable ..................
2,510
750
2,510
Problem 2.6 (Continued) (b)
PEREZ CONSULTING ENGINEERS Income Statement For the Year Ended December 31, 2025 Service revenue ($100,000 – $6,000 + $4,900) ........ Expenses Salaries and wages expense ($30,500 + $2,510) ......................................... Rent expense ($9,750 – $750) .......................... Depreciation expense ...................................... Bad debt expense ............................................ Utilities expenses ............................................. Office expense.................................................. Insurance expense ........................................... Interest expense ............................................... Total expenses ............................................ Net income ..............................................................
$98,900
$33,010 9,000 2,500 1,430 1,080 720 480 60 48,280 $50,620
PEREZ CONSULTING ENGINEERS Retained Earnings Statement For the Year Ended December 31, 2025 Retained Earnings, January 1 ................................. Add: Net income ....................................................... Less: Dividends........................................................ Retained Earnings, December 31 ............................
$ 42,010a 50,620 17,000 $ 75,630
(a)
$ 25,010 17,000 $ 42,010
Retained Earnings—trial balance ......................... 2025 Dividend recorded in Retained Earnings .... Retained Earnings, as of January 1, 2025 ..............
Problem 2.6 (Continued) PEREZ CONSULTING ENGINEERS Balance Sheet December 31, 2025 Assets Current assets Cash ......................................... Accounts receivable ($49,600 + $4,900) ................ Less: Allowance for doubtful accounts ........ Supplies ................................... Prepaid insurance ($1,100 – $480) ..................... Prepaid rent ............................. Total current assets ......... Equipment ...................................... Less: Accumulated depreciation .. Total assets ......................
Liabilities and stockholders’ equity Current liabilities Notes payable ........................... Unearned service revenue ....... Salaries and wages payable .... Interest payable ........................ Common Stock ................................ Retained earnings ........................... Total liabilities and stockholders’ equity ......
$29,500 $54,500 2,180*
52,320 1,960 620 750 $ 85,150 25,000 8,750**
16,250 $101,400
$7,200 6,000 2,510 60
$ 15,770
10,000 75,630
85,630
*($750 + $1,430) **($6,250 + $2,500) LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$101,400
Problem 2.7 (a)
Sep. 30 Accounts Receivable ($1,000 - $400) .............. Service Revenue .......................................
600
30 Rent Expense.................................................... Prepaid Rent ($1,800 - $900) .....................
900
30 Supplies Expense ............................................. Supplies ($1,200 - $180) ............................
1,020
30 Depreciation Expense ...................................... Accumulated Depreciation—Equipment .
350
30 Interest Expense ............................................... Interest Payable.........................................
50
30 Unearned Rent Revenue ($1,000 - $800) ......... Rent Revenue ............................................
200
30 Salaries and Wages Expense ($9,400 - $8,800) .. Salaries and Wages Payable ....................
600
(b)
600 900 1,020 350 50 200 600
ROLLING HILLS GOLF INC. Income Statement For the Quarter Ended September 30, 2025 Revenues Service revenue ............................................... Rent revenue .................................................... Total revenue............................................. Expenses Salaries and wages expense ........................... Rent expense ................................................... Supplies expense............................................. Utilities expenses............................................. Depreciation expense ...................................... Interest expense............................................... Total expenses ............................................ Net income ...............................................................
$14,700 900 $15,600 $9,400 1,800 1,020 470 350 50 13,090 $ 2,510
Problem 2.7 (Continued) ROLLING HILLS GOLF INC. Retained Earnings Statement For the Quarter Ended September 30, 2025 Retained earnings, July 1, 2025 ........................................... Add: Net income ................................................................... Less: Dividends .................................................................... Retained earnings, September 30, 2025 ..............................
$
0 2,510 600 $1,910
ROLLING HILLS GOLF INC. Balance Sheet September 30, 2025 Assets Current assets Cash ......................................... Accounts receivable ................ Supplies ................................... Prepaid rent ............................. Total current assets .......... Equipment ....................................... Less: Accumulated depreciation.. Total assets ....................... Liabilities and Stockholders’ Equity Current liabilities Notes payable ........................... Accounts payable..................... Unearned rent revenue ............ Salaries and wages payable .... Interest payable ........................ Stockholders’ Equity Common stock ................................ Retained earnings ........................... Total stockholders’ equity Total liabilities and stockholders’ equity ........
$ 6,700 1,000 180 900 $ 8,780 15,000 350
$ 5,000 1,070 800 600 50
14,650 $23,430
$ 7,520
14,000 1,910 15,910 $23,430
Problem 2.7 (Continued) (c) The following accounts would be closed: Service Revenue, Rent Revenue, Salaries and Wages Expense, Rent Expense, Utilities Expenses, Depreciation Expense, Supplies Expense, Interest Expense, Dividends. (d) Interest of 12% per year equals a monthly rate of 1%; monthly interest is $50 ($5,000 X 1%). Since total interest expense is $50, the note has been outstanding one month. LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 2.8 (a) Dec. 31 Accounts Receivable ($19,500 − $16,000)....... Service Revenue........................................
(b)
3,500 3,500
31 Supplies Expense ............................................. Supplies ($9,400 − $6,500) ........................
2,900
31 Insurance Expense ........................................... Prepaid Insurance ($3,350 − $1,790) ........
1,560
31 Depreciation Expense ...................................... Accumulated Depreciation—Equipment . ($30,000 - $25,000)
5,000
31 Interest Expense ............................................... Interest Payable .........................................
560
31 Unearned Service Revenue ($5,000 − $3,100). Service Revenue........................................
1,900
31 Salaries and Wages Expense ($9,820 - $9,000) .. Salaries and Wages Payable ....................
820
2,900 1,560 5,000
560 1,900 820
VEDULA ADVERTISING Income Statement For the Year Ended December 31, 2025 Revenues Service revenue ................................................ Expenses Salaries and wages expense ............................ Depreciation expense ....................................... Rent expense..................................................... Supplies expense .............................................. Insurance expense ............................................ Interest expense ................................................ Total expenses ............................................. Net income.................................................................
$63,000 $9,820 5,000 4,350 2,900 1,560 560 24,190 $38,810
Problem 2.8 (Continued) VEDULA ADVERTISING Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1 ............................. Add: Net income .................................................. Less: Dividends ................................................... Retained earnings, December 31........................
$ 5,500 38,810 10,000 $34,310
VEDULA ADVERTISING Balance Sheet December 31, 2025 Assets Current assets Cash .......................................................... $11,000 Accounts receivable ................................. 19,500 Supplies .................................................... 6,500 Prepaid insurance .................................... 1,790 Total current assets ........................... Equipment .................................................... 60,000 Less: Accumulated depreciation ................ 30,000 Total assets ........................................ Liabilities and Stockholders’ Equity Current liabilities Notes payable ........................................ Accounts payable .................................. Unearned service revenue .................... Salaries and wages payable .................. Interest payable..................................... Stockholders’ Equity Common stock ....................................... Retained earnings .................................. Total stockholders’ equity .................. Total liabilities and stockholders’ equity.....................
$ 8,000 2,000 3,100 820 560
$38,790 30,000 $68,790
$ 14,480
20,000 34,310 54,310 $68,790
Problem 2.8 (Continued) (c) Service Revenue, Salaries and Wages Expense, Depreciation Expense, Rent Expense, Supplies Expense, Insurance Expense, Interest Expense, Dividends. (d) Interest is $56 per month or 0.7% of the note payable ($56 ÷ $8,000). 0.7% X 12 = 8.4% interest per year. (e) Salaries and Wages Expense, $9,820, less Salaries and Wages Payable 12/31/25, $820 = $9,000. Total payments, $10,500 – $9,000 = $1,500 Salaries and Wages Payable 12/31/24. LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 2.9 (a), (b), (d)
Bal.
Cash 15,000
Prepaid Insurance 9,000 Adj. 3,500 5,500
Bal.
Salaries and Wages Expense Bal. 80,000 Close 83,600 Adj. 3,600 83,600 83,600
Common Stock Bal. 400,000
Accounts Receivable Bal. 13,000
Retained Earnings Bal. 82,000 Inc. 31,640 113,640
Allow. for Doubtful Accts. Bal. 1,100 Adj. 460 1,560
Dues Revenue 8,900 Bal. 200,000 191,100 200,000 200,000
Adj. Cls.
Land Bal.
350,000
Close
120,000
Accum. Depr.—Buildings
Rent Receivable Adj. $1,600
5,900 Bal.
19,200 Bal. Adj. 19,200
Depr. Expense 4,000 Close 19,000 15,000 19,000
Equipment
5,900
Rent Revenue Close
Bal. 38,400 Adj. 4,000 42,400
Adj. Adj.
Green Fees Revenue
Buildings Bal.
Maintenance and Repairs Expense Bal. 24,000 Close 24,000
Bal.
150,000
Accum. Depr.—Equipment 17,600 1,600 19,200
Bal. Adj.
Utilities Expenses
70,000 15,000 85,000
Insurance Expense
Bal.
54,000 Close
54,000
Adj.
Bad Debt Expense 460 Close
460
Adj.
Exp. Inc.
3,500 Close
3,500
Income Summary 184,560 216,200 31,640 216,200 216,200
Problem 2.9 (Continued) Salaries and Wages Payable Adj. 3,600
(b)
Unearned Dues Revenue Adj. 8,900
-1Dec. 31 Depreciation Expense ............................. Accumulated Depreciation—Buildings (1/30 X $120,000) .................................. -2Dec. 31 Depreciation Expense ............................. Accumulated Depreciation— Equipment (10% X $150,000)………
4,000 4,000 15,000 15,000
-3Dec. 31 Insurance Expense .................................. Prepaid Insurance .................................
3,500
-4Dec. 31 Rent Receivable ....................................... Rent Revenue (1/11 X $17,600)……
1,600
-5Dec. 31 Bad Debt Expense ................................... Allowance for Doubtful Accounts [($13,000 X 12%) – $1,100] .................
3,500
1,600 460 460
-6Dec. 31 Salaries and Wages Expense ................. Salaries and Wages Payable ................
3,600
-7Dec. 31 Dues Revenue .......................................... Unearned Dues Revenue .....................
8,900
3,600
8,900
Problem 2.9 (Continued)
(c)
CRESTWOOD GOLF CLUB, INC. Adjusted Trial Balance December 31, XXXX Cash ............................................................... Accounts Receivable .................................... Allowance for Doubtful Accounts ................ Rent Receivable ............................................. Prepaid Insurance …………………………….. Land ........................................................................ ........................................................................ Buildings ........................................................ Accum. Depreciation—Buildings ................. Equipment ...................................................... Accum. Depreciation—Equipment ............... Salaries and Wages Payable ........................ Unearned Dues Revenue .............................. Common Stock ………………………………… Retained Earnings ......................................... Dues Revenue................................................ Green Fees Revenue ..................................... Rent Revenue ................................................ Utilities Expenses .......................................... Salaries and Wages Expense ....................... Maintenance and Repairs Expense .............. Bad Debt Expense ......................................... Depreciation Expense ($15,000 + $4,000) .... Insurance Expense ........................................ Totals ...................................................
Dr. $ 15,000 13,000
Cr.
$
1,560
1,600 5,500 350,000 120,000 42,400 150,000 85,000 3,600 8,900 400,000 82,000 191,100 5,900 19,200 54,000 83,600 24,000 460 19,000 3,500 $839,660
$839,660
Problem 2.9 (Continued) (d)
-Dec. 31Dues Revenue ........................................................ Green Fees Revenue ............................................. Rent Revenue ......................................................... Income Summary ............................................ -Dec 31Income Summary ................................................... Utilities Expenses ........................................... Bad Debt Expense .......................................... Salaries and Wages Expense ........................ Maintenance and Repairs Expense ............... Depreciation Expense .................................... Insurance Expense ......................................... -Dec 31Income Summary ($216,200 -$184,560b) ............. Retained Earnings .......................................... a
191,100 5,900 19,200 216,200a 184,560b 54,000 460 83,600 24,000 19,000 3,500 31,640
LO: 2, 3, 4,, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
31,640
Problem 2.10 (a), (b), (c) Bal.
Cash 18,500
Bal.
Inventory 80,000
Bal.
Accounts Receivable 32,000
Allogw. for Doubtful Accts. Bal. 700 Adj. 1,400 2,100
Bal.
Equipment 84,000
Accum. Depr.—Equipment Bal. 35,000 Adj. 12,000 47,000
Prepaid Insurance Bal. 5,100 Adj. 2,550 2,550
Notes Payable Bal. 28,000
Adj.
Common Stock Bal. 80,600
Sales Revenue 600,000 Bal. 600,000
Insurance Expense Bal. 2,550 Cls. 2,550
Salaries and Wages Expense (Sales) Bal. 50,000 Cls. 52,400 Adj. 2,400 52,400 52,400 Bad Debt Expense Adj. 1,400 Cls. 1,400
Interest Payable Adj. 3,360
Adj.
Supplies 1,500
Retained Earnings Bal. 10,000 Inc. 45,790 Bal. 55,790
Cls.
Bal.
Bal.
Adj.
Advertising Expense 6,700 Adj. 700 Cls. 6,000 6,700 6,700 Supplies Expense 5,000 Adj. 1,500 Cls. 3,500 5,000 5,000 Depr. Exp. 12,000 Cls.
12,000
Salaries and Wages Payable Adj. 2,400
Cost of Goods Sold Bal. 408,000 Cls. 408,000
Interest Expense 3,360 Cls. 3,360
Salaries and Wages Expense (Administrative) Adj. 65,000 Cls. 65,000
Prepaid Advertising Adj. 700
Exp. Inc.
Income Summary 554,210 Sales 600,000 45,790 600,000 600,000
Problem 2.10 (Continued) (b)
-1Dec. 31 Bad Debt Expense ................................... Allowance for Doubtful Accounts........ -2Dec. 31 Depreciation Expense ($84,000 ÷ 7) ....... Accumulated Depreciation— Equipment ..................................
1,400 1,400
12,000 12,000
-3Dec. 31 Insurance Expense .................................. Prepaid Insurance .................................
2,550
-4Dec. 31 Interest Expense ...................................... Interest Payable ....................................
3,360
-5Dec. 31 Salaries and Wages Expense (Sales) ..... Salaries and Wages Payable ................
2,400
-6Dec. 31 Prepaid Advertising ................................. Advertising Expense ............................
700
-7Dec. 31 Supplies ................................................... Supplies Expense .................................
1,500
2,550
3,360
2,400
700
1,500
Problem 2.10 (Continued) (c)
Dec. 31 Sales Revenue.................................................... Income Summary ........................................ Dec. 31 Income Summary ............................................... Cost of Goods Sold .................................... Advertising Expense .................................. Salaries and Wages Expense (Admin.) ..... Salaries and Wages Expense (Sales) ........ Supplies Expense ....................................... Insurance Expense ..................................... Bad Debt Expense ......................................
600,000 600,000a
554,210b 408,000 6,000 65,000 52,400 3,500 2,550 1,400
Depreciation Expense ................................ Interest Expense ......................................... Dec. 31 Income Summary ($600,000a - $554,210b) ........ Retained Earnings ......................................
12,000 3,360
45,790
LO: 2, 3, 4 Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
45,790
*Problem 2.11
(a)
ARKANSAS SALES AND SERVICE Income Statement For the Month Ended January 31, 2025 (1) Cash Basis
(2) Accrual Basis
$ 75,000
$98,400*
Revenues ............................................. Expenses Cost of computers & printers: Purchased and paid ............ Cost of goods sold.............. Salaries and wages ................... Rent............................................ Other operating expenses ........ Total expenses .................. Net income (loss) ................................ *($2,550 X 30) + ($3,600 X 4) + ($500 X 15) **($1,500 X 40) + ($2,500 X 6) + ($300 X 25) ***($1,500 X 30) + ($2,500 X 4) + ($300 X 15) a
($6,000 / 3 months) b ($8,400 + $2,000)
82,500** 9,600 6,000 8,400 106,500 $(31,500)
59,500*** 12,600 2,000a 10,400b 84,500 $13,900
*Problem 2.11 (Continued)
(b)
ARKANSAS SALES AND SERVICE Balance Sheet As of January 31, 2025
Assets Cash ................................................ Accounts receivable ...................... Inventory ......................................... Prepaid rent ($6,000 - $2,000) ........ Total assets ............................... Liabilities and owners’ equity Salaries and wages payable .......... Accounts payable .......................... Owner’s capital............................... Total liabilities and owner’s equity ......................................
a
Original investment Cash sales Cash purchases Rent paid Salaries paid Other operating expenses Cash balance Jan. 31
b
c
(1) Cash Basis
(2) Accrual Basis
$58,500a
$ 58,500a 23,400 23,000b 4,000 $108,900
$58,500
$ $58,500c
3,000 2,000 103,900d
$58,500
$108,900
$ 90,000 75,000 (82,500) (6,000) (9,600) (8,400) $ 58,500
[(40 – 30) @ $1,500] + (2 @ $2,500) + (10 @ $300).
Initial investment minus net loss: $90,000 – $31,500.
d
Initial investment plus net income: $90,000 + $13,900.
*Problem 2.11 (Continued) (c)
1.
The $23,400 in receivables from customers is an asset and a future cash flow resulting from sales that is ignored. The cash basis understates the amount of revenues and inflow of assets in January from the sale of computers and printers by $23,400.
2.
The cost of computers and printers sold in January is overstated by $23,000. The unsold computers and printers are an asset of $23,000 in the form of inventory.
3.
The cash basis ignores $3,000 of the salaries that have been earned by the employees in January and will be paid in February.
4.
Rent expense on the cash basis is overstated by $4,000. This prepayment is an asset in the form of two months’ future right to the use of office, showroom, and repair space and should appear on the balance sheet.
5.
Other operating expenses on a cash basis are understated by $2,000 as is the liability for the unpaid portion of these expenses incurred in January.
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
3,000 59,200
506,500
5,800
506,500
3,000
6,000
247,000
5,800
280,500
280,500
280,500
Cr.
259,500
259,500
14,000
80,000 120,000
3,900
4,200
37,400
Dr.
259,500
33,500
226,000
3,000
6,000
14,600 700 50,000 107,700 2,000
42,000
Cr.
Balance Sheet
Key: (a) Expired Insurance ($31,900 - $3,900); (b) Supplies Used ($18,600 - $4,200); (c) Depreciation Expensed ($42,000 - $36,200); (d) Service Revenue Recognized ($2,700 - $700); (e) Accrued Property Taxes ($21,000 - $18,000); (f) Taxes Accrued ($0 - $6,000)
33,500
(e)
6,000
14,400
28,000
12,000
21,000
280,500
59,200
5,800
(f)
14,400
28,000
12,000
21,000
30,500 9,400 16,900
109,000
Dr.
Totals
(c)
14,400
28,000
6,000
3,000
280,500
14,600 700 50,000 107,700 2,000
42,000
Cr.
Income Statement
Net Income
Totals
Prop. Taxes Payable
Depreciation Expense
Interest Payable
(a) (b)
491,700
(f)
Supplies Expense
491,700
6,000
Insurance Expense
Totals
Interest Expense
(e)
18,000
14,000
Prop. Tax Expense
2,000
80,000 120,000
3,900
4,200
30,500 9,400 16,900
278,500
(d)
5,800
28,000
14,400
37,400
Dr.
30,500 9,400 16,900
2,000
(c)
(a)
(b)
Cr.
109,000
(d)
Dr.
Adjusted Trial Balance
109,000
14,000
14,600 2,700 50,000 107,700 2,000
36,200
Cr.
Adjustments
For the Year Ended September 30, 2025
Worksheet
COOKE COMPANY
Accounts Payable Unearned Service Rev. Mortgage Payable Common Stock Retained Earnings Dividends Service Revenue Sal. and Wages Exp. Maintenance and Repairs Expense Advertising Expense Utilities Expenses
80,000 120,000
31,900
Prepaid Insurance
Land Equipment Accum. Depr.-Equip.
18,600
Supplies
Dr.
Trial Balance
37,400
Account Titles
Cash
(a)
*Problem 2.12
*Problem 2.12 (Continued) (b)
COOKE COMPANY Balance Sheet September 30, 2025 Assets Current assets Cash ...................................................... Supplies ....................................... Prepaid insurance ....................... Total current assets ........... Property, plant, and equipment Land ...................................................... Equipment ................................... Less: Accum. depreciation – equipment .................................. Total assets ........................
$37,400 4,200 3,900 $ 45,500 80,000 $120,000 42,000
78,000
158,000 $203,500
Liabilities and Stockholders’ Equity Current liabilities Accounts payable .......................................... Current maturity of long-term debt ............... Interest payable .............................................. Property taxes payable .................................. Unearned service revenue............................. Total current liabilities .......................... Long-term liabilities Mortgage payable ($50,000 - $10,000*) ......... Total liabilities ....................................... Stockholders’ equity Common stock …………………………………. Retained earnings ($2,000 + $33,500 – $14,000) ........................ Total liabilities and stockholders’ equity .....
$14,600 10,000* 6,000 3,000 700 $ 34,300 40,000 74,300 107,700 21,500
129,200 $203,500
*Problem 2.12 (Continued) (c) Sep. 30 Insurance Expense ................................... Prepaid Insurance .............................
28,000
30 Supplies Expense ..................................... Supplies .............................................
14,400
30 Depreciation Expense .............................. Accum. Depreciation— Equipment .......................................
5,800
30 Unearned Service Revenue ($2,700 - $700) Service Revenue ................................
2,000
30 Property Tax Expense .............................. Property Taxes Payable ....................
3,000
30 Interest Expense ....................................... Interest Payable .................................
6,000
(d) Sep. 30 Service Revenue ..................................... Income Summary ............................
280,500
30 Income Summary .................................... Salaries and Wages Expense ......... Maintenance and Repairs Expense ........................................ Insurance Expense .......................... Property Tax Expense ..................... Supplies Expense ............................ Utilities Expenses ............................ Interest Expense .............................. Advertising Expense ....................... Depreciation Expense .....................
247,000b
30 Income Summary ($280,500a - $247,000b).. Retained Earnings ..........................
33,500
30 Retained Earnings ................................. Dividends ........................................
14,000d
28,000 14,400
5,800 2,000 3,000 6,000 280,500a 109,000 30,500 28,000 21,000 14,400 16,900 12,000 9,400 5,800 33,500c 14,000
*Problem 2.12 (Continued) (e)
COOKE COMPANY Post-Closing Trial Balance September 30, 2025 Debit Cash ....................................................................... ....................................................................... Supplies ........................................................ Prepaid Insurance ........................................ Land ....................................................................... ....................................................................... Equipment .................................................... Accumulated Depreciation – Equipment .... Accounts Payable ........................................ Unearned Service Revenue ......................... Interest Payable............................................ Property Tax Payable ................................... Mortgage Payable ........................................ Common Stock ............................................. Retained Earnings ($2,000 + $33,500c - $14,000d) .............
Credit
$ 37,400
4,200 3,900 80,000 120,000 $ 42,000 14,600 700 6,000 3,000 50,000 107,700 $245,500
21,500 $245,500
LO: 3, 4, 8, , Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
UYJ2.1 Financial Reporting Problem (a)
June 30, 2020 total assets: $120,700 million. June 30, 2019 total assets: $115,095 million.
(b)
June 30, 2020 cash and cash equivalents: $16,181 million.
(c)
2020 research and development costs: $1,834 million. 2019 research and development costs: $1,861 million.
(d)
2020 net sales: $70,950 million. 2019 net sales: $67,684 million.
(e)
An adjusting entry for deferrals is necessary when the receipt/disbursement precedes the recognition in the financial statements. Accounts such as prepaid insurance and prepaid rent may be included in the Prepaid Expenses and Other Current Assets ($2,130 million at June 30, 2020). Both of these accounts would require an adjusting entry to recognize the proper amount of expense incurred during the period. In addition, depreciation expense is an adjusting entry related to a deferral. An adjusting entry for an accrual is necessary when recognition in the financial statements precedes the cash receipt/disbursement, such as interest or taxes payable. Other adjusting entries probably made by P&G include interest revenue and expense and interest receivable and interest payable. P&G reports $9,722 million of Accrued and Other Liabilities at June 30, 2020.
(f)
2020 Depreciation and amortization expense: $3,013 million 2019 Depreciation and amortization expense: $2,824 million (From the Statement of Cash Flows)
LO: 3, 4, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ2.2 Comparative Analysis Case (a)
The Coca-Cola Company percentage increase is computed as follows: Total assets (December 31, 2020) .......................................... Less: Total assets (December 31, 2019) ............................... Difference ................................................................................
$87,296 86,381b $915a
$915a ÷ $86,381b = 1.1% PepsiCo, Inc.’s percentage increase is computed as follows: Total assets (December 26, 2020) .......................................... Less: Total assets (December 28, 2019) ............................... Difference ................................................................................
$92,918 78,547c $14,371d
$14,371d ÷ $78,547c = 18.3% Coca-Cola Company had a very small increase; but, PepsiCo had a larger increase. (b) 3-Year Growth Rate Net sales Net income e
($33,014 ÷ $34,300)-1 f ($7,768 ÷ $6,476)-1
(c)
The Coca-Cola Company (3.75)%e 19.95%f
PepsiCo, Inc. 8.83%g (42.87)%h
g
($70,372 ÷ $64,661) -1 h ($7,175 ÷ $12,559) -1
The Coca-Cola Company had depreciation and amortization expense of $1,536 million; PepsiCo, Inc. had depreciation and amortization expense of $2,548 million.
Comparative Analysis Case (Continued) PepsiCo has substantially more property, plant, and equipment than does Coca-Cola. PepsiCo is engaged in three different types of businesses: soft drinks, snack-food, and juices. As a result, it has more tangible fixed assets. PepsiCo also has substantially more amortizable intangible assets. Amortizable intangible assets for Coke and Pepsi increase the amount of amortization expense recorded in income. The amount of property, plant, and equipment and amortizable intangible assets reported for these two companies is as follows: (000,000) The Coca-Cola Company Property, plant, and equipment (net) Amortizable intangible assets (net)
PepsiCo, Inc.
$ 10,777
$21,369
649 $11,426
1,703 $23,072
LO: 3, 4, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ2.3 Financial Statement Analysis Current Year
Prior Year
2 Years Ago
% Change Current year
% Change Last year
$14,580
$14,792
$14,197
-1.43%
4.19
Operating Profit
1,024
2,837
1,562
-63.91%
81.63%
Net Cash Flow less Capital Expenditures
1,211
1,170
1,225
3.50%
-4.49%
633
1,808
961
-64.99%
88.14%
(a)
Sales
Net Earnings
(b)
Kellogg experienced a slight decrease in sales in the current year which followed an increase in the previous year. The gross profit percentage decreased after an increase in the prior year. This coincides with declining operating profit but a solid increase in cash flows, compared to prior years, suggests it faces a challenging period and might be starting to recover. This may bode well for the strength and flexibility of its business model.
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ2.4 Accounting, Analysis, and Principles Accounting Dec. 31
Dec. 31
Dec. 31
Dec. 31
Dec. 31
Depreciation Expense .............................. Accumulated Depreciation— Equipment .................................. ($9,500 = ($192,000 – $40,000) ÷ 16)
9,500a
Interest Expense ....................................... Interest Payable ................................. $8,250 = ($90,000 X 10%) X 11/12)
8,250d
Unearned Service Revenue...................... Service Revenue................................ ($10,000 = ($50 X 200))
10,000
Advertising Expense ................................ Prepaid Advertising ..........................
2,500b
Salaries and Wages Expense .................. Salaries and Wages Payable ............
3,500c
9,500
8,250
10,000
2,500
3,500
Accounting, Analysis, and Principles (Continued) Analysis
Ticket revenue Less: Depreciation expense Advertising expense Salaries and wages expense Interest expense Net income
Income before Adjustments $360,000
Adjustments $10,000
Income after Adjustments $370,000
(18,680)
(9,500)a (2,500)b
(9,500) (21,180)
(3,500)c (8,250)d
(71,100) (9,650) $258,570
(67,600) (1,400) $272,320
Without recording the adjusting entries, Amato’s income is overstated. In addition, without the adjustments, Amato’s current liabilities and current assets are misstated, which could affect the evaluation of Amato's liquidity. Principles The tradeoffs are between the timeliness of the reports, which contributes to relevance, and verifiability, the lack of which detracts from faithful representation. That is, by preparing reports more frequently, the company provides more timely information, which can make a difference to a statement reader who needs to make a decision. However, preparing statements more frequently requires more subjective estimates, which reduces faithful representation. LO: 3, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Codification Research Case
(a) The three essential characteristics of assets. Search String: asset and characteristics. CON6, Par26. An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows, (b) a particular entity can obtain the benefit and control others’ access to it, and (c) the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred. (b) Three essential characteristics of liabilities. Search String: liability and characteristic. CON6, Par36. A liability has three essential characteristics: (a) it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand, (b) the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and (c) the transaction or other event obligating the entity has already happened. (c) Uncertainty, and its effects on financial statements. Search Strings: “uncertainty”, effect of uncertainty. CON6, Par44. Uncertainty about economic and business activities and results is pervasive, and it often clouds whether a particular item qualifies as an asset or a liability of a particular entity at the time the definitions are applied. The presence or absence of future economic benefit that can be obtained and controlled by the entity or of the entity’s legal, equitable, or constructive obligation to sacrifice assets in the future can often be discerned reliably only with hindsight. As a result, some items that with hindsight actually qualified as assets or liabilities of the entity under the definitions may, as a practical matter, have been recognized as expenses, losses, revenues, or gains or
Codification Research Case (Continued) remained unrecognized in its financial statements because of uncertainty about whether they qualified as assets or liabilities of the entity or because of recognition and measurement considerations stemming from uncertainty at the time of assessment. Conversely, some items that with hindsight did not qualify under the definitions may have been included as assets or liabilities because of judgments made in the face of uncertainty at the time of assessment. CON6, Par45. An effect of uncertainty is to increase the costs of financial reporting in general and the costs of recognition and measurement in particular. Some items that qualify as assets or liabilities under the definitions may, therefore, be recognized as expenses, losses, revenues, or gains or remain unrecognized as a result of cost and benefit analyses indicating that their formal incorporation in financial statements is not useful enough to justify the time and effort needed to do it. It may be possible, for example, to make the information more reliable in the face of uncertainty by exerting greater effort or by spending more money, but it also may not be worth the added cost. Note to instructors: The FASB codification does not contain the Concepts Statements. However, the Concepts Statements can be accessed at another link on the FASB website. (d) The difference between realization and recognition Search String: realization, recognition. CON6, Par143. Realization in the most precise sense means the process of converting noncash resources and rights into money and is most precisely used in accounting and financial reporting to refer to sales of assets for cash or claims to cash. The related terms realized and unrealized, therefore, identify revenues or gains or losses on assets sold and unsold, respectively. Those are the meanings of realization and related terms in the Board’s conceptual framework. Recognition is the process of formally recording or incorporating an item in the financial statements of an entity. Thus, an asset, liability, revenue, expense, gain, or loss may be recognized (recorded) or unrecognized (unrecorded). Realization and recognition are not used as synonyms, as they sometimes are in accounting and financial literature. LO: 1, Bloom: C, Difficulty: Moderate, Time: 25-30, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Measurement, Reporting, Research, AICPA PC: Communication
CHAPTER 3 Income Statement and Related Information Assignment Classification Table (By Topic) Topics
Questions
1.
Income measurement concepts, quality of earnings.
1, 2, 3, 5, 6, 7, 8, 9, 10, 22, 28, 29, 30, 38, 39, 40, 41
2.
Computation of net income from balance sheets and selected accounts.
3.
Multiple-step income statements; earrings per share.
4.
Brief Exercises
Exercises
2, 3, 4, 6
1
1, 2, 3, 8
10, 11, 12,13, 14, 15, 20, 21, 22, 23, 24
3, 4 5, 6
5, 6, 7, 9, 11 1, 4
Single-step income statements.
8, 11, 25, 26
1, 2, 8
4, 5, 7, 13, 16
2, 3, 4, 5
5.
Discontinued operations; Intraperiod tax allocation.
16, 17, 18, 19, 21, 22, 23, 25, 26, 27, 32
4, 5
8, 9, 13,
3, 5, 7
6.
Comprehensive income.
31
8
14, 15, 16
7.
Retained earnings statement; statement of stockholders’ equity
27
7, 8
9, 10, 12, 15, 16
8.
Revenue recognition
33, 34, 35, 36, 37, 38
9, 10, 11, 12, 13,14
17, 18, 19
*9.
Accounting changes; prior period adjustments; errors.
4, 11, 41
15, 16, 17
20
*This material covered in an appendix.
Critical Thinking
Problems
1, 5
7 1, 2, 4, 5, 6
Assignment Classification Table (By Learning Objective) Learning Objectives
Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Identify the uses, limitations, and basic content of an income statement.
1, 2, 3, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 17, 19, 20, 27, 28, 29
1, 2, 3, 4, 5, 6
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 13, 16
1, 2, 3, 4, 5, 6, 7
1, 4, 5, 6
2.
Discuss the accounting for unusual income items.
12, 16, 17, 18, 21, 22, 23, 25, , 27, 30, 31,
4, , 8
2, 8, 13, 14, 16
1, 3, 6, 7
1, 4, 5, 6, 7
3.
Explain the reporting of stockholders’ equity.
3, 10,11, 24, 26, 28,
7,
9, 12, 15, 16
1, 2, , 4, 5, 6, 7
6
4.
Explain the revenue recognition principle.
32,33, 34, 35, 36, 37,
9, 10, 11 12, 13, 14
17, 18, 19
5.
Describe the concept of earnings quality.
38,39, 40
*6. Explain the reporting of accounting changes, estimates, and errors.
4, 10,11, 41
*This material covered in an appendix.
2, 15, 16, 17
20
3
6
Assignment Characteristics Table Level of Difficulty
Time (minutes)
Computation of net income. Compute income measures. Income statement items. Single-step income statement. Multiple-step and single-step statements Multiple-step statement Multiple-step and single-step statements Income statement, EPS. Multiple-step statement with retained earnings statement Earnings per share. Condensed income statement—periodic inventory method. Retained earnings statement. Earnings per share. Comprehensive income. Comprehensive income. Various reporting formats. Fundamentals of revenue recognition Determine transaction price Allocate transaction price Change in accounting principle.
Simple Simple Simple Moderate Simple Moderate Moderate Simple Simple Simple Moderate
18–20 10–15 25–35 20–25 30–35 30–35 30–40 15–20 30–35 20–25 20–25
Simple Moderate Simple Moderate Moderate Simple Simple Moderate Moderate
20–25 15–20 15–20 15–20 30–35 10–15 10–15 15–20 15–20
Moderate Simple
30–35 25–30
Moderate Moderate
30–40 45–55
P3.5 P3.6 P3.7
Multiple-step statement, retained earnings statement Single-step statement, retained earnings statement, periodic inventory. Various income-related items. Multiple- and single-step statements, retained earnings statement. Unusual or infrequent items. Retained earnings statement, prior period adjustment. Income statement, irregular items.
Moderate Moderate Moderate
20–25 25–35 25–35
CT3.1 CT3.2 CT3.3 CT3.4 CT3.5 CT3.6 CT3.7
Identification of income statement deficiencies. Earnings management. Earnings management. Income reporting items. Identification of income statement weaknesses. Classification of income statement items. Comprehensive income.
Simple Moderate Simple Moderate Moderate Moderate Simple
20–25 20–25 15–20 30–35 30–40 20–25 10–15
Item
Description
E3.1 E3.2 E3.3 E3.4 E3.5 E3.6 E3.7 E3.8 E3.9 E3.10 E3.11 E3.12 E3.13 E3.14 E3.15 E3.16 E3.17 E3.18 E3.19 E3.20 P3.1 P3.2 P3.3 P3.4
Answers to Questions 1. The income statement is important because it provides investors and creditors with information that helps them predict the amount, timing, and uncertainty of future cash flows. It helps investors and creditors predict future cash flows in a number of different ways. First, investors and creditors can use the information on the income statement to evaluate the past performance of the company. Second, the income statement helps users of the financial statements to determine the risk (level of uncertainty) of income—revenues, expenses, gains, and losses—and highlights the relationship among these various components. It should be emphasized that the income statement is used by parties other than investors and creditors. For example, customers can use the income statement to determine a company’s ability to provide needed goods or services, unions examine earnings closely as a basis for salary discussions, and the government uses the income statements of companies as a basis for formulating tax and economic policy. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
2. Information on past transactions can be used to identify important trends that, if continued, provide information about future performance. If a reasonable correlation exists between past and future performance, predictions about future earnings and cash flows can be made. For example, a loan analyst can develop a prediction of future performance by estimating the rate of growth of past income over the past several periods and project this into the next period. Additional information about current economic and industry factors can be used to adjust the trend rate based on historical information. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
3. Some situations in which changes in value are not recorded in income are: (a) Unrealized gains or losses on available-for-sale debt investments, (b) Changes in the fair values of long-term liabilities, such as bonds payable, (c) Changes (increases) in value of property, plant and equipment, such as land, natural resources, or equipment, (d) Changes (increases) in the values of intangible assets such as customer goodwill, brand value, or intellectual capital. Note that some of these omissions arise because the items (e.g., brand value) are not recognized in financial statements, while others (value of land) are recorded in financial statements but measurement is at historical cost. LO: 1, 3 Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
4. Some situations in which application of different accounting methods or estimates lead to comparison problems include: (a) Inventory methods—LIFO vs. FIFO, (b) Depreciation Methods—straight-line vs. accelerated, (c) Accounting for long-term contracts—percentage-of-completion vs. completed-contract, (d) Estimates of useful lives or salvage values for depreciable assets, (e) Estimates of bad debts, (f) Estimates of warranty costs. LO: 6, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Questions Chapter 3 (Continued) 5. The transaction approach focuses on the activities that have occurred during a given period and instead of presenting only a net change, a description of the components that comprise the change is included. In the capital maintenance approach, only the net change (income) is reflected whereas the transaction approach not only provides the net change (income) but the components of income (revenues and expenses, gains and losses). The final net income figure should be the same under either approach given the same valuation base. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge,Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
6. Caution should be exercised because many assumptions and estimates are made in accounting and the net income figure is a reflection of these assumptions. If for any reason the assumptions are not well-founded, distortions will appear in the income reported. The objectives of the application of generally accepted accounting principles to the income statement are to measure and report the results of operations as they occur for a specified period without recognizing any artificial exclusions or modifications. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge,Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
7. The major distinction between revenues and gains (or expenses and losses) depends on the typical activities of the company. Revenues (expenses) can occur from a variety of different sources, but these sources constitute the entity’s ongoing major or central operations. Gains (losses) also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
8. The advantages of the single-step income statement are: (1) simplicity and conciseness, (2) probably better understood by the layperson, (3) emphasis on total costs and expenses, and net income, and (4) does not imply priority of one revenue or expense over another. The disadvantages are that it does not show the relationship between sales revenue and cost of goods sold and it does not show other important relationships and information, such as income from operations, income before income tax, etc. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
9. Operating items are the expenses and revenues which relate directly to the principal activity of the company; they are the revenue and expenses which contribute to the sale of goods or services for which a company was organized. The nonoperating section of an income statement is a report of the revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, gains and losses that are infrequent or unusual, or both, are normally reported in the section. Generally these breakdown into two main subsections: "Other revenues and gains" and "Other expenses and losses." LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
10. (a) This transaction will be shown in the income statement in the "Other revenues and gains" section. (b) The bonus should be shown as an operating expense in the income statement. Although the basis of computation is a percentage of net income, it is an ordinary operating expense to the company and represents a cost of the service received from employees. (c) If the amount is immaterial, it may be combined with the depreciation expense for the year and included as a part of the depreciation expense appearing in the income statement. If the amount is material, it should be shown in the retained earnings statement as an adjustment to the beginning balance of retained earnings. (d) This should be shown in the income statement. One treatment would be to show it in the statement as a deduction from the rent expense, as it reduces an operating expense and therefore is directly related to operations. Another treatment is to show it in the other revenues and gains section of the income statement.
Questions Chapter 3 (Continued) (e) Assuming that a provision for the loss had not been made at the time the patent infringement suit was instituted, the loss should be recognized in the current period in computing net income. It should be reported as an unusual loss in the other expenses and losses section. (f) This should be reported in the income statement in the operating section because it relates to usual business operations of the company. LO: 1, 3, *6 Bloom: C, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
11. (a) The remaining book value of the equipment should be depreciated over the remainder of the five-year period. The additional depreciation ($425,000) is not a correction of an error and is not shown as an adjustment to retained earnings. The change is considered a change in estimate. (b) The loss should be shown in the other expenses and losses section of the income statement. (c) The write-off should be shown as other expenses and losses in the income statement. *(d) A correction of an error should be considered a prior period adjustment and the beginning balance of Retained Earnings should be restated, if material. *(e) The cumulative effect of the change is reported as an adjustment to beginning retained earnings. Prior years’ statements are recast on a basis consistent with the new standard. LO: 1, 3, *6 Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
12. (a) Other expenses and losses section. (b) Other expenses and losses section. (c) Operating expense section, as a selling expense, but sometimes reflected as an administrative expense. (d) Separate section after income from continuing operations, entitled discontinued operations. (e) Other revenues and gains section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent. (f) Other revenues and gains section. (g) Operating expense section, normally administrative. If a manufacturing concern, may be included in cost of goods sold. (h) Other expenses and losses section. LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
13. Perlman and Sheehan should not report the sales in a similar manner. This type of transaction appears to be typical of Perlman’s central operations. Therefore, Perlman should report revenues of $160,000 and expenses of $100,000 ($70,000 + $30,000). However, Sheehan’s transaction appears to be a peripheral or incidental activity not related to its central operations. Thus, Sheehan should report a gain of $60,000 ($160,000 – $100,000). Note that although the classification is different, the effect on net income is the same ($60,000 increase). LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Anallysis and Interpretatio, Reporting, AICPA PC: Communication
Questions Chapter 3 (Continued) 14. You should tell Greg that a company’s reported net income is the same whether the single-step or multiple-step format is used. Either way, the company has the same revenues, gains, expenses, and losses; they are simply organized in a different format. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
15. Both formats are acceptable. The amount of detail reported in the income statement is left to the judgment of the company whose goal in making this decision should be to present financial statements which are most useful to decision makers. We want to present a simple, understandable statement so that a reader can easily discover the facts of importance; therefore, a single amount for selling expenses might be preferable. However, we also want to fully disclose the results of all activities; thus, a separate listing of expenses may be preferred. Note that if the condensed version is used, it should be accompanied by a supporting schedule of the eight components in the notes to the financial statements. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge,Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
16. Intraperiod tax allocation should not affect the reporting of an unusual gain. The FASB specifically prohibits a “net-of-tax” treatment for such items to ensure that users of financial statements can easily differentiate items that are unusual or infrequent. “Net-of-tax” treatment is reserved for discontinued operations, prior period adjustments, and other comprehensive income. LO: 2, Bloom: K, Difficulty: Complex, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
17. (a) A loss on discontinued operations is reported net of tax in the income statement between income from continuing operations and net income. (b) Noncontrolling interest allocation is reported in the income statement after the net income. (c) Earnings per share is shown in the income statement after the noncontrolling interest allocation. (d) A gain on sale of equipment is shown under other revenues and gains in the income statement. LO: 1, 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
18. Intraperiod tax allocation has no effect on reported net income, although it does affect the amounts reported for various components of income. The effects on these components offset each other so net income remains the same. Intraperiod tax allocation merely takes the total income tax expense and allocates it to the various items which affect the tax amount. LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
19. If Neumann has preferred stock outstanding, the numerator in its computation may be incorrect. A better description of “earnings per share” is “earnings per common share.” The numerator should include only the earnings available to common shareholders. Therefore, the numerator should be net income less preferred dividends. The denominator is also incorrect if Neumann h ad any common stock transactions during the year. Since the numerator represents the results for the entire year, the denominator should reflect the weighted-average number of common shares outstanding during the year, not the shares outstanding at one point in time (year-end). LO: 3, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
20. The earnings per share trend is not favorable. Discontinued items are often one-time occurrences which are not expected to be reported in the future. Therefore, earnings per share on income from continuing operations is more useful because it represents the results of ordinary business activity. Considering this EPS amount, EPS has decreased from $7.21 to $6.40. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, Analysis, AACSB: Knowledge,Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 3 (Continued) 21. Tax allocation within a period is the practice of allocating the income tax expense for a period to such items as income from continuing operations, and discontinued items. The justification for tax allocation within a period is to produce financial statements which disclose an appropriate relationship, for example, between income tax expense and (a) income before from continuing operations versus (b) discontinued operations. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
22. Tax allocation within a period (intraperiod) becomes necessary when a firm encounters such items as discontinued operations, or corrections of errors. Such allocation is necessary to bring about an appropriate relationship between income tax expense and income from continuing operations and discontinued operations. Tax allocation within a period is handled by first computing the tax expense attributable to income before discontinued operations. This is computed by ascertaining the income tax expense related to revenue and expense transactions entering into the determination of such income. Next, the remaining income tax expense attributable to other items is determined by the tax consequences of transactions involving these items. The applicable tax effect of these items should be disclosed separately because of their materiality. LO: 2, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
23. LISELOTTE COMPANY Partial Income Statement For the Year Ended December 31, 2025 Income before income tax ........................................................... Income tax ($1,500,000 x 34%) .................................................. Income from continuing operations ............................................. Discontinued operations— Gain on disposal of assets .................................................. Less: Applicable income tax ($450,000 x 30%)................... Net income..................................................................................
$1,500,000 510,000 990,000 $450,000 135,000
315,000 $1,305,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
24. The damages are reported in Frazier Corporation’s financial statements in the other expenses and losses section. The damages would not be reported as a correction of an error (prior period adjustment). LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
25. No, these sales would not be reported as discontinued operations after income from continuing operations. A discontinued operation occurs when two things happen: (1) A company eliminates the results of operations of a component or group of components of the business. A component comprises operations and cash flows that can be clearly distinguished operationally and for financial reporting purposes. (2) The elimination represents a strategic shift, having a major effect on the company’s operations and financial results. LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
26. The major items reported in the retained earnings statement are: (1) adjustments of the beginning balance for corrections of errors or changes in accounting principle, (2) the net income or loss for the period, (3) dividends for the year, and (4) restrictions (appropriations) of retained earnings. It should be noted that the retained earnings statement is sometimes composed of two parts, free and appropriated. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 3 (Continued) 27. Generally accepted accounting principles are ordinarily concerned only with a “fair presentation” of business income. In contrast, taxable income is a statutory concept which defines the base for raising tax revenues by the government, and any method of accounting which meets the statutory definition will “clearly reflect” taxable income as defined by the Internal Revenue Code. It should be noted that the Code prohibits use of the cash receipts and disbursements method as a method which will clearly reflect income in accounting for purchases and sales if inventories are involved. The cash receipts and disbursements method will not usually fairly present income because: (1) The completed transaction, not receipt or disbursement of cash, increases or diminishes income. Thus, a sale on account produces revenue and increases income, and the incurrence of expense reduces income without regard to the time of payment of cash. (2) The expense recognition principle generally results in costs being matched against related revenues produced. In most situations the cash receipts and disbursements method will violate this principle. (3) Consistency requires that accountable events receive the same accounting treatment from accounting period to accounting period. The cash receipts and disbursements method permits manipulation of the timing of revenues and expenses and may result in treatments which are not consistent, detracting from the usefulness of comparative statements. LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
28. From the revenue side, there are many types of revenue transactions which require estimation. For example, it is difficult to estimate the amount of revenue to recognize for a long-term contract in a given period. Other estimation involving revenue include high rates of return on products sold, net versus gross sales issues, sales with buyback options, estimating revenues in licensing arrangements and so on. During a single fiscal period it often is difficult to determine the expiration of certain costs which may benefit several periods. Business is continuous and estimates have to be made of the future if we are to systematically apportion costs to fiscal periods. Examples of items which present serious obstacles include such items as institutional advertising costs. Accountants have established certain rules for handling revenues and costs which are applied consistently and in a systematic manner. From period to period, application of these rules generally results in a satisfactory matching of costs and revenues unless there are large changes from one period to another. These rules, influenced by conservatism in the face of the uncertainties involved, tend to charge costs to expense earlier than might be ideally desirable if we had more knowledge of the future. Costs or expenses of the types mentioned above, by their very nature, defy any attempt to relate them to revenues of a specific period or periods. Although it is known that advertising will yield benefits beyond the present, both the amount of such benefits and when they will be enjoyed are shrouded in uncertainty. The degree of certainty with which their time distribution can be forecast is so small and the results, therefore, so unreliable that the accountant writes them off as applicable to the period or periods in which the expense was incurred. LO: 1, 3, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Questions Chapter 3 (Continued) 29. Elements are the basic ingredients which comprise the income statement; that is, revenues, gains, expenses, and losses. Items are descriptions of the elements such as rent revenue, rent expense, etc. In order to predict the future, the amounts of individual items may have to be reported. For example, if “income from continuing operations” is significantly lower this year and is reported as a single amount, users would not know whether to attribute the decrease to a temporary increase in an expense item (for example, an unusually large bad debt), a structural change (for example, a change in the relationship between variable and fixed expenses), or some other factor. Another example is income data that are distorted because of large discretionary expenses. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
30. Other comprehensive income must be displayed (reported) in one of two ways: (1) a single continuous income statement (one statement approach) or (2) two separate but consecutive statements of net income and other comprehensive income (two statement approach). LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
31. The results of continuing operations should be reported separately from discontinued operations, and any gain or loss from disposal of a component of a business should be reported with the related results of discontinued operations. The following format illustrates the proper disclosure: Income before income tax...................................................................... Income tax ............................................................................................. Income from continuing operations ........................................................ Discontinued operations Income (loss) from operations of discontinued Division X, net of tax ($–XX)…………………………. Gain (loss) on disposal of Division X net of tax ($–XX) .............................................................................. Net income ............................................................................................
$XXX XXX XXX XXX XXX
XXX $XXX
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
32. The five steps in the revenue recognition process are: 1. Identify the contract(s) with customers. 2. Identify the separate performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the separate performance obligations. 5. Recognize revenue when each performance obligation is satisfied. LO: 4, Bloom: K, Difficulty: Simple, Time: 1, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Problem Solving
33. The first step in the revenue recognition process is the identification of a contract or contracts with the customer. A contract is an agreement between two or more parties that creates enforceable rights or obligations. That is, the contract identifies the performance obligations in a revenue arrangement. Contracts can be written, oral, or implied from customary business practice. In some cases, there may be multiple contracts related to the transaction, and accounting for each contract may or may not occur, depending on the circumstances. These situations often develop when not only a product is provided but some type of service is performed as well. LO: 4, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Problem Solving
34. Change in control is the deciding factor in determining when a performance obligation is satisfied. Control is transferred when the customer has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control is also indicated if the customer has the ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. LO: 4, Bloom: K, Difficulty: Moderate, Time: 2, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Problem Solving
Questions Chapter 3 (Continued)
35. To determine whether a performance obligation exists, the company must provide a distinct product or service to the customer. To determine whether a company has to account for multiple performance obligations, the company’s promise to sell the good or service to the customer must be separately identifiable from other promises within the contract (that is, the good or service must be distinct within the contract). In other words, the objective is to determine whether the nature of a company’s promise is to transfer individual goods and services to the customer or to transfer a combined item (or items) for which individual goods or services are inputs. LO: 4, Blloom: C, Difficulty: Simple, Time: 3, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Problem Solving
36. The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods and services. The transaction price in a contract is often easily obtained because the customer agrees to pay a fixed amount to the company over a short period of time. In other contracts, companies must consider the following factors: (1) Variable consideration, (2) Time value of money, (3) Noncash consideration, and (4) Consideration paid or payable to customer. LO: 4, Bloom: K, Difficulty: Simple, Time: 2, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Problem Solving
37. The revenue recognition principle indicates that revenue is recognized in the accounting period when a performance obligation is satisfied. That is, a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services. LO: 4, Bloom: K, Difficulty: Simple, Time: 1, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretationn, AICPA PC: Problem Solving
38. Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves, which are established by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges and warranty claims. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Anallysis and Interpretation, Reporting, AICPA PC: Communication
39. Earnings management has a negative effect on the quality of earnings if it distorts the information in a way that is less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and representationally faithful. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth). LO: 5, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
40. The term “quality of earnings” refers to the credibility of the earnings number reported. Companies that use aggressive accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly, if higher expenses are recorded in the current period, in order to report higher income in the future, then the quality of earnings is also considered low. LO: 5, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
*41. Items considered corrections of errors should be charged or credited to the opening balance of retained earnings as a prior period adjustment. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises
Brief Exercise 3.1 STARR CO. Income Statement For the Year 2025 Revenues Sales revenue .................................................... Expenses Cost of goods sold ............................................ Salaries and wages expense ............................ Other operating expenses................................. Income tax expense........................................... Total expenses ..........................................
$540,000 $330,000 120,000 10,000 25,000 485,000
Net income ............................................................................
$ 55,000
Earnings per share.......................................................
$0.55*
*$55,000 ÷ 100,000 shares. Note: The increase in value of the company reputation and the unrealized gain on the value of patents are not reported. LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Brief Exercise 3.2 BRISKY CORPORATION Income Statement For the Year Ended December 31, 2025 Revenues Net sales ..................................................... Interest revenue .......................................... Total revenues .................................... Expenses Cost of goods sold ..................................... Selling expenses ........................................ Administrative expenses ........................... Interest expense ......................................... Income tax expense* .................................. Total expenses...................................
$2,400,000 31,000 2,431,000 $1,450,000 280,000 212,000 45,000 133,200 2,120,200
Net income ............................................................
$ 310,800
Earnings per share** ............................................
$4.44
*($2,431,000 – $1,450,000 – $280,000 – $212,000 – $45,000) x 30% = $133,200. **$310,800 ÷ 70,000 shares. LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Brief Exercise 3.3 BRISKY CORPORATION Income Statement For the Year Ended December 31, 2025 Net sales .............................................................. Cost of goods sold.............................................. Gross profit ............................................... Selling expenses ................................................. Administrative expenses .................................... Income from operations ..................................... Other revenue and gains Interest revenue ........................................ Other expenses and losses Interest expense ....................................... Income before income tax .................................. Income tax expense ($444,000 x 30%) ............... Net income........................................................... Earnings per share..............................................
$2,400,000 1,450,000 950,000 $280,000 212,000
492,000 458,000
$31,000 45,000
(14,000) 444,000 133,200 $ 310,800 $4.44*
*$310,800 ÷ 70,000 shares. LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Innterpretation, Reporting, AICPA PC: None
Brief Exercise 3.4 Income from continuing operations .................. Discontinued operations Loss from operations of discontinued restaurant division net of tax ................ Loss on disposal of restaurant division net of tax .................................. Net income .......................................................... Earnings per share ............................................. Income from continuing operations ......... Loss from operations of discontinued division, net of tax ................................. Loss on disposal of discontinued operation, net of tax .............................. Discontinued operations, net of tax ......... Net income ................................................. *$10,600,000 ÷ 10,000,000 shares
$10,600,000 $315,000 (504,000) 189,000 $10,096,000 $1.06* 0.03** 0.02*** (0.05)** $1.01
**$315,000 ÷ 10,000,000 shares ***$189,000 ÷ 10,000,000 shares
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Brief Exercise 3.5 Income from operations ...................................... Other revenues and gains Interest revenue .............................................. Other Expenses and Losses Loss due to volcano eruption ........................ $770,000 Impairment loss - building ............................. 53,000 Income before income tax ..................................... Income tax ($6,394,000 x .30) ..................... Net income ............................................................... Per share of common stock: Net income ($4,475,800 ÷ 5,000,000) .............
$7,200,000 17,000 7,217,000 823,000 6,394,000 1,918,200 $4,475,800 $ .90*
*Rounded LO: 1, , Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Brief Exercise 3.6 $1,000,000 – $250,000 190,000
=
$3.95 per share* *Rounded
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analllysis and Interpretation, Reporting, AICPA PC: None
Brief Exercise 3.7 PORTMAN CORPORATION Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1 ....................................... Add: Net income .......................................................... Less: Cash dividends ................................................... Retained earnings, December 31 ..................................
$ 675,000 1,400,000 75,000 $2,000,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 3.8 (a)
Net income (Interest revenue) ..............................
$3,000
(b)
Net income ............................................................ Unrealized holding gain (net of tax) ..................... Comprehensive income ........................................
$3,000 4,000 $7,000
(c)
Unrealized holding gain (net of tax) Other comprehensive income ..............................
$4,000
(d)
Accumulated other comprehensive income, January 1, 2025 ................................................. Unrealized holding gain (net of tax) ..................... Accumulated other comprehensive income, December 31, 2025 ............................................
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$
0 4,000
$4,000
Brief Exercise 3.9 (a) In applying the 5-step process, it appears that a valid contract exists between Leno Computers and Fallon Electronics for the following reasons: 1. The contract has commercial substance—Fallon Electronics has agreed to pay cash for the computers. 2. The parties have approved the contract and are committed to perform—Fallon Electronics has made a commitment to purchase the computers and Leno has approved the selling of the computers. In fact, Leno has delivered the computers to Fallon. 3. The identification of the rights of the parties—Fallon has the right to the computers and Leno has the right to payment. 4. The identification of the payment terms—Fallon has agreed to pay $20,000 within 30 days for the computers. 5. It is probable that the consideration will be collected—although no cash has yet been paid by Fallon. Fallon has a good credit rating which indicates that the consideration will be collected. (b) The contract may not be valid if the contract is wholly unperformed and each party can unilaterally terminate the contract without consideration. In addition, if Fallon has a poor credit rating and it is not probable that the consideration will be collected on the contract, a valid contract does not exist. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Brief Exercise 3.10 There is one performance obligation in this situation, which is the providing of the licensed software and customer support together. Both the software license and the custom customer support services are distinct, but they are not distinct within the contract. It appears that Hillside’s objective is to transfer a combined product. That is, the customer support services are highly interrelated and interdependent with the licensed software and therefore, these customer support services should be combined with the licensed software in determining the performance obligation. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Brief Exercise 3.11 Three performance obligations exist in this contract—manufacture of the 3D printer, installation services and the maintenance services. Destin does clearly have a performance obligation for the manufacture of the 3-D printer. Destin may or may not have a performance obligation for the installation of the 3-D printer as installation can be done by another company. In other words, there is no indication that installation is required by Destin. Also, Destin may or may not have a separate performance obligation for the maintenance agreement, as it can be provided by other companies. In summary, there are three performance obligations related to this contract, some of which may end up being performed by companies other than Destin. LO: 4, Bloom: AP, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
Brief Exercise 3.12 Ismail accounts for the bundle of goods and services as a single performance obligation because the goods or services in the bundle are highly interrelated. Ismail also provides a significant service by integrating the goods or services into the combined item (that is, the hospital) for which the customer has contracted. In addition, the goods or services are significantly modified and customized to fulfill the contract. In other words, the company’s objective is to transfer a combined item. Revenue for the performance obligation would be recognized over time by selecting an appropriate measure of progress toward satisfaction of the performance obligation. LO: 4, Bloom: AP, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretatio, AICPA PC: Communicatio
Brief Exercise 3.13 The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration in this situation: Completion Date August 1 August 8 August 15 After August 15
Probability Expected Value 70% chance of $1,150,000 = $ 805,000 20% chance of $1,100,000 = 220,000 5% chance of $1,050,000 = 52,500 5% chance of $1,000,000 = 50,000 $1,127,500
Thus, the total transaction price is $1,127,500 based on the probabilityweighted estimate. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 3.14 (a) No revenue is earned on June 15, 2025, as Mount has not satisfied the performance obligation. Note to instructor: No entry is required on May 1, 2025 because neither party has performed on the contract. On June 15, 2025, Eric agreed to pay the full price and therefore, Mount has an unconditional right to those funds on that date. On receiving the cash on June 15, 2025, Mount records the following entry. June 15, 2025 Cash 25,000 Unearned Sales Revenue 25,000 (b) On satisfying the performance obligation on September 30, 2025, Mount records revenue of $25,000 with the following entry September 30, 2025 Unearned Sales Revenue 25,000 Sales Revenue 25,000 LO: 4, Bloom: AP, Difficulty: Simple, Time: 4, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 3.15 Income before income tax Income tax (30%) Net Income
2025 $180,000 54,000 $126,000
2024 $145,000 43,500 $101,500
2023 $170,000 51,000 $119,000
Note: The company must report income under the weighted-average method for all three years. LO: 6, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation, Reporting, AICPA PC: None
*Brief Exercise 3.16 Vandross would not report any cumulative effect because a change in estimate is not handled retrospectively. Vandross would report bad debt expense of $120,000 in 2025. LO: 6, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation , Reporting, AICPA PC: Communication
*Brief Exercise 3.17 PORTMAN CORPORATION Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1, as reported .................. Correction for overstatement of expenses in prior period (net of tax) ....................................... Retained earnings, January 1, as adjusted .................. Add: Net income .......................................................... Less: Cash dividends ................................................... Retained earnings, December 31 .................................. LO: 6 Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 675,000 80,000 755,000 1,400,000 2,155,000 75,000 $2,080,000
Solutions to Exercises Exercise 3.1 (18–20 minutes) Computation of net income Change in assets ..................................................... Less: Change in liabilities ......................................
$204,000 Increase (a) 31,000 Increase (b)
Change in stockholders’ equity .............................
$173,000 Increase
(a) $79,000 + $45,000 + $127,000 – $47,000 (b) $82,000 – $51,000
Change in stockholders’ equity accounted for as follows: Net increase ............................................................. $ 173,000 Increase in common stock .................................. $125,000 Increase in paid-in capital in excess of par ........ 13,000 Decrease in retained earnings due to dividend declaration.......................................... (19,000) Net increase accounted for .................................... (119,000) Increase in retained earnings due to net income .. $ 54,000 LO: 1, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation , Reporting, AICPA PC: None
Exercise 3.2 (10–15 minutes) Sales revenue ................................................................... Cost of goods sold ........................................................... Gross profit ....................................................................... Selling and administrative expenses .............................. Income from operations ................................................... Other revenues and gains Gain on sale of plant assets ................................... Other expenses and losses Interest expense ...................................................... Income from continuing operations ................................ Loss on discontinued operations ................................... Net income ........................................................................
$310,000 140,000 170,000 50,000 120,000(a) 30,000 6,000
24,000 144,000 (12,000) $132,000(b)
Net income ........................................................................
$132,000
Unrealized gain on available-for-sale debt investments
10,000
Comprehensive income ...................................................
$142,000(c)
Net income ........................................................................
$132,000
Dividends ..........................................................................
(5,000)
12/31/25 Retained earnings .............................................
$127,000(d)
(a) (b) (c) (d)
Income from operations Net income Comprehensive income Retained earnings balance
$120,000 $132,000 $142,000 $127,000
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 3.3 (25–35 minutes) (a) Total net revenue: Sales revenue ............................................... Less: Sales discounts ................................. Sales returns and allowances .......... Net sales........................................................ Dividend revenue.......................................... Rent revenue ................................................. Total net revenue .................................. (b) Net income: Total net revenue (from a) ............................ Expenses: Cost of goods sold ................................. Selling expenses .................................... Administrative expenses........................ Interest expense ..................................... Total expenses .................................. Income before income tax ........................... Income tax..................................................... Net income ..............................................
$390,000 $ 7,800 12,400
20,200 369,800 71,000 6,500 $447,300
$447,300 $184,400 99,400 82,500 12,700
LO: 1, , Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
379,000 68,300 31,000 $ 37,300
Exercise 3.4 (20–25 minutes) LEROI JONES INC. Income Statement For Year Ended December 31, 2025 Revenues Net sales ($1,250,000(b) – $17,000) ............. Expenses Cost of goods sold ..................................... Selling expenses ........................................ Administrative expenses ........................... Interest expense ......................................... Total expenses ................................... Income before income tax .................................... Income tax ($213,000 X 30%) ..................... Net income ............................................................ Earnings per share(d) ............................................. *Rounded
$1,233,000 $500,000 400,000(c) 100,000(a) 20,000 1,020,000 213,000 63,900 $ 149,100 $
7.46*
Exercise 3.4 (Continued) Determination of amounts (a)
Administrative expenses
= 20% of cost of good sold = 20% x $500,000 = $100,000
(b)
Gross sales x 8%
= administrative expenses = $100,000 ÷ .08 = $1,250,000
(c)
Selling expenses
= four times administrative expenses. (operating expenses consist of selling and administrative expenses; since selling expenses are 4/5 of operating expenses, selling expenses are 4 times administrative expenses.) = 4 x $100,000 = $400,000
(d) Earnings per share $7.46 ($149,100 ÷ 20,000) Note: An alternative income statement format is to show income tax as part of expenses, and not as a separate item. In this case, total expenses are $1,083,900. LO: 1 Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation, Reporting, AICPA PC: None
Exercise 3.5 (30–35 minutes) (a)
Multiple-Step Form P. BRIDE COMPANY Income Statement For the Year Ended December 31, 2025 (In thousands, except earnings per share)
Sales revenue ................................................. Cost of goods sold......................................... Gross profit .................................................... Operating expenses:
$96,500 60,570 35,930
Selling expenses Sales commissions ............................ Depr. of sales equipment ................... Delivery expense ................................ Administrative expenses Officers’ salaries ................................ Depr. of office furn. and equip...........
$7,980 6,480 2,690
$17,150
4,900 3,960
8,860
26,010
Income from operations ............... Other revenues and gains: Rent revenue ............................................ Other expenses and losses: Interest expense ....................................... Income before income tax ............................. Income tax ................................................ Net income......................................................
9,920
1,860 25,290 9,070 $16,220
Earnings per share ($16,220 ÷ 40,550) ..........
$.40
17,230
Exercise 3.5 (Continued) (b)
Single-Step Form P. BRIDE COMPANY Income Statement For the Year Ended December 31, 2025 (In thousands, except earnings per share)
Revenues Net sales ................................................................ Rental revenue ...................................................... Total revenues.................................................
$ 96,500 17,230
Expenses Cost of goods sold ............................................... Selling expenses ................................................... Administrative expenses ...................................... Interest expense ................................................... Total expenses ................................................
60,570 17,150 8,860 1,860
Income before income tax ........................................ Income tax ................................................................. Net income ............................................................ Earnings per share ....................................................
0 113,730
88,440 25,290 9,070 $ 16,220 $.40
Note: An alternative income statement format for the single-step form is to show income tax as part of expenses, and not as a separate item. (c)
Single-step: 1. Simplicity and conciseness. 2. Probably better understood by users. 3. Emphasis on total costs and expenses and net income. 4. Does not imply priority of one revenue or expense over another.
Exercise 3.5 (Continued) Multiple-step: 1. Provides more information through segregation of operating and nonoperating items. 2. Expenses are matched with related revenue. Note to instructor: Students’ answers will vary due to the nature of the question; i.e., it asks for an opinion. However, the discussion supporting the answer should include the previous points. LO: 1 Bloom: AP, Difficulty: Simple, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 3.6 (30–35 minutes) ALONZO CORP. Income Statement For the Year Ended December 31, 2025 Revenue Sales revenue ........................................................ Less: Sales returns and allowances .................... Sales discounts .......................................... Net sales ................................................................ Cost of goods sold ................................................ Gross profit ................................................................. Operating expenses Selling expenses ................................................ Administrative and general expenses .............. Income from operations .............................................
$1,380,000 $150,000 45,000
194,000 97,000
195,000 1,185,000 621,000 564,000
291,000 273,000
Exercise 3.6 (Continued) Other revenues and gains Interest revenue .......................................................
86,000 359,000
Other expenses and losses Loss from earthquake damage ............................... Interest expense ...................................................... Income before income tax .............................................. Income tax ($149,000 x .20)..................................... Net income.......................................................................
150,000 60,000 149,000 29,800 $119,200
Per share of common stock: Net income ($119,200 ÷ 100,000) ............................
$ 1.19*
*Rounded LO: 1, , Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation, Reporting, AICPA PC: None
Exercise 3.7 (30–40 minutes) (a)
Multiple-Step Form LATIFA SHOE CO. Income Statement For the Year Ended December 31, 2025
Net sales ...................................................... Cost of goods sold...................................... Gross profit ................................................ Operating Expenses
$980,000 496,000 484,000
Selling expenses Salaries and wages expense .......... Depreciation exp. (70% x $65,000) . Supplies ........................................... Administrative expenses Salaries and wages expense .......... Other admin. expenses ................... Depreciation exp. (30% x $65,000) . Income from operations ............................. Other Revenues and Gains Rent revenue .........................................
$114,800 45,500 17,600 $177,900 135,900 51,700 19,500
207,100
385,000 99,000 29,000 128,000
Other Expenses and Losses Interest expense .................................... Income before income tax .......................... Income tax ............................................. Net income...................................................
18,000 110,000 23,100 $ 86,900
Earnings per share ($86,900 ÷ 20,000).......
$4.35*
*Rounded
Exercise 3.7 (Continued) (b)
Single-Step Form LATIFA SHOE CO. Income Statement For the Year Ended December 31, 2025
Revenues Net sales ....................................................................... Rent revenue ................................................................ Total revenues ........................................................ Expenses Cost of goods sold....................................................... Selling expenses(**)....................................................... Administrative expenses(***) ......................................... Interest expense ........................................................... Total expenses ....................................................... Income before income tax ................................................. Income tax .................................................................... Net income ......................................................................... Earnings per share ($86,900 ÷ 20,000)..............................
$ 980,000 29,000 1,009,000 496,000 177,900 207,100 18,000 899,000 110,000 23,100 $ 86,900 $4.35*
*Rounded ** $114,800 + (70% x $65,000) + $17,600 = $177,900 *** $135,900 + $51,700 + (30% x $65,000) = $207,100 Note: An alternative income statement format for the single-step form is to show income tax as part of expenses, and not as a separate item. (c)
Single-step: 1. Simplicity and conciseness. 2. Probably better understood by users.
Exercise 3.7 (Continued) 3. Emphasis on total costs and expenses and net income. 4. Does not imply priority of one revenue or expense over another. Multiple-step: 1. Provides more information through segregation of operating and nonoperating items. 2. Expenses are matched with related revenue. Note to instructor: Students’ answers will vary due to the nature of the question, i.e., it asks for an opinion. However, the discussion supporting the answer should include the above points. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation, Reporting, AICPA PC: Communication
Exercise 3.8 (15–20 minutes) (a) Net sales Cost of goods sold Administrative expenses Selling expenses Discontinued operations-loss Income before income tax Income tax ($110,000 x .20) Net income
$ 540,000 (210,000) (100,000) (80,000) (40,000) 110,000 22,000 $ 88,000
(b) Income from continuing operations before income tax Income tax ($150,000 x .20) Income from continuing operations Loss or discontinued operations, net of ($8,000) Net income
$150,000* 30,000 120,000 32,000 $ 88,000
*Income before income tax from part(a) Discontinued operations
$110,000 40,000 $150,000
Exercise 3.8 (Continued) Earnings per share: Income from continuing operations ($120,000 ÷ 10,000) $12.00 Loss on discontinued operations, net of tax ($32,000 ÷ 10,000) (3.20) Net Income ($88,000 ÷ 10,000) $ 8.80 LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation, Reporting, AICPA PC: None
Exercise 3.9 (30–35 minutes) (a)
IVAN CALDERON CORP. Income Statement For the Year Ended December 31, 2025
Revenue Net sales .................................................................. $1,300,000 Cost of goods sold.................................................. 780,000 Gross profit .................................................. 520,000 Operating expenses Selling expenses ................................................ $65,000 Administrative expenses ................................... 48,000 113,000 Income from operations ............................................... 407,000 Other revenues and gains Dividend revenue ............................................... 20,000 Interest revenue .................................................. 7,000 27,000 434,000 Other expenses and losses Casualty loss ...................................................... 50,000 Write-off of inventory due to obsolescence ......... 80,000 130,000 Income before income tax .................................................. 304,000 Income tax ($304,000 x .20)................................ 60,800 Net income $ 243,200 ............................................................................. Per share of common stock: Net income ($243,200 ÷ 60,000) ......................... $4.05* *Rounded
Exercise 3.9 (Continued) (b)
IVAN CALDERON CORP. Retained Earnings Statement For the Year Ended December 31, 2025
Retained earnings, Jan. 1, as reported .................................... Correction for overstatement of net income in prior period (depreciation error) (net of $11,000* tax) ...................... Retained earnings, Jan. 1, as adjusted.................................... Add: Net income........................................................................
$
980,000
(44,000) 936,000 243,200 1,179,200 45,000 $1,134,200
Less: Dividends declared ......................................................... Retained earnings, Dec. 31 ....................................................... *$55,000 x .20 LO: 1, , 3, Bloom: AP, Difficulty: Simple, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 3.10 (20–25 minutes) Net income......................................................................... Less: Preferred dividends (.08 x $4,500,000) ........................................................... Income available to common stockholders .................... Weighted-average common shares outstanding ............ Earnings per share............................................................
360,000 32,640,000 ÷ 10,000,000 $3.26*
Income statement presentation Earnings per common share ......................................
$3.26
*Rounded LO: 1, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$33,000,000
Exercise 3.11 (20–25 minutes) SPOCK CORPORATION Income Statement For the Year Ended December 31, 2025 Net sales(a) ............................................................. Cost of goods sold(b)............................................. Gross profit ..................................................... Selling expenses(c) ................................................ Administrative expenses(d) ................................... Income from operations ................................. Rent revenue ......................................................... Casualty loss......................................................... Interest expense.................................................... Income before income tax .................................... Income tax ($364,000 x .20) ............................ Net income ............................................................
$4,162,000 2,665,000 1,497,000 $636,000 491,000 240,000 (70,000) (176,000)
Earnings per share ($900,000 ÷ $10 par value = 90,000 shares) ($291,200 ÷ 90,000) ..................................................................
1,127,000 370,000 (6,000) 364,000 72,800 $ 291,200
$3.24*
*Rounded Supporting computations (a) Net sales: $4,275,000 – $34,000 – $79,000 = $4,162,000 (b) Cost of goods sold: $535,000 + ($2,786,000 + $72,000 – $27,000 – $15,000) – $686,000 = $2,665,000 (c) Selling expenses: $284,000 + $83,000 + $69,000 + $54,000 + $93,000 + $36,000 + $17,000 = $636,000 (d) Administrative expenses: $346,000 + $33,000 + $24,000 + $48,000 + $32,000 + $8,000 = $491,000 LO: 1, , Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation , Reporting, AICPA PC: None
Exercise 3.12 (20–25 minutes) (a)
EDDIE ZAMBRANO CORPORATION Retained Earnings Statement For the Year Ended December 31, 2025
Balance, January 1, as reported ........................................... Correction for depreciation error (net of $5,000 tax) ........... Balance, January 1, as adjusted ........................................... Add: Net income..................................................................... Less: Dividends declared ...................................................... Balance, December 31 ...........................................................
$225,000* (20,000) 205,000 192,000** 397,000 100,000 $297,000
*($40,000 + $125,000 + $160,000) – ($50,000 + $50,000) **[$240,000 – (20% x $240,000)]
(b) Total retained earnings would still be reported as $297,000. A restriction does not affect total retained earnings; it merely labels part of the retained earnings as being unavailable for dividend distribution. Retained earnings would be reported as follows: Retained earnings: Appropriated ..................................... Unappropriated ................................. Total .................................................
$ 70,000 227,000 $297,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation, Reporting, AICPA PC: Communication
Exercise 3.13 (15–20 minutes) Net income: Income from continuing operations before income tax ....................................... Income tax (17% x $23,650,000) ..................... Income from continuing operations .............. Discontinued operations Loss before income tax ............................ Less: Applicable income tax (17%) .......... Net income ......................................................
$23,650,000 4,020,500 19,629,500 $3,225,000 548,250
(2,676,750) $16,952,750
Preferred dividends declared:..............................
$ 1,075,000
Weighted average common shares outstanding ....
4,000,000
Earnings per share Income from continuing operations .............. Loss from discontinued operations, net of tax Net income ......................................................
$4.64* .67** $3.97***
*($19,629,500 – $1,075,000) ÷ 4,000,000. (Rounded) **$2,676,750 ÷ 4,000,000. (Rounded) ***($16,952,750 – $1,075,000) ÷ 4,000,000. LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Iterpretation, Reporting, AICPA PC: None
Exercise 3.14 (15–20 minutes) (a) ROXANNE CARTER CORPORATION Statement of Comprehensive Income For the Year Ended December 31, 2025 Net sales ............................................................................... Cost of goods sold................................................................ Gross profit ........................................................................... Selling and administrative expenses ................................... Net income............................................................................. Other comprehensive income, unrealized holding gain ..................................................... Comprehensive income ........................................................
$1,200,000 750,000 450,000 320,000 130,000 18,000 $ 148,000
(b) ROXANNE CARTER CORPORATION Income Statement For the Year Ended December 31, 2025 Net sales ............................................................................... Cost of goods sold................................................................ Gross profit ........................................................................... Selling and administrative expenses ................................... Net income.............................................................................
$1,200,000 750,000 450,000 320,000 $ 130,000
ROXANNE CARTER CORPORATION Comprehensive Income Statement For the Year Ended December 31, 2025 Net income............................................................................. Other comprehensive income, unrealized holding gain ..................................................... Comprehensive income ........................................................ LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 130,000 18,000 $ 148,000
Exercise 3.15 (15–20 minutes) C. REITHER CO. Statement of Stockholders’ Equity For the Year Ended December 31, 2025 Accumulated Other Retained
Comprehensive
Common
Total
Earnings
Income
Stock
Beginning balance
$520,000
$ 90,000
$80,000
$350,000
Net income*
120,000
120,000
Other comprehensive income Unrealized holding loss Dividends Ending balance
(60,000)
(60,000)
(10,000)
(10,000)
$570,000
$200,000
$20,000
$350,000
*($700,000 – $500,000 – $80,000). LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 3.16 (30–35 minutes) (a)
ROLAND CARLSON INC. Income Statement For the Year Ended December 31, 2025
Revenues Sales revenue .................................................................................. .................................................................................. .................................................................................. Rent revenue ................................................ Total revenues .................................... Expenses Cost of goods sold ....................................... Selling expenses .......................................... Administrative expenses ............................. Total expenses ..................................... Income from operations ................................ Other revenues and gains Gain on sale of equipment ............................ Other expenses and losses Inventory loss................................................. Income before income tax ...................................... Income tax ...................................................... Income from continuing operations ...................... Discontinued operations Loss on discontinued operations (net of $25,500 tax) ......................................... Net income...............................................................
$1,900,000
40,000 $1,940,000 850,000 300,000 240,000 1,390,000 550,000 95,000 60,000
Per share of common stock: Income from continuing operations ($398,000 ÷ 100,000) ..... Loss on discontinued operations ($49,500 ÷ 100,000) ...... Net income ($348,500 ÷ 100,000)......................................... * Rounded
35,000 585,000 187,000 398,000
49,500 $ 348,500 $3.98 .50* $3.48*
Exercise 3.16 (Continued) (b)
ROLAND CARLSON INC. Comprehensive Income Statement For the Year Ended December 31, 2025
Net income ............................................................................ Other comprehensive income Unrealized holding gain, net of tax ................................ Comprehensive income........................................................ (c)
$348,500 15,000 $363,500
ROLAND CARLSON INC. Retained Earnings Statement For the Year Ended December 31, 2025
Retained earnings, January 1 ...................................................... Add: Net income ........................................................................... Less: Dividends declared ............................................................. Retained earnings, December 31 ................................................. LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$600,000 348,500 948,500 150,000 $798,500
Exercise 3.17 (10–15 minutes) (1) This statement is not correct. This criterion was used in previous GAAP but often proved difficult to implement in practice. In the new standard, indicators that control has passed to the customer include having (1) a present obligation to pay, (2) physical possession, (3) legal title, (4) risks and rewards of ownership, and (5) acceptance of the asset. (2) This statement is not correct. For a valid contract to exist, the collection of revenue must be probable. (3) A wholly unperformed contract is not recorded until one or both of the parties have performed. The new revenue standard uses an assetliability approach for recognizing revenue. In this model, until one of the parties performs, a net asset or net liability does not exist, and therefore, there is no effect on the company’s financial position. (4) This statement is true. One of the difficulties in the revenue recognition process is identifying the performance obligations in the contract. (5) Elaina should account for this additional option. Whether the option provides for free goods or goods at a discount, the option is a separate performance obligation which affects the current transaction price. Consideration payable to a customer is a reduction of the transaction price unless the payment is for a distinct good or service. (6) Under the GAAP, the collectability criterion is designed to prevent companies from applying the revenue model to problematic contracts and recognizing revenue and a large impairment loss at the same time. However, if the company determines that it is probable that it will collect the funds, then the normal risks of nonpayment are not considered at the time the revenue is reported. LO: 4, Bloom: C, Difficulty: Moderate, Time: 10-15, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 3.18 (20-25 minutes) (a)
The transaction price for this contract should be computed as follows:
Contract price Expected value of the bonus Transaction price Completion Time
$200,000 34,000 $234,000
Probability of completion
On time Within one week Within two weeks Total expected value of bonus
55% 30% 15%
x
Bonus Amounts*
= Expected Value
$40,000 30,000 20,000
$22,000 9,000 3,000 $34,000
* ($10,000 decrease/week) (b)
The transaction price for this contract should be computed as follow:
Contract price Expected value of the bonus Transaction price
$200,000 39,000 $239,000
Completion Time
Probability of Completion
X Bonus Amounts*
= Expected Value
On time Within one week Computation of expected value
90% 10%
$40,000 30,000
$36,000 3,000 $39,000
* ($10,000 decrease/week) Note to instructor: Given just two outcomes, the company could determine the bonus component of the transaction price based on the most likely outcome ($40,000). If reliable, use of probability outcomes is more accurate. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 3.19 (10–15 minutes) (a)
Shaw recognizes revenue of $370,000 on the sale of the goods, which were delivered (performance obligation satisfied) on January 2, 2025.
Note to instructor: The entries to record the sale and related cost of goods sold are as follows: January 2, 2025
(b)
Accounts Receivable Sales Revenue Unearned Service Revenue
410,000
Cost of Goods Sold Inventory
300,000
370,000 40,000
300,000
Income on the arrangement to be recorded in the first quarter is as follows. Sales revenue Cost of goods sold Gross profit
$370,000 300,000 $ 70,000
The revenue for installation will be recognized in the second quarter. LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
* Exercise 3.20 (15–20 minutes) (a)
2025 $450,000 90,000 $360,000
Income before income tax Income tax (.20 x $450,000) Net Income (b)
Cumulative effect for years prior to 2025.
Year 2023 2024
WeightedAverage $370,000 390,000
Tax Rate FIFO Difference (20%) Net Effect $395,000 $25,000 430,000 40,000 Total $65,000 $13,000 $52,000
(c) Income before income tax Income tax (20%) Net income
2025 2024 $450,000 $430,000 90,000 86,000 $360,000 $344,000
2023 $395,000 79,000 $316,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Time and Purpose of Problems Problem 3.1 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to prepare a multi-step income statement and a retained earnings statement. A number of special items such as loss from discontinued operations, unusual items, and ordinary gains and losses are presented in the problem for analysis purposes. Problem 3.2 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to prepare a single-step income statement and a retained earnings statement. The student must determine through analysis the ending balance in retained earnings. Problem 3.3 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to analyze a number of transactions and to prepare a partial income statement. The problem includes discontinued operations and the effect of a change in accounting principle. Problem 3.4 (Time 45–55 minutes) Purpose—to provide the student with the opportunity to prepare multiple-step and single-step income statements and a retained earnings statement from the same underlying information. A substantial number of operating expenses must be reported in this problem unlike Problem 3.1. As a consequence, the problem is time-consuming and emphasizes the differences between the multiple-step and singlestep income statement. Problem 3.5 (Time 20–25 minutes) Purpose—to provide the student with a problem on the income statement treatment of (1) a change that is usual but infrequently occurring, (2) loss on sale of equipment, (3) a correction of an error, and (4) earnings per share. The student is required not only to identify the proper income statement treatment but also to provide the rationale for such treatment. Problem 3.6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare a retained earnings statement. A number of special items must be reclassified and reported in the income statement. This problem illustrates the fact that ending retained earnings is unaffected by the choice of disclosing items in the income statement or the retained earnings statement, although the income reported would be different. Problem 3.7 (Time 25–35 minutes) Purpose—to provide the student with a problem to determine the reporting of several items, which may get special treatment as irregular items. This is a good problem for a group assignment.
Solutions to Problems Problem 3.1 DICKINSON COMPANY Income Statement For the Year Ended December 31, 2025 Sales revenue............................................................... $25,000,000 Cost of goods sold ...................................................... 16,000,000 Gross profit .................................................................. 9,000,000 Selling and administrative expenses.......................... 4,700,000 Income from operations .............................................. 4,300,000 Other revenues and gains Interest revenue ................................................. $ 70,000 Gain on the sale of investments ....................... 110,000 180,000 4,480,000 Other expenses and losses Loss from flood damage 390,000 Write-off of goodwill .......................................... 820,000 (1,210,000) Income before income tax ................................................. 3,270,000 Income tax .................................................................... 1,244,000 Income from continuing operations ........................... 2,026,000 Discontinued operations Loss from operation of wholesale division, net of applicable tax ................................ 90,000 Loss on disposal of wholesale division, net of applicable tax ........................................... 440,000 (530,000) Net income ................................................................... $ 1,496,000 Earnings per share: Income from continuing operations ................. Loss from operations of discontinued division, net of tax .............................. Loss on disposal of discontinued division, net of tax .............................. Net income ......................................................... a
$2,026,000 – $80,000 500,000 shares
=
$3.89
$1,496,000 – $80,000 500,000 shares
=
$2.83
b
$ 3.89a $0.18 0.88
(1.06) $ 2.83b
Problem 3.1 (Continued) DICKINSON COMPANY Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1 .............................. Add: Net income ................................................. Less: Dividends declared on: Preferred stock .......................................... Common stock ........................................... Retained earnings, December 31 .........................
$
$ 80,000 250,000
LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
980,000 1,496,000 2,476,000
330,000 $2,146,000
Problem 3.2 THOMPSON CORPORATION Income Statement For the Year Ended December 31, 2025 Revenues Net sales ($1,100,000 – $14,500 – $17,500).... Gain on sale of land........................................ Rent revenue ................................................... Total revenues ....................................... Expenses Cost of goods sold* ........................................ Selling expenses ............................................ Administrative expenses ............................... Total expenses....................................... Income before income tax ........................................ Income tax ....................................................... Net income ......................................................................... Earnings per share ($86,100 ÷ 30,000) ..................... *Cost of goods sold: Can be verified as follows: Inventory, Jan. 1 ................................................... Purchases ............................................................. Less: Purchase discounts .................................. Net purchases ...................................................... Add: Freight-in ................................................... Inventory available for sale ................................. Less: Inventory, Dec. 31 ..................................... Cost of goods sold ............................................
$1,068,000 30,000 18,000 $1,116,000
645,000 232,000 99,000 976,000 140,000 53,900 $ 86,100 $2.87
$ 89,000 $610,000 10,000 600,000 20,000
620,000 709,000 64,000 $645,000
Problem 3.2 (Continued) THOMPSON CORPORATION Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1 ............................................ Add: Net income ............................................................... Less: Cash dividends ........................................................ Retained earnings, December 31 .......................................
$160,000 86,100 246,100 45,000 $201,100
LO: 1, , 3, Bloom: AP, Difficulty: Simple, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 3.3 MAHER INC. Income Statement (Partial) For the Year Ended December 31, 2025 $748,500(a) 193,350(b) 555,150
Income before income tax ..................................... Income tax .................................................... Income from continuing operations ..................... Discontinued operations Loss on disposal of recreational division Less applicable income tax of 34,500 (1)………………………………………. Net income.............................................................. (1) $115,000 30%
(80,500) $474,650
Per share Income from continuing operations ($555,150 ÷ 120,000) Loss on disposal of discontinued operation, net of tax ................................ Net income ($474,650 ÷ 120,000) ................
$4.63* (0.67)* $3.96
*Rounded (a)
Computation of income before taxes: As previously stated ............................................. Loss on sale of securities ..................................... Gain on proceeds of life insurance policy ($150,000 – $46,000) ............................... Flood Loss Error in computation of depreciation As computed ($54,000 ÷ 6) ........................................ Corrected ($54,000 – $9,000) ÷ 6 ............................... As restated .................................................................
$790,000 57,000 104,000 90,000 $9,000 (7,500)
1,500 $748,500
Problem 3.3 (Continued) (b)
Computation of income tax: Income before taxes ........................................................ Nontaxable income (gain on life insurance) .................. Taxable income ............................................................... Tax rate ............................................................................ Income tax .......................................................................
$748,500 (104,000) 644,500 x .30 $193,350
Note: No adjustment is needed for the inventory method change, since the new method is reported in 2025 income. The cumulative effect on prior years of retroactive application of the new inventory method will be recorded in retained earnings. LO: 1, 2, *6 Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 3.4 (a)
TWAIN CORPORATION Income Statement For the Year Ended June 30, 2025
Sales Sales revenue ......................................... Less: Sales discounts .......................... Sales returns and allowances ... Net sales ................................................. Cost of goods sold ...................................... Gross profit .................................................. Operating expenses Selling expenses Sales commissions ............................ Salaries and wages expense ............. Travel expense ................................... Delivery expense ................................ Entertainment expense ...................... Telephone and Internet expense....... Maintenance and repairs expense .... Depreciation expense ........................ Bad debt expense .............................. Miscellaneous selling expenses ....... Administrative Expenses Maintenance and repairs expense ............ Property tax expense .................................... Depreciation expense ................................ Supplies expense....................................... Telephone and Internet expense .............. Office expenses ......................................... Income from operations .....................................
$1,578,500 $31,150 62,300
97,600 56,260 28,930 21,400 14,820 9,030 6,200 4,980 4,850 4,715 9,130 7,320 7,250 3,450 2,820 6,000
93,450 1,485,050 896,770 588,280
248,785
35,970 303,525
Problem 3.4 (Continued) Other revenues and gains Dividend revenue ............................................ 38,000 Other expenses and losses Interest expense ............................................. Income before income tax.................................. Income tax expense ........................................ Net income .......................................................... Earnings per common share [($221,525 – $9,000) ÷ 80,000] ........................
18,000
20,000 323,525 102,000 $221,525 $2.66*
*Rounded TWAIN CORPORATION Retained Earnings Statement For the Year Ended June 30, 2025 Retained earnings, July 1, 2024, as reported ..... Correction of depreciation understatement, net of tax ........................................................... Retained earnings, July 1, 2024, as adjusted ..... Add: Net income ..................................................
$337,000 (17,700) 319,300 221,525 540,825
Less: Dividends declared on preferred stock..... Dividends declared on common stock ..... Retained earnings, June 30, 2025 .......................
$ 9,000 37,000
46,000 $494,825
Problem 3.4 (Continued) (b)
TWAIN CORPORATION Income Statement For the Year Ended June 30, 2025 Revenues Net sales ............................................................ Dividend revenue .............................................. Total revenues .......................................... Expenses Cost of goods sold ............................................ Selling expenses ............................................... Administrative expenses .................................. Interest expense ................................................ Total expenses ......................................... Income before income tax .......................................... Income tax ......................................................... Net income ................................................................... Earnings per common share [($221,525 - $9,000) ÷ 80,000] * Rounded
$1,485,050 38,000 1,523,050 896,770 248,785 35,970 18,000 1,199,525 323,525 102,000 $ 221,525 $2.66*
TWAIN CORPORATION Retained Earnings Statement For the Year Ended June 30, 2025 Retained earnings, July 1, 2024, as reported ... Correction of depreciation understatement, net of tax ......................................................... Retained earnings, July 1, 2024 as adjusted .... Add: Net income ................................................
$337,000 (17,700) 319,300 221,525 540,825
Less: Dividends declared on preferred stock .. Dividends declared on common stock ... Retained earnings, June 30, 2025 .....................
$ 9,000 37,000
LO: 1, , 3 Bloom: AP, Difficulty: Moderate, Time: 45-55, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
46,000 $494,825
Problem 3.5 1.
The usual but infrequently occurring charge of $8,500,000 should be disclosed separately, assuming it is material. This charge is shown above income before income tax and would not be reported net of tax. This item should be separately disclosed to inform the users of the financial statements that this item is nonrecurring and therefore may not impact next year’s results.
2.
The loss on sale of equipment of $6,000,000 should be reported as an "Other expense or loss". It should not be reported net of tax. As with the first item, if material, it should be separately reported.
3.
The adjustment required for a change in estimated useful life is inappropriately labeled. It also should not be reported in the retained earnings statement. Changes in estimate should be handled in current and future periods through the income statement. Catch-up adjustments are not permitted. To restate financial statements every time a change in estimate occurred would be extremely costly. In addition, adjusting the beginning balance of retained earnings is inappropriate as the increased charge in this case affects current and future income statements.
4.
Earnings per share should be reported on the face of the income statement and not in the notes to the financial statements. Because such importance is ascribed to this statistic, the profession believes it necessary to highlight the earnings per share figure.
LO: 1, , 3, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 3.6 (a)
ACADIAN CORP. Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1, as reported ........................... Correction of error from prior period (net of tax) ................. Adjustment for change in accounting principle (net of tax) ............................................................................ Retained earnings, January 1, as adjusted ........................... Add: Net income ................................................................... Less: Cash dividends declared ............................................ Retained earnings, December 31 ...........................................
$257,600 25,400 (23,200) 259,800 52,300* 32,000 $280,100
*$52,300 = ($84,500 + $41,200 + $21,600 – $35,000 – $60,000) (b)
1. Gain on sale of investments—body of income statement. This gain should not be shown net of tax on the income statement. 2. Refund on litigation with government—body of income statement, possibly unusual item. This refund should not be shown net of tax on the income statement. 3. Loss on discontinued operations—body of the income statement, following the caption, “Income from continuing operations.” 4. Write-off of goodwill—body of income statement, possibly unusual item. The write-off should not be shown net of tax on the income statement.
LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation , Reporting, AICPA PC: Communication
Problem 3.7 WADE CORP. Income Statement (Partial) For the Year Ended December 31, 2025 Income before income tax ................................ Income tax ................................................ Income from continuing operations ................ Discontinued operations Loss from operations of subsidiary, less applicable income tax of $17,100 Loss on disposal of subsidiary, less applicable income tax of $19,000 Net income ........................................................
$1,200,000* 228,000** 972,000
$ 72,900 81,000
(153,900) $ 818,100
Per share of common stock: Income from continuing operations ($972,000 ÷ 150,000)....................................................... Loss from operations of discontinued subsidiary, net of tax .................................................... Loss on disposal of discontinued operations, net of tax......... Net income ($818,100 ÷ 150,000).......................................
0.49 0.54 $5.45
*Computation of income from continuing operations before income tax: As previously stated Loss on sale of equipment [$40,000 – ($80,000 – $30,000)] Restated
$1,210,000 (10,000) $1,200,000
$6.48
**Computation of income tax: $1,200,000 x .19 = $228,000 Note: The gain on condemnation is appropriately included in income from continuing operations (and is taxed at 19%). The error related to the intangible asset was correctly charged to retained earnings. LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation , Reporting, AICPA PC: None
UYJ 3.1 Financial Reporting Problem (a) P&G uses the multiple-step income statement because it separates operating from nonoperating activities. A multiple-step income statement is used to recognize additional relationships related to revenues and expenses. P&G recognizes a separation of operating transactions from nonoperating transactions. As a result, trends in income from continuing operations should be easier to understand and analyze. Disclosure of operating income may assist in comparing different companies and assessing operating efficiencies. (b) P&G operates in the consumer products market. The company separates its operations into five global segments: (sales by segment) Fabric and Home Care Beauty Baby, Feminine and Family Care Health Care Grooming
33% 19% 26% 13% 9%
(c) P&G’s gross profit (Net Sales – Cost of Products Sold) was $35,700 million in 2020, $32,916 million in 2019, and $32,400 million in 2018. P&G’s gross profit increased by approximately 8.5% in 2020 compared to 2019. The increase in gross profit percentage from 2019 to 2020 was probably due to a number of factors. The MD&A explains that net sales increased 5% with a 4% increase in unit volume. It looks like P&G may have increased its sales price while keeping its cost of products stable. (d) P&G probably makes a distinction between operating and nonoperating revenue for the reasons mentioned in the solution to Part (a). By separating out these revenue and expense items, the statement reader can see the separate impacts of operating and financing activities. (e) P&G reports the following ratios in its 5-year “Financial Summary” section: Earnings and Dividends per share. It also reports a ratio similar to profit margin on sales. P&G reports net earning margin from continuing operations which is calculated as income from continuing operations ÷ Net Sales. The Financial Summary also reports income statement items, such as advertising and research and development expenses and operating income. LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 3.2 Comparative Analysis Case (a)
Both companies use the multiple-step format in presenting income statement information. Companies use the multiple-step income statement to recognize additional relationships related to revenues and expenses. Both companies distinguish between operating and nonoperating transactions. As a result, trends in income from continuing operations should be easier to understand and analyze. Disclosure of operating income may assist in comparing different companies and assessing operating efficiencies.
(b)
The gross profit, operating profit, and net income for these two companies are as follows: PepsiCo Sales revenue ……… Cost of Goods sold ... Gross Profit ...............
2020 $70,372 31,797 38,575
2019 $67,161 30,132 37,029
2018 $64,661 29,381 35,280
% Change 8.83% 8.22% 9.34%
Operating Profit ........
10,080
10,291
10,110
−0.30%
Net Income ................
$ 7,120
$ 7,314
$12,513
−43.11%
Coca-Cola 2020 Sales revenue............ $33,014 Cost of goods sold 13,433 ............................. Gross Profit ............... 19,581
2019 $37,266 14,619
2018 $34,300 13,067
% Change −3.75% 2.80%
22,647
21,233
−7.78%
Operating Profit ........
8,997
10,086
9,152
−1.69%
Net Income ................
$ 7,747
$ 8,920
$ 6,434
20.41%
As shown in the table above, PepsiCo is performing better than CocaCola when comparing 2020's sales revenue, gross profit, and operating profit to 2018's. The changes in net income are very different. Coca-Cola experienced a significant improvement, 20%, while PepsiCo had a very large decrease, 43%. UYJ 3.2 Comparative Analysis Case (Continued)
These large swings are due to unusual events. PepsiCo recorded a larger than usual income tax benefit during 2018 that is explained in Note 5. In contrast Coca-Cola recorded larger than usual Other losses. Note 17 explains that the company recognized several impairment charges during 2018. These results illustrate the importance of disclosing nonrecurring activities and events when using financial statements to predict future performance. (c)
Both companies use the two-statement approach in reporting comprehensive income.
LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Anaysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 3.3 Financial Statement Analysis Case (a)
Given the ready availability, the analysis for Walgreens is provided below:
Z-Score Analysis Z=
Working Capital Total Assets
X 1.2 +
Retained Earnings X 1.4 + Total Assets
EBIT Sales X 3.3 + Total Assets Total Assets
X .99 +
MV Equity X 0.6 Total Liabilities
Walgreens ($ 000,000) 2020
2019
Total Assets
$ 87,174
$ 67,598
Current Assets
$ 18,073
$ 18,700
Current Liabilities
$ 27,070
$ 25,769
$ −8,997
$ −7,069
Multiple
−0.1032
−0.105
$ 34,210
$ 35,815
0.392
0.530
Working Capital Working Capital/Assets Retained Earnings Retained Earnings/Assets EBIT EBIT/Assets
$
1,382
$
0.077
$ 139,537
$ 136,866
1.601
2.025
MV Equity
$ 32,910*
$45,835**
Total Liabilities
$ 66,038
$ 43,447
0.498
1.055
Sales/Assets
MV Equity/Total Liabilities
*$38.02 865,603,519 shares **$51.19 895,387,502 shares
Z-Score
2020
2019
1.2
−0.1236
−0.1260
1.4
0.5488
0.7420
3.3
0.0528
0.2541
0.99
1.5850
2.0048
0.6
0.2988
0.6330
Z-Score
2.3618
3.5079
5,231
0.016
Sales
Z-Score
UYJ 3.3 Financial Statement Analysis Case (Continued) (b)
Walgreens’ Z-score in 2020 has decreased and is below the cutoff score for companies that are unlikely to fail. The company has deteriorated all components of the Z-score. Investors have noted greater risk as indicated by lower stock prices. Note to instructors—as an extension, students could be asked to conduct the analysis on companies which are in financial distress (e.g., Xerox) to examine whether their financial distress could have been predicted in advance.
(c)
EBIT is an operating income measure. By adding back items less relevant to predicting future operating results (interest, taxes), management views it as a better indicator of future profitability.
LO 1, 2, 3, 5 Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 3.4 Financial Statement Analysis Case (a)
Assumptions and estimates related to items such as bad debt expense, warranties, or the useful lives or residual values for fixed assets could result in income being overstated.
(b)
See the table below.
December 31, 2020 Tootsie Roll Hershey
Price (a) $ 28.75 $151.52
EPS (b) $0.89 $6.11
Sales per Share (c) $ 7.03* $39.14**
P/E (a) ÷ (b) 32.3034 24.7987
Price to Sales (a) ÷ (c) 4.09 3.87
*$467,427 ÷ 66,512 shares **$8,149,719,000 ÷ 208,227,127 shares per note 14 (c)
Tootsie Roll has a higher P/E relative to Hershey by approximately 30%. Tootsie Roll’s PSR is higher than Hershey’s. Thus, Tootsie Roll’s stock may be overpriced.
LO: 5, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
UYJ 3.5 Accounting, Analysis, And Principles Accounting COUNTING CROWS, INC. Income Statement For the Year Ending December 31, 2025 Revenues Sales revenue Rent revenue Total revenues
$1,900,000 102,700 $2,002,700
Expenses Cost of goods sold Selling expenses Administrative expenses Income tax Total expenses
850,000 300,000 240,000 187,000 1,577,000
Income from continuing operations Discontinued operations Loss on discontinued operations, less applicable income tax $60,500 Net income Per share of common stock: Income from continuing operations ($425,700 ÷ 100,000) Loss on discontinued operations, net of tax Net income ($376,200 ÷ 100,000) All EPS are rounded
$ 425,700
$
49,500 $ 376,200
$4.26 (0.50) $3.76
UYJ 3.5 Accounting, Analysis, And Principles (Continued) COUNTING CROWS, INC. Retained Earnings Statement For the Year ended December 31, 2025 Retained earnings, January 1 Net income
$600,000 376,200 976,200 Dividends declared (80,000) Retained earnings, December 31 $896,200 COUNTING CROWS, INC. Comprehensive Income Statement For the Year ended December 31, 2025 Net income $376,200 Other comprehensive income: Unrealized holding gain, net of $2,000 tax 15,000 Comprehensive income $391,200 Analysis The multiple-step income statement recognizes important relationships between income statement elements. For example, by separating operating transactions from nonoperating transactions, the statement user can distinguish between elements with differing implications for future operating results. In addition, the multiple-step format generally groups costs and expenses with related revenues (e.g., cost of goods sold with sales revenue to yield a gross profit measure). Finally, the multiple-step format highlights certain intermediate components of income that analysts use to compute ratios for assessing the performance of the company. Principles Non-GAAP reporting is inconsistent with the conceptual framework’s qualitative characteristic of comparability. For example, similar to the discussion in the opening story, if Counting Crows Inc. classifies some items in a pro forma manner but other companies do not, investors and creditors will not be able to compare the reported incomes. This is the reason the SEC issued Regulation G, which requires companies that issue pro forma income reports to provide a reconciliation to net income measured under GAAP, which interested parties can then compare across companies. LO: 1, 2, 3 Bloom: S, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT3.1 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to comment on deficiencies in an income statement format. The student is required to comment on such items as inappropriate heading, incorrect classification of special items, proper net of tax treatment, and presentation of per share data. CT3.2 (Time 20–25 minutes) Purpose—to provide the student an illustration of how earnings can be managed. The case allows students to see the effects of warranty expense timing on the trend of income and illustrates the potential use of accruals to smooth earnings. CT3.3 (Time 15–20 minutes) Purpose—to provide the student an illustration of how earnings can be managed by how losses are reported, including ethical issues. CT3.4 (Time 30–35 minutes) Purpose—to provide the student with an unstructured case to comment on the reporting of discontinued operations. In addition, the student is asked to comment on materiality considerations and earnings per share implications. CT3.5 (Time 30–40 minutes) Purpose—to provide the student with the opportunity to comment on deficiencies in an income statement. This case includes discussion of discontinued items, and gains and losses. The case is complete and therefore provides a broad overview to a number of items discussed in the textbook. CT3.6 (Time 20–25 minutes) Purpose—to provide the student with a variety of situations involving classification of special items. This case is different from CT3.5 in that an income statement is not presented. Instead, short factual situations are described. A good comprehensive case for discussing the presentation of special items. CT3.7 (Time 10–15 minutes) Purpose—to provide the student with an opportunity to show how comprehensive income should be reported.
Solutions to Critical Thinking CT3.1 The deficiencies of O’Malley Corporation’s income statement are as follows: 1. 2.
The heading is inappropriate. The heading should include the period of time for which the income statement is presented. Insert Revenues: as first line in body of statement and then list the detail in a left hand column with subtotal in right hand column.
3.
Change Less: to Expenses:
4.
Gain on recovery of insurance proceeds is properly classified in a single-step income statement.
5.
Cost of goods sold is usually listed as the first expense, followed by selling, administrative, and other expenses.
6.
Advertising expense is a selling expense and should usually be classified as such, unless this expense is unusually different from previous periods.
7.
Loss on obsolescence of inventories is properly classified in a single step income statement.
8.
Loss on discontinued operations requires a separate classification after income from continuing operations.
9.
Intraperiod income tax allocation is required to relate income tax expense to income from continuing operations and loss on discontinued operations.
10. Per share data is a required presentation for income from continuing operations, discontinued operations, and net income. LO: 1, 2, Bloom: C, Difficulty: Simple, Time: 20-25, AACSB: knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT3.2 (a) Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves, which are established, by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges and warranty returns. (b) Proposed Accounting Income before warranty expense Warranty expense Income
2022
2023
2024
$20,000
$25,000
$30,000
2025 $43,000 7,000 $36,000
2026 $43,000 3,000 $40,000
Assuming the same income before warranty expense for both 2025 and 2026 and total warranty expense over the 2-year period of $10,000, this proposed accounting results in steadily increasing income over the two-year period.
CT3.2 (Continued) (c) Appropriate Accounting Income before warranty expense Warranty expense Income
2022
2023
2024
$20,000
$25,000
$30,000
2025 $43,000 5,000 $38,000
2026 $43,000 5,000 $38,000
The appropriate accounting would be to record $5,000 of warranty expense in 2025, resulting in income of $38,000. However, with the same amount of warranty expense in 2026, Bobek no longer shows an increasing trend in income. Thus, by taking more expense in 2025, Bobek can save some income (a classic case of “cookie-jar” reserves) and maintain growth in income. LO: 5, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT3.3 (a) The ethical issues involved are integrity and honesty in financial reporting, full disclosure, accountant’s professionalism, and job security for Charlie. (b) If Charlie believes the losses are relevant information important to users of the income statement, he should disclose the losses separately. If they are considered incidental to the company’s normal activities—i.e., the major activities of the Kelly Corporation do not include selling equipment—the transactions should be reported among any gains and losses that occurred during the year. LO: 5, Bloom: E, Difficulty: Simple, Time: 15-20, AACSB: Ethics, Communication, AICPA BB: None, , AICPA AC: Reporting, AICPA PC: Ethical Conduct
CT3.4 (a) It appears that the sale of the Casino Knights Division would qualify as a discontinued operation. The operation of gambling facilities appears to meet the criteria for discontinued operations for Simpson Corp. and, therefore, the accounting requirements related to discontinued operations should be followed. Although the financial vice-president might be correct theoretically, professional pronouncements require that such segregation be made. A separate classification is required for disposals meeting the requirements of discontinued operations. If this disposal did not meet the requirements for disposal of a component of a business, treatment as “other gain or loss” might be considered appropriate. (b) The “walkout” or strike generally does not get special reporting. Events of this nature are a general risk that any business enterprise takes and should not warrant special treatment. Such events may call for expanded disclosure if the effects are significant. (c) The financial vice-president is incorrect in his/her observations concerning the materiality of irregular items. The materiality of each item must be considered individually. It is not appropriate to consider only the materiality of the net effect. Each irregular item must be reported separately on the income statement. (d) Earnings per share for income from continuing operations and discontinued operations, and net income, must be reported on the face of the income statement. LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Decision Making, Communication
CT3.5 The income statement of Walters Corporation contains the following weaknesses in classification and disclosure: 1.
Sales taxes. Sales taxes have been erroneously included in both gross sales and cost of goods sold on the income statement of Walters Corporation. Failure to deduct these taxes directly from customer billings results in a deceptive inflation of the amount of sales. These taxes should be deducted from gross sales because the corporation acts as an agent in collecting and remitting such taxes to the state government.
2.
Purchase discounts. Purchase discounts should not be treated as revenue by being lumped with other revenues such as dividends and interest. A purchase discount is more logically a reduction of the cost of purchases because revenue is not created by purchasing goods and paying for them. In a cash transaction, cost is measured by the amount of the cash consideration. In a credit transaction, however, cost is measured by the amount of cash required to settle immediately the obligation incurred. The discount should reduce the cost of goods sold to the amount of cash that would be required to settle the obligation immediately.
3.
Recoveries of accounts written off in prior years. These collections should be credited to the allowance for doubtful accounts unless the direct write-off method was used in accounting for bad debt expense. Generally, the direct write-off method is not allowed.
4.
Delivery expense. Although delivery expense (sometimes referred to as freight-out) is an expense of selling and is therefore reported properly in the statement, freight-in is an inventoriable cost and should have been included in the computation of cost of goods sold. The value assigned to inventory should represent the value of the economic resources given up in obtaining goods and readying them for sale.
5.
Loss on discontinued styles. This type of loss, though often substantial, should not be treated as discontinued operation unless it eliminates a component of the business of the corporation and/or represents a strategic shift. Otherwise it should be reported as “Other expenses and losses” before Income before taxes.
6.
Loss on sale of marketable securities. This item should be reported as a separate component of income from continuing operations as an "Other expense or loss."
7.
Loss on sale of warehouse. This type of item does not get special treatment, even if the loss is the direct result of a major casualty, an expropriation, or a prohibition under a newly enacted law or regulation. This item should be separately disclosed as an unusual item, if either unusual in nature and/or infrequent in occurrence. Note that as a result of a recent FASB ASU, special extraordinary item treatment of unusual and infrequent items is no longer allowed.
8.
Federal Income taxes. The provision for federal income taxes and intraperiod tax allocation are not presented in the income statement. This omission implies that the federal income tax is a distribution of net income instead of an operating expense and a determinant of net income. This assumption is not as relevant to the majority of financial statement users as the concept of net income to investors, stockholders, or residual equity holders. Also, by law the corporation must pay federal income taxes whether the benefits it receives from the government are direct or indirect. Finally, those who base their decisions upon financial statements are thought to look to net income as being a more relevant measure of income than income before taxes.
LO: 1, 2 Bloom: C, Difficulty: Moderate, Time: 30-40, AACSB: knowledge Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT3.6 Classification 1.
No disclosure.
Rationale Error has “reversed out”; that is, subsequent income statement compensated for the error. However, prior year income statements should be restated if the amount of the error is material.
2.
Reported in body of the income statement, as Other revenues and gains.
While unusual in nature, and infrequent in occurrence, GAAP requires reporting in income from continuing operations.
3.
Depreciation expense in body of income statement, based on new useful life.
Material item, but change in estimated useful life is considered part of normal business activity.
*4. No separate disclosure unless material.
Change in estimate, considered part of normal business activity.
5.
Reported in body of the income statement, possibly as an unusual item.
Sale does not meet criteria for the disposal of a component of the business.
6.
Adjustment to the beginning balance of retained earnings.
A change in inventory methods is a change in accounting principle and prior periods are adjusted.
7.
Reported in body of the income statement, as Other expenses and losses.
Loss on preparation of such proposals does not get special reporting.
8.
Reported in body of the income statement, as Other expenses and losses.
Strikes are the result of general business risk and do not receive special reporting.
9.
Prior period adjustment, adjust beginning retained earnings.
Corrections of errors are shown as prior period adjustments.
10.
Reported in body of the income statement, possibly as an unusual item (other losses).
While unusual in nature, and infrequent in occurrence, GAAP requires reporting in income from continuing operations.
11.
Discontinued operations section.
Division’s assets, results of operations, and activities are clearly distinguishable physically, operationally, and for financial reporting purposes. As indicated the charge reflects a strategic shift for the company.
LO: 1, 2, 3, *6, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT3.7 (a) Separate Statement . . . income components . . . Net income ....................................................................... Comprehensive Income Statement Net income ....................................................................... Unrealized gains ............................................................... Comprehensive income .................................................... (b) Combined Format . . . income components . . . Net income ....................................................................... Other comprehensive income Unrealized gains ............................................................... Comprehensive income ....................................................
Current Year
Prior Year
$400,000
$410,000
$400,000 15,000 $415,000
$410,000
$400,000
$410,000
15,000 $415,000
$410,000
$410,000
(c) Nelson can choose either approach, according to FASB ASC 220-10-45. The method chosen should be based on which one provides the most useful information. For example, Nelson should not choose the combined format because the gains result in an increasing trend in comprehensive income, while net income is declining. LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Codification Exercises CE3.1 According to the Glossary: (a) A change in accounting estimate is a change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage value of depreciable assets, and warranty obligations. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. (b) A change in accounting principle reflects a change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle. A “Change in Accounting Estimate Effected by a Change in Accounting Principle” is a change in accounting estimate that is inseparable from the effect of a related change in accounting principle. An example of a change in estimate effected by a change in principle is a change in the method of depreciation, amortization, or depletion for long-lived, nonfinancial assets. (c) Comprehensive Income is defined as the change in equity (net assets) of a business during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. LO: 2, 3, *6 Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, AICPA BB: None AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
CE3.2 According to FASB ASC 810-10-45-21 (Attributing Net Income and Comprehensive Income to the Parent and the Noncontrolling Interest) 45-21 Losses attributable to the parent and the noncontrolling interest in a subsidiary may exceed their interests in the subsidiary's equity. The excess, and any further losses attributable to the parent and the noncontrolling interest, shall be attributed to those interests. That is, the noncontrolling interest shall continue to be attributed its share of losses even if that attribution results in a deficit noncontrolling interest balance. LO: 2, Bloom: K, Difficulty: Simple, Time: 5, AACSB: Knowledge Communication, AICPA BB: None, AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
CE3.3 Entering “effect of preferred stock” in the search window yields the following link (FASB ASC 260-10S55): 260 Earnings per Share > 10 Overall > S55 Implementation Guidance and Illustrations. General Effect of Preferred Stock Dividends and Accretion of Carrying Amount of Preferred Stock on Earnings Per Share S55-1 See paragraph 225-10-S99-5, SAB . . . views on this topic. Following that link yields the following guidance: Income or Loss Applicable to Common Stock S99-5 The following is the text of SAB Topic 6.B, Accounting Series Release 280—General Revision Of Regulation S-X: Income Or Loss Applicable To Common Stock. Facts: A registrant has various classes of preferred stock. Dividends on those preferred stocks and accretions of their carrying amounts cause income applicable to common stock to be less than reported net income. Question: In ASR 280, the Commission stated that although it had determined not to mandate presentation of income or loss applicable to common stock in all cases, it believes that disclosure of that amount is of value in certain situations. In what situations should the amount be reported, where should it be reported, and how should it be computed? Interpretive Response: Income or loss applicable to common stock should be reported on the face of the income statement (FN1) when it is materially different in quantitative terms from reported net income or loss (FN2) or when it is indicative of significant trends or other qualitative considerations. The amount to be reported should be computed for each period as net income or loss less: (a) dividends on preferred stock, including undeclared or unpaid dividends if cumulative; and (b) periodic increases in the carrying amounts of instruments reported as redeemable preferred stock (as discussed in Topic 3.C) or increasing rate preferred stock (as discussed in Topic 5.Q). (FN1) If a registrant elects to follow the encouraged disclosure discussed in paragraph 23 of Statement 130, and displays the components of other comprehensive income and the total for comprehensive income using a one-statement approach, the registrant must continue to follow the guidance set forth in the SAB Topic. One approach may be to provide a separate reconciliation of net income to income available to common stock below comprehensive income reported on a statement of income and comprehensive income. (FN2) The assessment of materiality is the responsibility of each registrant. However, absent concerns about trends or other qualitative considerations, the staff generally will not insist on the reporting of income or loss applicable to common stock if the amount differs from net income or loss by less than ten percent. LO: 2, 3, *6, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
Codification Research Case (a)
FASB ASC 220 – Presentation, Comprehensive Income. The predecessor standard for this topic is FAS No. 130 Reporting Comprehensive Income (Issued June, 1997). By following this Codification String: Presentation > 220 Comprehensive Income > 10 Overall > 5 Background and then click on Printer-Friendly with sources, FAS 130 is identified; you can then go to www.fasb.org/st/ to find the issue date.
(b)
The definition of comprehensive income (Master Glossary of ASC): The change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
(c)
Classifications within net income and examples (FASB ASC 220-10-45-7): 45-7
(d)
[Items included in net income are displayed in various classifications. Those classifications can include income from continuing operations and discontinued operations. This Subtopic does not change those classifications or other requirements for reporting results of operations.]
The classifications within other comprehensive income (220-10-45-13): Accounting Standards Update No. 2011-05–Comprehensive Income (Topic 220) Under the amendments to Topic 220, comprehensive Income, in this Update, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This Update eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in this Update do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.
Codification Research Case (Continued) (e)
Reclassification adjustments (FASB ASC 220-10-45-15) 45-15 Reclassification adjustments shall be made to avoid double counting in comprehensive income items that are displayed as part of net income for a period that also had been displayed as part of other comprehensive income in that period or earlier periods. For example, gains on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains in the period in which they arose must be deducted through other comprehensive income of the period in which they are included in net income to avoid including them in comprehensive income twice (see paragraph 320-10-40-2).
LO: 6, Bloom: C, Difficulty: Moderate, Time: 25-30, AACSB: Knowledge, Communication, Technology, AICPA BB: None, AICPA FC: Reporting, Research, Technology & Tools, AICPA PC: Communication
CHAPTER 4 Balance Sheet and Statement of Cash Flows Assignment Classification Table (By Topic) Brief Exercises
Exercises
Critical Thinking
Topics
Questions
Problems
1.
Disclosure principles, uses of the balance sheet, financial flexibility.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 18, 29, 30, 31
2.
Classification of items in the balance sheet. Issues of disclosure terminology and valuation.
11, 12, 13, 14, 15, 16, 18, 19, 20, 29, 30, 31, 32
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 8, 9, 10
3.
Statement of cash flows.
21, 22, 23, 24, 25, 26, 27, 28
12, 13, 14, 15, 16
13, 14, 15, 16, 17, 18
6, 7
5
4.
Preparation of balance 15, 16, 17, sheet.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
4, 5, 6, 7, 9, 11, 12, 17
1, 2, 3, 4, 5, 6, 7
2, 3, 4
3, 4
1, 2, 3, 4
Assignment Classification Table (By Learning Objective)
Learning Objectives
Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Explain the uses, limitations, and content of the balance sheet.
1, 2, 3, 4, 5, 6, 7, 8, 9,10, 11, 12, 13, 14, 15, 16, 17, 18,19, 20
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 17
1, 2, 3, 4, 5, 6, 7
1 2 3 4
2.
Explain the purpose, content, preparation, and usefulness of the statement of cash flows.
21, 22, 23, 24, 25, 26, 27, 28,
12, 13, 14, 15, 16
13, 14, 15, 16, 17, 18
6, 7
5
3.
Describe additional types of information provided.
20, 29, 30, 31, 32
4.
Identify the major types of financial ratios and what they measure.
5
Assignment Characteristics Table Level of Difficulty
Time (minutes)
Balance sheet classifications. Classification of balance sheet accounts. Classification of balance sheet accounts. Preparation of a classified balance sheet. Preparation of a corrected balance sheet. Corrections of a balance sheet. Current assets section of the balance sheet. Current vs. long-term liabilities. Current assets and current liabilities. Current liabilities. Balance sheet preparation. Preparation of a balance sheet. Statement of cash flows—classifications. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows, analysis.
Simple Simple Simple Simple Simple Complex Moderate Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate
15–20 15–20 15–20 30–35 30–35 30–35 15–20 10–15 30–35 15–20 25–30 30–35 5-10 25–35 25–35 25–35 30–35
Moderate
25–35
Preparation of a classified balance sheet, periodic inventory. Balance sheet preparation. Balance sheet adjustment and preparation. Preparation of a corrected balance sheet. Balance sheet adjustment and preparation. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows and balance sheet.
Moderate
30–35
Moderate Moderate Complex Complex Complex
35–40 40–45 40–45 40–45 35–45
Complex
40–50
Reporting the financial effects of varied transactions. Identifying balance sheet deficiencies. Critique of balance sheet format and content. Presentation of property, plant, and equipment. Cash flow analysis.
Moderate Moderate Simple Simple Complex
20–25 20–25 20–25 20–25 40–50
Item
Description
E4.1 E4.2 E4.3 E4.4 E4.5 E4.6 E4.7 E4.8 E4.9 E4.10 E4.11 E4.12 E4.13 E4.14 E4.15 E4.16 E4.17 E4.18 P4.1 P4.2 P4.3 P4.4 P4.5 P4.6 P4.7
CT4.1 CT4.2 CT4.3 CT4.4 CT4.5
Answers to Questions 1. The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to creditors, and the owners’ equity in net enterprise resources. That information not only complements information about the components of income, but also contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity solvency, and financial flexibility of the enterprise. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
2. Solvency refers to the ability of a company to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency. Information on long-term obligations, such as long-term debt and notes payable, in comparison to total assets, can be used to assess resources that will be needed to meet these fixed obligations (such as interest and principal payments). LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
3. Financial flexibility is the ability of a company to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. An enterprise with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater the financial flexibility, the lower the risk of enterprise failure. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
4. Some situations in which estimates affect amounts reported in the balance sheet include: (a) allowance for doubtful accounts. (b) depreciable lives and estimated salvage values for plant and equipment. (c) warranty returns. (d) determining the amount of revenues that should be recorded as unearned. When estimates are required, there is subjectivity in determining the amounts. Such subjectivity can impact the usefulness of the information by reducing the degree to which the measures are faithful representations, either because of bias or lack of verifiability. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement, Reporting, AICPA PC: Communication
5. A higher level of inventories increases current assets, which is in the numerator of the current ratio. Therefore, a higher inventory will increase the current ratio. In general, a higher current ratio indicates a company has better liquidity since there are more current assets relative to current liabilities. Note to instructors—When inventories increase faster than sales, this may not be a good signal about liquidity. That is, inventory can only be used to meet current obligations when it is sold (and converted to cash). That is why some analysts use a liquidity ratio—the acid-test ratio—that excludes inventories from current assets in the numerator. LO: 1, 4, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
6. Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until a liability has to be paid. The ranking of the assets given in order of liquidity is: (1) (d) Short-term investments (2) (e) Accounts receivable (3) (b) Inventory (4) (c) Buildings (5) (a) Goodwill LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued) 7. The major limitations of the balance sheet are: (a) The values stated are generally historical and not at fair value. (b) Judgements and estimates are used in many instances, such as in determining the collectability of receivables or finding the approximate useful life of long-term tangible and intangible assets. (c) Many items, even though they have financial value to the business, are not recorded. One example is the value of a company’s human resources. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
8. Some items of value to technology companies such as Intel or IBM are the value of research and development (new products that are being developed but which are not yet marketable), the value of the “intellectual capital” of its workforce (the ability of the companies’ employees to come up with new ideas and products in the fast-changing technology industry), and the value of the companies’ reputation or name brand. In most cases, the reasons why the value of these items are not recorded in the balance sheet concern the lack of faithful representation of the estimates of the future cash flows that will be generated by these “assets” (for all three types) and the ability to control the use of the asset (in the case of employees). Being able to reliably measure the expected future benefits and to control the use of an item are essential elements of the definition of an asset, according to the Conceptual Framework. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement, Reporting, AICPA PC: Communication
9. Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. Current assets are expected to be converted to cash within one year or the operating cycle, whichever is longer—property, plant, and equipment will provide cash inflows over a longer period of time. Thus, separating long-term assets from current assets facilitates computation of useful ratios, especially liquidity ratios such as the current ratio. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
10. Separate amounts should be reported for accounts receivable and notes receivable. The amounts should be reported gross, and an amount for the allowance for doubtful accounts should be deducted. The amount and nature of any nontrade receivables and any amounts designated or pledged as collateral should be clearly identified. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement, Reporting, AICPA PC: Communication
11. No. Available-for-sale securities should be reported as a current asset only if management expects to convert them into cash as needed within one year or the operating cycle, whichever is longer. If available-for-sale securities are not held with this expectation, they should be reported as long-term investments. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
12. The relationship between current assets and current liabilities is that current liabilities are those obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
13. The total selling price of the season tickets is $20,000,000 (10,000 x $2,000). Of this amount, $8,000,000 has been earned by 12/31/25 (16/40 x $20,000,000). The remaining $12,000,000 should be reported as unearned revenue, a current liability in the 12/31/25 balance sheet (24/40 x $20,000,000) or ($20,000,000 - $8,000,000). LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued) 14. Working capital is the excess of total current assets over total current liabilities. This excess is sometimes called net working capital. Working capital represents the net amount of a company’s relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
15. (a) (b) (c) (d) (e) (f) (g) (h) (i)
Stockholders’ Equity. “Treasury stock (at cost).” Note: This is a reduction of total stockholders’ equity (reported as contra-equity). Current Assets. Included in “Cash.” Long-Term Investments. “Land held as an investment.” Long-Term Investments, “Sinking Fund.” Long-Term Debt (adjunct account to bonds payable). “Unamortized premium on bonds payable.” Intangible Assets. “Copyrights.” Long-Term Investments. “Employees’ pension fund,” with subcaptions of “Cash” and “Securities” if desired. (Assumes that the company still owns these assets.) Stockholders’ Equity. “Additional paid-in capital.” Investments. Nature of investments should be given together with parenthetical information as follows: “pledged to secure loans payable to banks.”
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
16. (a) (b) (c) (d) (e) (f) (g) (h) (i)
Allowance for doubtful accounts (a contra-asset) should be deducted from accounts receivable in current assets. Merchandise held on consignment should not appear on the consignee’s balance sheet except possibly as a note to the financial statements. Advances received on sales contract are normally a current liability and should be shown as such in the balance sheet. Cash surrender value of life insurance should be shown as a long-term investment. Land should be reported in property, plant, and equipment unless held for investment. Merchandise out on consignment should be shown among current assets under the heading of inventory. Franchises should be itemized in a section for intangible assets. Accumulated depreciation of plant and equipment (a contra-asset) should be deducted from the equipment account. Materials in transit should not be shown on the balance sheet of the buyer if purchased f.o.b. destination.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
17. (a) (b) (c) (d) (e)
Trade accounts receivable should be stated at their estimated amount collectible, often referred to as net realizable value. The method most generally followed is to deduct from the total accounts receivable the amount of the allowance for doubtful accounts. Land is generally stated in the balance sheet at cost. Inventories are generally stated at the lower-of-cost-or-net realizable value. If LIFO or retail inventory methods are used, market is used instead of net realizable value. Trading securities are stated at fair value. Prepaid expenses should be stated at cost less the amount apportioned to and written off over the previous accounting periods.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
18. Assets are defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. If a building is leased under a lease, the future economic benefits of using the building (the right-of-use asset) are controlled by the lessee (tenant) as the result of a past event (the signing of a lease agreement). LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued) 19. Battle is incorrect. Retained earnings is a source of assets, but is not an asset itself. For example, even though the funds obtained from issuing a note payable are invested in the business, the note payable is not reported as an asset. It is a source of assets, but it is reported as a liability because the company has an obligation to repay the note in the future. Similarly, even though the earnings are invested in the business, retained earnings is not reported as an asset. It is reported as part of shareholders’ equity because it is, in effect, an investment by owners which increases the ownership interest in the assets of an entity. LO: 1, Bloom: C Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
20. The notes should appear as long-term liabilities with full disclosure as to their terms. Each year, as the profit is determined, notes of an amount equal to two-thirds of the year’s profits should be transferred from the long-term liabilities to current liabilities until all of the notes have been liquidated. LO: 1, 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
21. The purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. It differs from the balance sheet and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications. While the income statement and the balance sheet are accrual basis statements, the statement of cash flows is a cash basis statement—noncash items are omitted. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
22. The difference between these two amounts may be due to increases in current assets (e.g., an increase in accounts receivable from a sale on account would result in an increase in revenue and net income but have no effect yet on cash). Similarly, a cash payment that results in a decrease in an existing current liability (e.g., payment of accounts payable would decrease cash provided by operations without affecting net income). LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
23. The difference between these two amounts could be due to noncash charges that appear in the income statement. Examples of noncash charges are depreciation, depletion, and amortization of intangibles. Expenses recorded but unpaid (e.g., increase in accounts payable) and collection of previously recorded sales on credit (i.e., now decreasing accounts receivable) also would cause cash provided by operating activities to exceed net income. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
24. Operating activities involve the cash effects of transactions that enter into the determination of net income. Investing activities include making and collecting loans and acquiring and disposing of debt and equity instruments; property, plant, and equipment and intangibles. Financing activities involve liability and stockholders’ equity items and include obtaining resources from owners and providing them with a return on (dividends) and a return of their investment and borrowing money from creditors and repaying the amounts borrowed. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued) 25. (a)
Net income is adjusted downward by deducting $5,000 ($39,000 - $34,000) from $90,000 and reporting cash provided by operating activities as $85,000.
(b)
The issuance of the preferred stock is a financing activity. The issuance is reported as follows: Cash flows from financing activities Issuance of preferred stock (10,000 shares x $115)..................... $1,150,000
(c)
Net income is adjusted as follows: Cash flows from operating activities Net income ........................................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense................................................................... Bond premium amortization.......................................................... Net cash provided by operating activities ..........................................
(d)
$90,000 14,000 (5,000) $99,000
The increase of $20,000 reflects an investing activity. The increase in Land is reported as follows: Cash flows from investing activities: Purchase land ($10,000 - $30,000) .............................................. $(20,000)
LO: 2, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
26. The company appears to have good liquidity and reasonable financial flexibility. Its current cash debt $1,200,000 , which indicates that it can pay off its current liabilities in a given $1,000,000
coverage is 1.20 year
from
its
operations.
In
addition,
its
cash
debt
coverage
is
also
good
at
$1,200,000 0.80 , which indicates that it can pay off approximately 80% of its debt out of current $1,500,000
operations. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
27. Free cash flow = $860,000 – $75,000 – $30,000 = $755,000. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
28. Free cash flow is net cash provided by operating activities less capital expenditures and dividends. The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity and financial flexibility. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 4 (Continued) *29. Some of the techniques of disclosure for the balance sheet are: (a) Parenthetical explanations. (b) Notes to the financial statements. (c) Cross-references and contra items. (d) Supporting schedules. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*30. A note entitled “Summary of Significant Accounting Policies” would indicate the basic accounting principles used by that enterprise. This note should be very useful from a comparative standpoint since it should be easy to determine whether the company uses the same accounting policies as other companies in the same industry. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*31. General debt obligations, lease contracts, pension arrangements and stock compensation plans are four items for which disclosure is mandatory in the financial statements. The reason for disclosing these contractual situations is that these commitments are of a long-term nature, are often significant in amount, and are very important to the company’s well-being. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*32. The profession has recommended that the use of the term “surplus” be discontinued in balance sheet presentations of stockholders’ equity. This term has a connotation outside accounting that is quite different from its meaning in the accounts or in the balance sheet. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing to the nonaccountant and leads to misinterpretation. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 4.1 Current assets Cash ................................................................. Accounts receivable ....................................... Less: Allowance for doubtful accounts .. Inventory ......................................................... Prepaid insurance ........................................... Total current assets ............................
$ 30,000 $110,000 8,000
102,000 290,000 9,500 $431,500
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.2 Current assets Cash and cash equivalents ............................ Equity Investments ........................................ Accounts receivable ....................................... Less: Allowance for doubtful accounts .. Inventory ......................................................... Prepaid insurance ........................................... Total current assets ............................
$ $90,000 4,000
7,000 11,000
86,000 30,000 5,200 $139,200
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.3 Long-term investments Debt investments ............................................ Land held for investment ............................... Notes receivable (long-term).......................... Total investments ..................................... LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 56,000 39,000 42,000 $137,000
Brief Exercise 4.4 Property, plant, and equipment Land ................................................................. Buildings ......................................................... Less: Accumulated depreciation ............. Equipment ....................................................... Less: Accumulated depreciation ............ Timberland ...................................................... Total property, plant, and equipment ..
$ 71,000 $207,000 45,000 190,000 19,000
162,000 171,000 70,000 $474,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.5 Intangible assets Goodwill .......................................................... Patents ............................................................ Franchises ...................................................... Total intangible assets .............................
$150,000 220,000 130,000 $500,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.6 Intangible assets Goodwill .......................................................... Franchises ...................................................... Patents ............................................................ Trademarks ..................................................... Total intangible assets .............................
$ 50,000 47,000 33,000 10,000 $140,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.7 Current liabilities Notes payable ................................................. Accounts payable ........................................... Salaries and wages payable .......................... Income taxes payable..................................... Total current liabilities ........................ LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 22,500 72,000 4,000 7,000 $105,500
Brief Exercise 4.8 Current liabilities Accounts payable ........................................... Unearned rent revenue ................................... Salaries and wages payable........................... Interest payable .............................................. Income taxes payable ..................................... Total current liabilities ........................
$220,000 41,000 27,000 12,000 29,000 $329,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.9 Long-term liabilities Bonds payable ................................................ Less: Discount on bonds payable ........... Pension liability .............................................. Total long-term liabilities ....................
$400,000 29,000
$371,000 375,000 $746,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.10 Stockholders’ equity Common stock ................................................ Paid-in capital in excess of par ...................... Retained earnings ........................................... Accumulated other comprehensive loss ...... Total stockholders’ equity..............................
$750,000 200,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$950,000 120,000 (150,000) $920,000
Brief Exercise 4.11 Stockholders’ equity Preferred stock ............................................... Common stock ................................................ Additional paid-in capital in excess of par ... Retained earnings........................................... Total stockholders’ equity .......................
$152,000 55,000 174,000 114,000 $495,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.12 Cash Flow Statement Operating Activities Net income ....................................................... Depreciation expense ...................................... Increase in accounts receivable ..................... Increase in accounts payable ......................... Net cash provided by operating activities....
$40,000 $ 4,000 (10,000) 7,000
Investing Activities Purchase of equipment ................................... Financing Activities Issue notes payable ......................................... Dividends paid ................................................. Net cash flow from financing activities .... Net increase in cash ($41,000 – $8,000 + $15,000) ..
1,000 41,000
(8,000) 20,000 (5,000) 15,000 $48,000
Free Cash Flow = $41,000 (Net cash provided by operating activities) – $8,000 (Purchase of equipment) – $5,000 (Dividends) = $28,000. LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Brief Exercise 4.13 Cash flows from operating activities Net income ........................................................ Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense ................................ Increase in accounts payable .................... Increase in accounts receivable................ Net cash provided by operating activities ......
$151,000 $44,000 9,500 (13,000)
40,500 $191,500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.14 Sale of land and building ....................................... Purchase of land .................................................... Purchase of equipment.......................................... Net cash provided by investing activities ......
$191,000 (37,000) (53,000) $101,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.15 Issuance of common stock ................................... Purchase of treasury stock ................................... Payment of cash dividend ..................................... Retirement of bonds .............................................. Net cash used by financing activities .............
$147,000 (40,000) (95,000) (100,000) $ (88,000)
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 4.16 Free Cash Flow Analysis Net cash provided by operating activities ............ Purchase of equipment ............................. Purchase of land* ...................................... Dividends ................................................... Free cash flow ........................................................
$400,000 (53,000) (37,000) (95,000) $215,000
*If the land were purchased as an investment, it would be excluded in the computation of free cash flow. LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 4.1 (15–20 minutes) (a)
If the debt investment (bonds) is readily marketable and held primarily for sale in the near term to generate income on short-term price differences, then the account should appear as a current asset and be included with trading securities. Available-for-sale securities are classified as current or noncurrent depending upon the circumstances. If the debt investment is a held-to-maturity investment, then it would be reported as noncurrent.
(b)
Treasury stock (a contra-stockholders’ equity account) is shown as a reduction of total stockholders’ equity.
(c)
Stockholders’ equity.
(d)
Current liability.
(e)
Property, plant, and equipment (as a deduction).
(f)
If the asset in process of construction is being constructed for another party, it is classified as an inventory account in the current assets section. If not, then classified as property, plant, and equipment.
(g)
Current asset.
(h)
Current liability.
(i)
Stockholder’s equity (Retained earnings).
Exercise 4.1 (Continued) (j)
Equity investments are reported as current assets if the shares are expected to be sold within one year. Otherwise, the equity investment is reported in the Long-term investments section.
(k)
Current liability.
(l)
Current liability.
(m)
Current asset (inventory).
(n)
Current liability.
LO: 1, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.2 (15–20 minutes) 1. 2. 3. 4. 5 6. 7. 8. 9. 10.
(h) (d) (f) (f) (c) (a) (f) (g) (a) (a)
11. 12. 13. 14. 15. 16. 17. 18.
(f) (a) (h) (c) (a) (a) (g) (f)
LO: 1, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.3 (15–20 minutes) 1. 2. 3. 4. 5 6. 7. 8. 9.
(a) (b) (f) (a) (f) (h) (i) (d) (a)
10. 11. 12. 13. 14. 15. 16. 17. 18.
(f) (a) (f) (a) or (e) (preferably (a)) (c) and (n) (f) (x) (f) (c)
LO: 1; Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.4 (30–35 minutes) Denis Savard Inc. Balance Sheet December 31, 20– Assets Current assets Cash .......................................................... Less: Cash restricted for plant expansion ........................................ Accounts receivable ................................ Less: Allowance for doubtful accounts .......................................... Notes receivable....................................... Receivables—officers .............................. Inventories Finished goods ................................... Work in process ................................. Raw materials ..................................... Total current assets ..................... Long-term investments Equity stock investments ........................ Land held for future plant site ................. Restricted cash (plant expansion) .......... Total long-term investments........ Property, plant, and equipment Buildings................................................... Less: Accum. depreciation— buildings .......................................... Intangible assets Copyrights ................................................ Total assets .......................................
$XXX XXX XXX
$XXX
XXX
XXX XXX XXX
XXX XXX XXX
XXX $XXX
XXX XXX XXX XXX
XXX XXX
XXX
XXX $XXX
Exercise 4.4 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable, short-term ............................ Salaries and wages payable ......................... Unearned subscriptions revenue................. Unearned rent revenue ................................. Total current liabilities ............................
$XXX XXX XXX XXX
Long-term debt Bonds payable, due in four years ................ Less: Discount on bonds payable ............... Total liabilities .........................................
$XXX XXX
Stockholders’ equity Capital stock: Common stock ........................................ Additional paid-in capital: Paid-in capital in excess of par (common stock) .................................... Total paid-in capital........................... Retained earnings ......................................... Total paid-in capital and retained earnings ........................... Less: Treasury stock, at cost ................ Total stockholders’ equity ................ Total liabilities and stockholders’ equity ......................
$XXX
XXX XXX
XXX
XXX XXX XXX
XXX XXX XXX $XXX
Note to instructor: An assumption made here is that cash included the restricted cash for plant expansion. If it did not, then a subtraction from cash would not be necessary. LO: 1, Bloom: AP, Difficulty: Simple, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.5 (30–35 minutes) Uhura Company Balance Sheet December 31, 2025 Assets Current assets Cash ........................................................ Equity investments, at fair value ........... Accounts receivable ($340,000 + $17,000) Less: Allowance for doubtful accounts ........................................ Inventory, at lower-of-average cost-or-NRV ......................................... Prepaid expenses ................................... Total current assets .........................
$230,000 120,000 $357,000 17,000
340,000 401,000 12,000 $1,103,000
Long-term investments Land held for future use ........................ Held to maturity debt investment ..........
175,000 90,000 265,000
Property, plant, and equipment Buildings ($570,000 + $160,000) ................. Less: Accum. depr.—buildings ....... Equipment ($160,000 + $105,000) ............... Less: Accum. depr.—equipment ..... Intangible assets Goodwill .................................................. Total assets .....................................
$730,000 160,000 265,000 105,000
570,000 160,000
730,000
80,000 $2,178,000
Exercise 4.5 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable (due 2026) .................... Accounts payable ................................ Rent payable......................................... Total current liabilities ................... Long-term liabilities Bonds payable ..................................... Add: Premium on bonds payable ....... Pension obligation ............................... Total liabilities ................................ Stockholders’ equity Common stock, $1 par, authorized 400,000 shares, issued 290,000 shares ................................................ Additional paid-in capital .................... Retained earnings ................................ Total stockholders’ equity ............. Total liabilities and stockholders’ equity ...................
$ 125,000 135,000 49,000 $309,000
$500,000 53,000
290,000 160,000
553,000 82,000
635,000 944,000
450,000 784,000* 1,234,000 $2,178,000
*$2,178,000 – $944,000 – $450,000 LO: 1, Bloom: AN, Difficulty: Simple, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 4.6 (30–35 minutes) Geronimo Company Balance Sheet July 31, 2025 Assets Current assets Cash ...................................................... Accounts receivable ............................ Less: Allowance for doubtful accounts ...................................... Inventory ............................................... Total current assets .......................
$60,000* $38,700** 3,500
35,200 65,300*** $160,500
Long-term investments Certificate of deposit............................ Property, plant, and equipment Equipment ............................................ Less: Accumulated depreciation— equipment .............................. Intangible assets Patents .................................................. Total assets ................................... *($69,000 – $15,000 + $6,000) **($44,000 – $5,300) ***($60,000 + $5,300)
15,000
112,000 28,000
84,000
21,000 $280,500
Exercise 4.6 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes and accounts payable ........................ Income taxes payable ................................... Total current liabilities ............................
$ 44,000 6,000 $ 50,000
Long-term liabilities ............................................ Total liabilities .........................................
75,000 125,000
Stockholders’ equity ........................................... Total liabilities and stockholders’ equity .......................................................
155,500 $280,500
LO: 1, Bloom: AN, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.7 (15–20 minutes) Current assets Cash ................................................................. Less: Restricted cash (plant expansion) ....... Debt investments (at fair value; cost, $31,000) ......................................................... Accounts receivable (of which $50,000 is pledged as collateral on a bank loan) ......... Less: Allowance for doubtful accounts ......... Interest receivable [($40,000 x 6%) x 8/12] .... Inventories at lower of cost (determined using LIFO) or market Finished goods .......................................... Work in process ........................................ Raw materials ............................................ Total current assets ............................
$ 87,000* 50,000
$ 37,000 29,000
161,000 12,000
52,000 34,000 207,000
149,000 1,600
293,000 $509,600
* ($37,000 + $50,000). An acceptable alternative is to report cash at $37,000 and simply report the restricted cash (plant expansion) in the Long-term investments section. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Exercise 4.8 (10–15 minutes) 1.
Dividends payable of $2,375,000 will be reported as a current liability [(1,000,000 – 50,000) x $2.50].
2.
Bonds payable of $25,000,000 and interest payable of $3,000,000 ($100,000,000 x 12% x 3/12) will be reported as current liabilities. Bonds payable of $75,000,000 ($100,000,000 - $25,000,000) will be reported as a long-term liability.
3.
Customer advances of $17,000,000 will be reported as a current liability ($12,000,000 + $30,000,000 – $25,000,000).
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.9 (30–35 minutes) (a)
Allessandro Scarlatti Company Balance Sheet (Partial) December 31, 2025 Current assets Cash ...................................................... Accounts receivable ............................ Less: Allowance for doubtful accounts ................................ Inventory ............................................... Prepaid expenses ................................. Total current assets .......................
$ 34,396* $ 91,300** 7,000
*Cash balance Add: Cash disbursement after discount ($39,000 x .98) Less: Cash sales in January ($30,000 – $21,500) Cash collected on account Bank loan proceeds ($35,324 – $23,324) Adjusted cash **Accounts receivable balance Add: Accounts reduced from January collection ($23,324 ÷ .98)
84,300 159,000*** 9,000 $286,696 $ 40,000 38,220 78,220
$ 8,500 23,324 12,000
43,824 $ 34,396 $ 89,000
Deduct: Accounts receivable in January Adjusted accounts receivable
23,800 112,800 21,500 $ 91,300
***Inventory Less: Inventory received on consignment Adjusted inventory
$171,000 12,000 $159,000
Exercise 4.9 (Continued) Current liabilities Notes payable ................................................ Accounts payable ......................................... Total current liabilities ............................
(b)
$55,000a 115,000b $170,000
a
Notes payable balance Less: Proceeds of bank loan Adjusted notes payable
$ 67,000 12,000 $ 55,000
b
Accounts payable balance Add: Cash disbursements Purchase invoice omitted ($27,000 – $12,000) Adjusted accounts payable
$ 61,000
Adjustment to retained earnings balance: Add: January sales discounts [($23,324 ÷ .98) X .02] ........................... Deduct: January sales ...................................... January purchase discounts ($39,000 X .02) ................................. December purchases ($27,000 - $12,000) Consignment inventory ..................... Change (decrease) to retained earnings ..........
$39,000 15,000
54,000 $115,000
$
476
$30,000 780 15,000 12,000
(57,780) $(57,304)
LO: 1, Bloom: AN, Difficulty: Complex, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.10 (15–20 minutes) (a)
A current liability of $150,000 should be recorded.
(b)
A current liability for accrued interest of $4,000 ($600,000 X 8% X 1/12) should be reported. Also, the $600,000 notes payable should be a current liability if payable in one year. Otherwise, the $600,000 notes payable would be a long-term liability.
(c)
Bad Debt Expense of $300,000 ($10,000,000 x .03) should be debited and the Allowance for Doubtful Accounts credited for $300,000, assuming that there is a $0 balance in the Allowance for Doubtful Accounts. However, this does not result in a liability as Baylor does not have an obligation to expend assets. The allowance for doubtful accounts is a valuation account (contra asset) and is deducted from accounts receivable on the balance sheet so that receivables are reported at net realizable value, or the amount expected to be collected.
(d)
A current liability of $80,000 ($2.00 x 40,000) should be reported. The liability is recorded on the date of declaration.
(e)
Customer advances of $110,000 ($160,000 – $50,000) will be reported as a current liability.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.11 (25–30 minutes) Kelly Corporation Balance Sheet December 31, 2025 Assets Current assets: Cash ................................................................... Supplies ............................................................. Prepaid insurance ............................................. Total current assets ................................... Property, plant and equipment: Equipment ....................................................... Less: Accumulated depr.—equipment .......... Intangible assets: Trademarks...................................................... Total assets ..................................................
$ 6,850 * 1,200 1,000 $ 9,050 48,000 4,000
44,000 950 $54,000
Liabilities and Stockholders’ Equity Current liabilities Accounts payable ............................................. Salaries and wages payable ............................. Unearned service revenue................................ Total current liabilities .............................. Long-term liabilities Bonds payable (due 2032) ................................ Total liabilities ............................................ Stockholders’ equity Common stock .................................................. Retained earnings ($25,000 – $2,500**) ........... Total stockholders’ equity .......................... Total liabilities and stockholders’ equity.......
$10,000 500 2,000 $12,500 9,000 21,500 10,000 22,500 32,500 $54,000
Exercise 4.11 (Continued) *[$54,000 - $950 - $44,000 - $1,000 - $1,200] **[$10,000 – ($9,000 + $1,400 + $1,200 + $900)] LO: 1, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.12 (30–35 minutes) Scott Butler Corporation Balance Sheet December 31, 2025 Assets Current assets Cash ..................................................... Debt investments (Trading) ................ Accounts receivable ........................... Less: Allowance for doubtful accounts ................................... Inventory.............................................. Total current assets .....................
$197,000 153,000 $435,000 25,000
Long-term investments Debt investments ................................ Equity investments ............................. Total long-term investments ...... Property, plant, and equipment Land ..................................................... Buildings ............................................. 1,040,000 Less: Accum. depreciation— building ...................................... 152,000 Equipment .......................................... 600,000 Less: Accum. depreciation— equipment .................................. 60,000 Total property, plant, and equipment .................................. Intangible assets Franchises.................................................... Patents ................................................. Total intangible assets.................. Total assets ...................................
410,000 597,000 1,357,000
299,000 277,000 576,000
260,000
888,000
540,000 1,688,000 160,000 195,000 355,000 $3,976,000
Exercise 4.12 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable (short-term) ............ Accounts payable .......................... Dividends payable .......................... Accrued liabilities .......................... Total current liabilities ........... Long-term debt Notes payable (long-term) ............. Bonds payable................................. Total long-term liabilities .......... Total liabilities .................... Stockholders’ equity Paid-in capital Common stock ($5 par)............ $1,000,000 Additional paid-in capital ......... 80,000 Retained earnings* .......................... Total paid-in capital and retained earnings ................. Less: Treasury stock ...................... Total stockholders’ equity ...... Total liabilities and stockholders’ equity.............
$ 90,000 455,000 136,000 96,000 $ 777,000
900,000 1,000,000 1,900,000 2,677,000
1,080,000 410,000 1,490,000 191,000 1,299,000 $3,976,000
Exercise 4.12 (Continued) *Computation of Retained Earnings: Sales revenue Investment revenue Gain Cost of goods sold Selling expenses Administrative expenses Interest expense Net income Beginning retained earnings Net income Ending retained earnings
$8,100,000 63,000 80,000 (4,800,000) (2,000,000) (900,000) (211,000) $ 332,000 $ 78,000 332,000 $410,000
Or ending retained earnings can be computed as follows: Total stockholders’ equity ($3,976,000 - $2,677,000) Add: Treasury stock Less: Total paid-in capital ($1,000,000 + $80,000) Ending retained earnings
$1,299,000 191,000 1,080,000 $ 410,000
Note to instructor: There is no dividends account. Thus, the 12/31/25 retained earnings balance already reflects any dividends declared, if any. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.13 (15–20 minutes) (a) (b) (c) (d) (e)
4. 3. 4. 3. 1.
(f) (g) (h) (i) (j)
1. 5. 4. 5. 4.
(k) 1. (l) 2. (m) 2.
LO: 2, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 4.14 (25–35 minutes) Constantine Cavamanlis Inc. Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Net income ......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ................................. Increase in accounts receivable................. Increase in accounts payable ..................... Net cash provided by operating activities ....... Cash flows from investing activities Purchase of equipment..................................... Cash flows from financing activities Issuance of common stock .............................. Payment of cash dividends .............................. Net cash used by financing activities .............. Net increase in cash ............................................... Cash at beginning of year ...................................... Cash at end of year .................................................
$44,000
$ 6,000 (3,000) 5,000
8,000 52,000 (17,000)
20,000 (23,000) (3,000) 32,000 13,000 $45,000
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.15 (25–35 minutes) (a)
Zubin Mehta Corporation Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income ........................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ($106,000 - $89,000) .... Loss on sale of investments ...................... Decrease in accounts receivable ............... Decrease in current liabilities..................... Net cash provided by operating activities....... Cash flows from investing activities Sale of investments .......................................... [($74,000 – $52,000) – $10,000] Purchase of equipment ($298,000 - $240,000) ..... Net cash used by investing activities .............. Cash flows from financing activities Payment of cash dividends .............................. Net increase in cash ............................................... Cash at beginning of year ...................................... Cash at end of year ................................................. (b)
$160,000
$17,000 10,000 5,000 (17,000)
15,000 175,000
12,000 (58,000) (46,000) (30,000) 99,000 78,000 $177,000
Free Cash Flow Analysis
Net cash provided by operating activities............. Purchase of equipment................................ Dividends ...................................................... Free cash flow .........................................................
$175,000 (58,000) (30,000) $ 87,000
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.16 (25–35 minutes) (a)
Shabbona Corporation Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income .......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ($69,000 - $42,000) ....... Increase in accounts receivable.................. Decrease in inventory .................................. Decrease in accounts payable .................... Net cash provided by operating activities ........ Cash flows from investing activities Sale of land ($110,000 - $71,000)............................ Purchase of equipment ($260,000 - $200,000)....... Net cash used by investing activities ............... Cash flows from financing activities Payment of cash dividends ............................... Net increase in cash ................................................ Cash at beginning of year ....................................... Cash at end of year ..................................................
$125,000
$27,000 (16,000) 9,000 (13,000)
7,000 132,000
39,000 (60,000)
Noncash investing and financing activities Issued common stock to retire $50,000 of bonds outstanding
(21,000) (60,000) 51,000 22,000 $ 73,000
Exercise 4.16 (Continued) (b) Current cash debt coverage = Net cash provided by operating activities Average current liabilities $132,000 ($34,000 + $47,000) / 2 3.26 to 1 Cash debt coverage = Net cash provided by operating activities Average total liabilities
$132,000 ÷
$184,000 + $247,000 2
=
=
.61 to 1
Free Cash Flow Analysis Net cash provided by operating activities ....................... Purchase of equipment........................................... Dividends ................................................................. Free cash flow ....................................................................
$132,000 (60,000) (60,000) $ 12,000
Shabbona has excellent liquidity. Its financial flexibility is good. It might be noted that it substantially reduced its long-term debt in 2025, which improved its financial flexibility. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communcation
Exercise 4.17 (30–35 minutes) (a)
Grant Wood Corporation Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income ............................................................. Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ($9,000 + $4,000) ........ 13,000 Patent amortization ......................................... 2,500 Loss on sale of equipment ............................. $ 2,000* Increase in current assets (other than cash) .... (29,000) Increase in current liabilities .......................... 13,000 Net cash provided by operating activities ........... Cash flows from investing activities Sale of equipment ................................................. Addition to building .............................................. Investment in stock ............................................... Net cash used by investing activities .................. Cash flows from financing activities Issuance of bonds ................................................. Payment of dividends ........................................... Purchase of treasury stock .................................. Net cash provided by financing activities ........... Net increase in cash ................................................... Cash at the beginning of the year ............................ Cash at the end of the year ......................................
$55,000
1,500 56,500
10,000 (27,000) (16,000) (33,000) 50,000 (30,000) (11,000) 9,000 32,500a 82,000 $114,500
*[$10,000 – ($20,000 – $8,000)] a An additional proof to arrive at the increase in cash is provided as follows: Total current assets—end of period …………… Total current assets—beginning of period …… Increase in current assets during the period ... Increase in current assets other than cash ….. Increase in cash during year …………………….
$296,500 [from part (b)] 235,000 61,500 (29,000) $ 32,500
Exercise 4.17 (Continued) (b)
Grant Wood Corporation Balance Sheet December 31, 2025
Assets Current assets ................................................ $296,500b Equity investments (Long-term) ................... 16,000 Property, plant, and equipment Land .......................................................... $ 30,000 Buildings ($120,000 + $27,000)................ $147,000 Less: Accum. depreciation—buildings ($30,000 + $4,000).................................. 34,000 113,000 Equipment ($90,000 – $20,000) ............... 70,000 Less: Accum. depreciation—equipment ($11,000 – $8,000 + $9,000) ................... 12,000 58,000 Total property, plant, and equipment ..... 201,000 Intangible assets—patents ($40,000 – $2,500) .................................. 37,500 Total assets ....................................... $551,000 Liabilities and Stockholders’ Equity Current liabilities ($150,000 + $13,000) ..................... Long-term liabilities Bonds payable ($100,000 + $50,000) .................. Total liabilities ................................................ Stockholders’ equity Paid-in capital Common stock ........................................................ Retained earnings ($44,000 + $55,000 – $30,000) ........... Total paid-in capital and retained earnings .... Less: Treasury stock (at cost) ............................ Total stockholders’ equity ............................. Total liabilities and stockholders’ equity .....
$163,000 150,000 313,000 $180,000 69,000 249,000 11,000 238,000 $551,000
b The amount determined for current assets could be computed last and then is a “plug”
figure. That is, total liabilities and stockholders’ equity is computed because information is available to determine this amount. Because the total assets amount is the same as total liabilities and stockholders’ equity amount, the amount of total assets is determined. Information is available to compute all the asset amounts except current assets and therefore current assets can be determined by deducting the total of all the other asset balances from the total asset balance (i.e., $551,000 – $37,500 – $201,000 – $16,000). Another way to compute this amount, given the information, is that beginning current assets plus the $29,000 increase in current assets other than cash plus the $32,500 increase in cash equals $296,500. LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 4.18 (25–35 minutes) (a)
Madrasah Corporation Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income ......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ....................................... Increase in accounts payable........................... Increase in accounts receivable ...................... Net cash provided by operating activities .......
$44,000 $ 6,000 5,000 (18,000)
Cash flows from investing activities Purchase of equipment..................................... Cash flows from financing activities Issuance of stock .............................................. Payment of dividends ....................................... Net cash used by financing activities .............. Net increase in cash ............................................... Cash at beginning of year ...................................... Cash at end of year ................................................. (b) Current ratio
Dec. 31, 2025 6.3 ($20,000 + $106,000) $ 20,000
(7,000) 37,000 (17,000)
20,000 (33,000) (13,000) 7,000 13,000 $20,000 Jan. 1, 2025 6.73 ($13,000 + $88,000) $ 15,000
Free Cash Flow Analysis Net cash provided by operating activities .................. Purchase of equipment ..................................... Paid dividends ................................................... Free cash flow ..............................................................
$ 37,000 (17,000) (33,000) $ (13,000)
(c) Although Madrasah’s current ratio has declined from Jan. 1 to Dec. 31, it is still in excess of 6. It appears the company has good liquidity and financial flexibility, even though it has a negative free cash flow. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Problems Problem 4.1 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to prepare a balance sheet, given a set of accounts. No monetary amounts are to be reported. Problem 4.2 (Time 35–40 minutes) Purpose—to provide the student with the opportunity to prepare a complete balance sheet, involving dollar amounts. A unique feature of this problem is that the student must solve for the retained earnings balance. Problem 4.3 (Time 40–45 minutes) Purpose—to provide an opportunity for the student to prepare a balance sheet in good form. Emphasis is given in this problem to additional important information that should be disclosed. For example, an inventory valuation method, bank loans secured by long-term investments, and information related to the capital stock accounts must be disclosed. Problem 4.4 (Time 40–45 minutes) Purpose—to provide the student with the opportunity to analyze a balance sheet and correct it where appropriate. The balance sheet as reported is incomplete, uses poor terminology, and is in error. A challenging problem. Problem 4.5 (Time 40–45 minutes) Purpose—to provide the student with the opportunity to prepare a balance sheet in good form. Additional information is provided on each asset and liability category for purposes of preparing the balance sheet. A challenging problem. Problem 4.6 (Time 35–45 minutes) Purpose—to provide the student with an opportunity to prepare a complete statement of cash flows. A condensed balance sheet is also required. The student is also required to explain the usefulness of the statement of cash flows. Because the textbook does not explain in Chapter 4 all of the steps involved in preparing the statement of cash flows, assignment of this problem is dependent upon additional instruction by the instructor or knowledge gained in elementary financial accounting. Problem 4.7 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to prepare a balance sheet in good form and a more complex cash flow statement.
Solutions to Problems Problem 4.1 COMPANY NAME Balance Sheet December 31, 20XX Assets Current assets Cash on hand (including petty cash) ............ Cash in bank ................................................... Accounts receivable ...................................... Less: Allowance for doubtful accounts ........................................ Interest receivable .......................................... Advances to employees ................................ Inventory (ending) .......................................... Prepaid rent .................................................... Total current assets .................................
$XXX XXX XXX XXX
Intangible assets Patents ............................................................ Total assets ...............................................
XXX XXX XXX XXX XXX $XXX
Long-term investments Bond sinking fund……………………………… Cash surrender value of life insurance…….. Land for future plant site ............................... Total long-term investments ................... Property, plant, and equipment Land ................................................................ Buildings......................................................... Less: Accum. depreciation—buildings .... Equipment ...................................................... Less: Accum. depreciation—equipment ... Total property, plant, and equipment......
$XXX
XXX XXX XXX XXX XXX XXX XXX XXX XXX
XXX XXX XXX XXX $XXX
Problem 4.1 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable................................................. Payroll taxes payable..................................... Salaries and wages payable .......................... Unearned subscriptions revenue.................. Total current liabilities ............................. Long-term liabilities Bonds payable ............................................... Add: Premium on bonds payable ........... Pension liability.............................................. Total long-term liabilities ......................... Total liabilities .......................................... Stockholders’ equity Capital stock Preferred stock (description) .................. Common stock (description) ................... Paid-in capital in excess of par – Preferred stock Total paid-in capital ................................. Retained earnings .......................................... Total paid-in capital and retained earnings ................................. Accumulated other comprehensive income ...................................................... Less: Treasury stock .................................... Total stockholders’ equity ....................... Total liabilities and stockholders’ equity .............................
$XXX XXX XXX XXX $XXX $XXX XXX
XXX XXX XXX XXX
XXX XXX
XXX XXX XXX XXX XXX XXX XXX XXX $XXX
LO: 1, Bloom: C, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 4.2 MONTOYA, INC. Balance Sheet December 31, 2025 Assets Current assets Cash ................................................. Debt investments (trading) ............. Notes receivable.............................. Income taxes receivable .................. Inventory .......................................... Prepaid expenses ............................ Total current assets .................. Property, plant, and equipment Land ................................................. Buildings.......................................... Less: Accum. depreciation— buildings ......................... Equipment ....................................... Less: Accum. depreciation— equipment ....................... Intangible assets Goodwill ........................................... Total assets ...............................
$ 360,000 121,000 445,700 97,630 239,800 87,920 $1,352,050 480,000 $1,640,000 270,200 1,470,000
1,369,800
292,000
1,178,000
3,027,800 125,000 $4,504,850
Problem 4.2 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable................................... Accounts payable ........................... Payroll taxes payable....................... Income taxes payable ...................... Rent payable..................................... Total current liabilities ............... Long-term liabilities Notes payable (long-term) …………. Bonds payable ................................. Less: Discount on bonds payable ............................. Rent payable (long-term) ................ Total long-term liabilities ........... Total liabilities ................................. Stockholders’ equity Capital stock Preferred stock, $10 par; 20,000 shares authorized, 15,000 shares issued .......................... Common stock, $1 par; 400,000 shares authorized, 200,000 issued ......................... Retained earnings ($1,063,897 – $350,000) ................. Total stockholders’ equity ($4,504,850 – $3,440,953) ........ Total liabilities and stockholders’ equity ...............
$ 265,000 490,000 177,591 98,362 45,000 $1,075,953 1,600,000 $300,000 15,000
285,000 480,000 2,365,000 3,440,953
150,000 200,000
350,000 713,897 1,063,897 $4,504,850
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 4.3 EASTWOOD COMPANY Balance Sheet December 31, 2025 Assets Current assets Cash .................................................... Accounts receivable .......................... Less: Allowance for doubtful accounts ............................ Inventory (at lower of LIFO cost or market) ...................................................... Prepaid insurance .............................. Total current assets .....................
$ 41,000 $163,500 8,700
154,800 208,500 5,900 $ 410,200
Long-term investments Equity investments ($120,000 have been pledged as security for notes payable)— at fair value ...................................... Property, plant, and equipment Land ................................................... Construction in process (building) ................................... Equipment .......................................... Less: Accum. depreciation— equipt. ................................ Intangible assets Patents (less $4,000 amortization) .... Total assets ..................................
339,000 85,000 124,000 400,000 240,000
160,000
369,000 36,000 $1,154,200
Problem 4.3 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable (secured by investments of $120,000)................... Accounts payable ............................... Accrued liabilities ............................... Total current liabilities ..................
$ 94,000 148,000 49,200 $ 291,200
Long-term liabilities 8% Bonds payable, due January 1, 2036 ................................ Less: Discount on bonds payable .... Total liabilities ............................... Stockholders’ equity Paid in capital Common stock Authorized 600,000 shares of $1 par value; issued and outstanding, 500,000 shares ....... Additional paid in capital in excess of par—common stock ............................. Retained earnings ............................... Total liabilities and stockholders’ equity ..................
200,000 20,000
180,000 471,200
$500,000 45,000
545,000 138,000
683,000 $1,154,200
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 4.4 KISHWAUKEE CORPORATION Balance Sheet December 31, 2025 Assets Current assets Cash ................................................... Accounts receivable ......................... Inventory ............................................ Total current assets ....................
$175,900 170,000 312,100 $ 658,000
Long-term investments Assets allocated to trustee for plant expansion: Cash in bank ............................... Debt investments (held-to-maturity).................... Property, plant, and equipment Land ................................................... Buildings............................................ Less: Accum. depreciation— buildings ........................... Total assets .................................
70,000 138,000
208,000
950,000 $1,070,000 410,000
a
660,000
1,610,000 $2,476,000
Liabilities and Stockholders’ Equity Current liabilities Notes payable—current installment .. Income taxes payable ....................... Total current liabilities ................
$100,000 75,000 $ 175,000
Problem 4.4 (Continued) Long-term liabilities Notes payable ($600,000 - $100,000)....... Total liabilities ................................ Stockholders’ equity Paid in capitall Common stock, no par; 1,000,000 shares authorized and issued; 950,000d shares outstanding ............ Retained earnings ...................................... Total paid in capital and retained earnings……………………… Less: Treasury stock, at cost (50,000 shares)........................... Total stockholders’ equity ............. Total liabilities and stockholders’ equity ...................
500,000b 675,000
1,150,000 738,000c 1,888,000 87,000 1,801,000 $2,476,000
$1,640,000 – $570,000 (to eliminate the excess of appraisal value over cost from the Buildings account. Note that the Appreciation Capital account is also deleted).
a
$600,000 – $100,000 (to reclassify the currently maturing portion of the notes payable as a current liability).
b
$858,000 – $120,000 (to remove the value of goodwill from retained earnings. Note 2 indicates that retained earnings was credited. Note that the Goodwill account is also deleted).
c
d
1,000,000 shares issued – 50,000 Treasury shares
Note: As an alternate presentation, the cash restricted for plant expansion would be added to the general cash account and then subtracted. The amount reported in the investments section would not change. LO: 1, Bloom: AN, Difficulty: Complex, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 4.5 SARGENT CORPORATION Balance Sheet December 31, 2025 Assets Current assets Cash ................................................... Equity investments (at fair value) .... Accounts receivable ......................... Less: Allowance for doubtful accounts ........................... Inventory (lower-of-FIFO cost or-net realizable value) ................. Total current assets ....................
$150,000 80,000 $ 170,000 10,000
180,000 $ 570,000
Long-term investments Equity investments (at fair value) ................................... Bond sinking fund ............................. Cash surrender value of life insurance ........................................ Land held for future use ................... Property, plant, and equipment Land ................................................... Buildings............................................ Less: Accum. depreciation— buildings ........................... Equipment ......................................... Less: Accum. depreciation— equipment ......................... Intangible assets Franchise ........................................... Goodwill ............................................. Total assets .................................
160,000
270,000 250,000 40,000 270,000
830,000
500,000 1,040,000 360,000 450,000
680,000
180,000
270,000 165,000 100,000
1,450,000
265,000 $3,115,000
Problem 4.5 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable.................................... Accounts payable ............................. Income taxes payable ....................... Unearned rent revenue ..................... Total current liabilities .................
$ 80,000 140,000 40,000 5,000 $ 265,000
Long-term liabilities Notes payable.................................... 7% Bonds payable, due 2033 ........... $1,000,000 Less: Discount on bonds payable .. 40,000 Total liabilities .............................. Stockholders’ equity Paid in capital Capital stock Preferred stock, no par value; 200,000 shares authorized, 70,000 issued and outstanding ... Common stock, $1 par value; 400,000 shares authorized, 100,000 issued and outstanding . Additional paid-in capital in excess of par— common stock [100,000 X ($10 – $1)] ................................... Retained earnings ............................. Total stockholders’ equity ........... Total liabilities and stockholders’ equity .................
120,000 960,000
1,080,000 1,345,000
450,000 100,000
900,000
1,450,000 320,000 1,770,000 $3,115,000
LO: 1, Bloom: AN, Difficulty: Complex, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 4.6
(a)
LANSBURY INC. Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income ......................................................... Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense ................................. Gain on sale of investments ....................... Increase in account receivable ($41,600 – $21,200) ................................... Net cash provided by operating activities .......
$32,000 $ 11,000 (3,400) (20,400)
Cash flows from investing activities Sale of investments .......................................... Purchase of land ............................................... Net cash provided by investing activities .......
15,000 (13,000)
Cash flows from financing activities Issuance of common stock .............................. Retirement of notes payable ............................ Payment of cash dividends .............................. Net cash used by financing activities ..............
20,000 (16,000) (8,200)
(12,800) 19,200
2,000
Net increase in cash ............................................... Cash at beginning of year ...................................... Cash at end of year ................................................. Noncash investing and financing activities Land purchased through issuance of $35,000 of bonds
(4,200) 17,000 20,000 $37,000
Problem 4.6 (Continued) (b)
LANSBURY INC. Balance Sheet December 31, 2025 Assets
Cash Accounts receivable Debt investments Plant assets (net) Land
$37,000 41,600 20,400 (1) 70,000 (2) 88,000 (3) $257,000
Liabilities and Stockholders’ Equity Accounts payable $30,000 Notes payable (long-term) 25,000 (4) Bonds payable 35,000 (5) Common stock 120,000 (6) Retained earnings 47,000 (7) $257,000
(1) $32,000 – ($15,000 – $3,400) (2) $81,000 – $11,000 (3) $40,000 + $13,000 + $35,000 (4) $41,000 – $16,000 (5) $0 + $35,000 (6) $100,000 + $20,000 (7) $23,200 + $32,000 – $8,200 (c)
Cash flow information is useful for assessing the amount, timing, and uncertainty of future cash flows. For example, by showing the specific inflows and outflows from operating activities, investing activities, and financing activities, the user has a better understanding of the liquidity and financial flexibility of the enterprise. Similarly, these reports are useful in providing feedback about the flow of enterprise resources. This information should help users make more accurate predictions of future cash flows.
Note to Instructor: In addition, some individuals have expressed concern about the quality of the earnings because the measurement of the income depends on a number of accruals and estimates which may be somewhat subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more comfort some users have in the reliability of the earnings. In this problem, the ratio of cash provided by operating activities to net income is 60% ($19,200 ÷ $32,000).
Problem 4.6 (Continued) An analysis of Lansbury’s free cash flow indicates it is negative as shown below: Free Cash Flow Analysis Net cash provided by operating activities .......................... Purchase of land ..................................................... Dividends ................................................................. Free cash flow ......................................................................
$19,200 (13,000) (8,200) $ (2,000)
Current cash debt coverage = $19,200 ÷ $30,000 = .64 to 1. Cash debt coverage = $19,200 ÷ [($71,000 + $90,000)/2] = .24 to 1. Current cash debt coverage ratio and cash debt coverage ratios are reasonable. Overall, it appears that its liquidity position is average and overall financial flexibility and solvency should be improved. LO: 1, 2, Bloom: AN, Difficulty: Complex, Time: 35-45, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 4.7 (a)
AERO INC. Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income ........................................................ Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense ................................. Loss on sale of investments ...................... Increase in accounts payable ($40,000 – $30,000) ................................ Increase in accounts receivable ($42,000 – $21,200) ................................ Net cash provided by operating activities.......
$35,000 $12,000 5,000 10,000 (20,800)
Cash flows from investing activities Sale of debt investments ($32,000 - $5,000) .... Purchase of land ............................................... Net cash used by investing activities ..............
27,000 (38,000)
Cash flows from financing activities Issuance of common stock .............................. Payment of cash dividends .............................. Net cash provided by financing activities .......
30,000 (10,000)
6,200 41,200
(11,000)
Net increase in cash ............................................... Cash at beginning of year ...................................... Cash at end of year ................................................. Noncash investing and financing activities Land purchased through issuance of $30,000 of bonds
20,000 50,200 20,000 $70,200
Problem 4.7 (Continued) (b)
AERO INC. Balance Sheet December 31, 2025 Assets
Cash Accounts receivable Plant assets (net) Land
$ 70,200 42,000 69,000 (1) 108,000 (2) $289,200
Liabilities and Stockholders’ Equity Accounts payable $ 40,000 Bonds payable 71,000 (3) Common stock 130,000 (4) Retained earnings 48,200 (5) $289,200
(1) $81,000 – $12,000 (2) $40,000 + $38,000 + $30,000 (3) $41,000 + $30,000 (4) $100,000 + $30,000 (5) $23,200 + $35,000 – $10,000 (c)
An analysis of Aero’s free cash flow indicates it is negative as shown below: Free Cash Flow Analysis
Net cash provided by operating activities ........................... Purchase of land ...................................................... Dividends .................................................................. Free cash flow .......................................................................
$41,200 (38,000) (10,000) $ (6,800)
Problem 4.7 (Continued) $41,200 . Overall, it appears that $35,000 * its liquidity position is average and overall financial flexibility should be improved.
Its current cash debt coverage is 1.18 to 1:
*($30,000 + $40,000) ÷ 2 (d)
This type of information is useful for assessing the amount, timing, and uncertainty of future cash flows. For example, by showing the specific inflows and outflows from operating activities, investing activities, and financing activities, the user has a better understanding of the liquidity and financial flexibility of the enterprise. Similarly, these reports are useful in providing feedback about the flow of enterprise resources. This information should help users make more accurate predictions of future cash flow.
Note to Instructor: In addition, some individuals have expressed concern about the quality of the earnings because the measurement of the income depends on a number of accruals and estimates which may be somewhat subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more comfort some users have in the reliability of the earnings. LO: 1, 2, Bloom: AN, Difficulty: Complex, Time: 40-50, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
UYJ4.1 Financial Reporting Problem (a)
P&G uses the report form.
(b)
The techniques of disclosing pertinent information include (1) parenthetical explanations, (2) notes, (3) cross-reference and contra items, and (4) supporting schedules. P&G uses parenthetical explanations and notes (see notes to financial statements section) and supporting schedules.
(c)
There are available-for-sale investments reported on P&G’s balance sheet under current assets. Note 1 (Significant Accounting Policies) states Available-for-Sale Debt securities are included as Other noncurrent assets in the Consolidated Balance Sheets. These securities are reported at fair value. Unrealized gains and losses relating to investments classified as available-for-sale are recorded as a component of accumulated other comprehensive income in shareholders’ equity. As of June 30, 2020, P&G had negative working capital (current assets less than current liabilities) of $4,989 million. At June 30, 2019, P&G’s negative working capital was $7,538 million.
(d)
The following table summarizes P&G’s cash flows from operating, investing, and financing activities in the 2018–2020 time period (in millions).
Net cash provided by operating activities Net cash provided in investing activities Net cash provided in financing activities
2020 $ 17,403 (3,045) (8,367)
2019 $15,242 (3,490) (9,994)
2018 $ 14,867 (3,511) (14,375)
Financial Reporting Problem (Continued) P&G’s net cash provided by operating activities increased by 2.5% from 2018 to 2019 and by 14.2% from 2019 to 2020. When accounts payable, accrued and other liabilities increase, cost of goods sold and operating expenses are higher on an accrued basis than they are on a cash basis. To convert to net cash provided by operating activities, the increase in accounts payable, and accrued and other liabilities must be added to net income. (e)
1.
Net Cash Provided by Operating Activities ÷ Average Current Liabilities = Current Cash Debt Coverage $17,403 ÷
2.
= .55:1
Net Cash Provided by Operating Activities ÷ Average Total Liabilities = Cash Debt Coverage $17,403 ÷
3.
($32,976 + $30,011) 2
($73,822 + $67,516) 2
= 0.25:1
Net cash provided by operating activities less capital expenditures and dividends Net cash provided by operating activities ...... Less: Capital expenditures ............................. Dividends ............................................... Free cash flow ...................................................
$17,403 $3,073 7,789
10,862 $ 6,541
Note that P&G also used cash ($7,405 million) to repurchase common stock, which reduces its free cash flow to negative $864 million. P&G’s financial position appears adequate. Twenty five percent of its total liabilities can be covered by the current year’s operating cash flow and its free cash flow position indicates it is easily meeting its capital investment and financing demands from current free cash flow. LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ4.2 Comparative Analysis Case (a)
Both the Coca-Cola Company and PepsiCo, Inc. use the report form.
(b) The Coca-Cola Company has working capital of $4,639 million ($19,240 million – $14,601 million): PepsiCo, Inc. has working capital of negative $371 million ($23,001 million – $23,372 million). The Coca-Cola Company indicates in its management discussion and analysis section that its ability to generate cash from operating activities is one of its fundamental financial strengths. This posture, coupled with use debt financing lowers the overall cost of capital and increases the return on shareowners’ equity. PepsiCo has a similar strategy (see discussion in “Liquidity and Capital Resources.”) (c) Total assets
Annual
Three-Year
The Coca-Cola Company PepsiCo, Inc.
1.06% 18.30%
4.90% 19.67%
45.82% 38.50%
58.19% 42.68%
Long-term debt The Coca-Cola Company PepsiCo, Inc.
(d) The Coca-Cola Company has increased net cash provided by operating activities from 2018 to 2020 by $2,217 million or 29.1%. PepsiCo, Inc. has increased net cash provided by operating activities by $1,198 million or 12.7%. Both Coca-Cola and Pepsi had favorable trends in the generation of internal funds from operations.
Comparative Analysis Case (Continued) (e)
The Coca-Cola Company Current Cash Debt Ratio ($14,601 + $26,973) 2
$9,844 ÷
= 0.47:1
Cash Debt Coverage Ratio $9,844 ÷
($66,012* + $65,283**) 2
= .15:1
*$14,601 + $40,125 + $9,453 + $1,833 = $66,012 **$26,973 + $27,516 + $8,510 + $2,284 = $65,283 ($ millions) Free cash flow Net cash provided by operating activities ................ Capital expenditures ....................................... Dividends ......................................................... Free cash flow ............................................................
$9,844 (1,177) (7,047) $1,620
Coca-Cola Company’s free cash flow is $1,620. Note that Coca-Cola is also using cash to repurchase shares. PepsiCo, Inc. Current Cash Debt Coverage $10,613 ÷
$23,372 + $20,461 = 0.48:1 2
Cash Debt Coverage $10,613 ÷
$79,366 + $63,679 = 0.15:1 2
Comparative Analysis Case (Continued) Free cash flow Net cash provided by operating activities................... Less: Capital spending ................................................ Dividends ........................................................... Free cash flow ...............................................................
$10,613 4,240 5,509 $ 864
PepsiCo also used cash to repurchase shares. PepsiCo appears to have similar liquidity and financial flexibility as Coca-Cola. LO: 1, 2, 4, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ4.3 Financial Statement Analysis Case - UTC (a)
The raw materials price increase is not a required disclosure. However, the company might well want to inform shareholders in the management discussion and analysis section, especially as a means for company management to point out an area of success. If the company had not been able to successfully meet the challenge, then the reporting in the discussion and analysis section would be for the purpose of explaining poorer than expected operating results.
(b) The information in item (2) should be reported as follows: The $4,000,000 outstanding should, of course, be included in the balance sheet as a part of liabilities (current- or long-term, depending on the terms of the loan). The fact that an additional $11,000,000 or so is available for borrowing should be disclosed in the notes to the financial statements, as should the fact that the loan is based on the accounts receivable. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ4.4 Financial Statement Analysis Case – Sherwin-Williams (a)
These accounts are shown in the order in which Sherwin-Williams actually presented the accounts. The order shown may be modified somewhat; however, cash should certainly be listed first and other current assets last within the current assets category; common stock should be listed first and retained earnings last in the stockholders’ equity category. For the remaining items, the order may be different than that shown. CURRENT ASSETS Cash and cash equivalents Short-term investments Accounts receivable, less allowance Finished goods inventories Work in process and raw materials inventories Other current assets PROPERTY, PLANT, AND EQUIPMENT Land Buildings Machinery and equipment INTANGIBLE ASSETS Intangibles OTHER ASSETS CURRENT LIABILITIES Accounts payable Employee compensation payable Taxes payable Other accruals Accrued taxes LONG-TERM LIABILITIES Long-term debt Postretirement obligations other than pensions Other long-term liabilities STOCKHOLDERS’ EQUITY Common stock Other capital Retained earnings
Financial Statement Analysis Case (Continued) (b)
There is some latitude for judgment in this question. The general answer is that the assets and liabilities specific to the automotive division will decrease and that cash will increase. Some students may be aware that retained earnings will increase or decrease, depending upon whether the assets were sold above or below historical cost. Cash and cash equivalents—increase from the sale of the assets Accounts receivable, less allowance—decrease from the sale of the Automotive Division’s receivables Finished goods inventories—decrease Work in process and raw materials inventories—decrease Land—decrease Buildings—decrease Machinery and equipment—decrease Current liabilities - decrease Long-term debt—decrease Retained earnings—increase or decrease, depending on whether the assets were sold above or below cost
LO: 1, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ4.5 Financial Statement Analysis Case - Deere (a)
Working Capital, Current Ratio Without Contractual Obligations Working Capital
Current Ratio
$50,060 – $21,394 = $28,666
$50,060 ÷ $21,394 = 2.34
With Contractual Obligations Off-balance sheet current obligations (Purchase obligations and operating leases) = $3,091 ($2,970 + $121) Working Capital
Current Ratio
$50,060 – ($21,394 + $3,091) = $25,575
$50,060 ÷ ($21,394 + $3,091) = 2.04
Without information on contractual obligations, an analyst would overstate Deere’s liquidity, as measured by working capital and the current ratio. (b)
1.
Based on the analysis in Part (a), Deere has a pretty good liquidity cushion. It would be able to pay a loan of up $25,575 billion if due in one year.
2.
Additional contractual obligations of $13,119 in years 2 and 3 and $8,211 in years 4 and 5 are relevant to assessing whether Deere can repay a loan maturing in 5 years. In evaluating a longer-term loan, an analyst would need to develop a prediction of Deere’s cash flows over the next 5 years that would be used to repay a longer-term loan. In summary, the schedule of contractual obligations provides information about off-balance sheet obligations—both the amounts and when due. This helps the analyst assess both liquidity and solvency of a company.
LO: 1, 2, 3, 4, Bloom: AN, Difficulty: Complex, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ4.6 Financial Statement Analysis Case - Amazon (a)
($ in millions) Current assets .................................... Total assets ........................................ Current liabilities ................................ Total liabilities .................................... (1) Cash provided by operations ....... (2) Capital expenditures..................... (3) Dividends paid .............................. Net Income (loss) ............................... Sales ................................................... Free Cash Flow................................... (1) – (2) – (3)
Current Year $31,327 54,505 28,089 43,764 6,842 4,893 (241) 88,988
Prior Year $24,625 40,159 22,980 30,413 5,475 3,444 274 74,452
1,949
2,031
As indicated above, Amazon’s free cash flow in the current and prior year was $1,949 million and $2,031 million respectively. Amazon showed a declining trend in profitability but an increase in cash provided by operations. Depending on the investment required to build the warehouses, it appears they might not have been able to finance the warehouses with internal funds at that time. (b)
Cash provided by operations has increased in the current year relative to the prior year by $1,367 million. This is the face of lower profitability but with a net increase in working capital and other non-cash income adjustments.
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ4.7 Accounting, Analysis, and Principles Accounting Hopkins Company Balance Sheet December 31, 2025 Assets Current assets Cash ($75,000 – $15,000) Accounts receivable ($52,000 – $9,000) Less: Allowance for doubtful accounts ($13,500 – $9,000) Inventory Total current assets
$ 60,000 $ 43,000 4,500
38,500 65,300 $163,800
Long-term investments Bond sinking fund Property, plant, and equipment Equipment Less: Accumulated depreciation—equipment Intangible assets Patents Total assets
112,000 28,000
Liabilities and Stockholders’ Equity Current liabilities Notes and accounts payable Long-term liabilities Notes payable (due 2027) Total liabilities
$ 52,000
Stockholders’ equity Common stock Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity
100,000 50,800
15,000 84,000 15,000 $277,800
75,000 $127,000
150,800 $277,800
Accounting, Analysis, and Principles (Continued) Analysis The classified balance sheet provides subtotals for current assets and current liabilities, which are assets expected to be converted to cash (or liabilities expected to be paid from cash) in the next year or operating cycle (also referred to as liquidity). Thus, an analysis of current assets relative to current liabilities provides information relevant to assessing Hopkins’ ability to repay a loan within the next year. Specifically, current assets in excess of current liabilities (working capital) is $111,800 ($163,800 – $52,000.) This seems to be a safe liquidity cushion relative to an additional loan of $45,000. Of course, the loan officer also would evaluate Hopkins’ earnings and cash flows in the analysis.
Principles The primary objection that the bank is likely to raise about this supplemental information is the subjectivity (which reduces faithful representation) of the estimates of fair values for the long-lived assets and the internally generated intangibles. In addition, the loan officer might not consider information about these long-term assets to be that relevant to the loan decision, because the loan is short-term. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 4.1 (Time 20–25 minutes) Purpose—to provide a varied number of financial transactions and then determine how each of these items should be reported in the financial statements. Accounting changes, additional assessments of income taxes, prior period adjustments, and changes in estimates are some of the financial transactions presented. CT 4.2 (Time 20–25 minutes) Purpose—to present the asset section of a partial balance sheet that must be analyzed to assess its deficiencies. Items such as improper classifications, terminology, and disclosure must be considered. CT 4.3 (Time 20–25 minutes) Purpose—to present a balance sheet that must be analyzed to assess its deficiencies. Items such as improper classification, terminology, and disclosure must be considered. CT 4.4 (Time 20–25 minutes) Purpose—to present the student an ethical issue related to the presentation of balance sheet information. The reporting involves “net presentation” of property, plant, and equipment. CT 4.5 (Time 40–50 minutes) Purpose—to present a cash flow statement that must be analyzed to explain differences in cash flow and net income, and sources and uses of cash flow and ways to improve cash flow.
Solutions to Critical Thinking CT 4.1 1.
The new estimate would be used in computing depreciation expense for 2025. No adjustment of the balance in accumulated depreciation at the beginning of the year would be made. Instead, the remaining depreciable cost would be divided by the estimated remaining life. This is a change in an estimate and is accounted for prospectively (in the current and future years). Disclosure in the notes to the financial statements is appropriate if material.
2.
The additional assessment should be shown on the current period’s income statement. If material, it should be shown separately; if immaterial it could be included with the current year’s income tax expense. This transaction does not represent a prior period adjustment.
3.
The effect of the error at December 31, 2024, should be shown as an adjustment of the beginning balance of retained earnings on the retained earnings statement. The current year’s expense should be adjusted (if necessary) for the possible carryforward of the error into the 2025 salaries expense computation.
4.
Generally, an entry is made for a cash dividend on the date of declaration. The appropriate entry would be a debit to Retained Earnings (or Dividends) for the amount to be paid, with a corresponding credit to Dividends Payable. Dividends Payable is reported as a current liability.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 4.2 1. Unclaimed payroll checks should be shown as a current liability if these are claims by employees. 2. Debt investments (trading) should be reported at fair value, not cost. 3. Bad debt reserve is an improper terminology; Allowance for doubtful accounts is considered more appropriate. The amount of estimated uncollectible accounts should be disclosed. 4. Next-in, First-out (NIFO) is not an acceptable inventory valuation method. 5. Heading “Tangible assets” should be changed to “Property, Plant, and Equipment”; also label for corresponding $630,000 should be changed to “Net property, plant, and equipment.” 6. Land should not be depreciated. 7. Buildings and equipment and their related accumulated depreciation balances should be separately disclosed. 8. The valuation basis for stocks should be disclosed (fair value or equity) and the description should be Debt investment (Available-for-Sale) or Equity investment in X Company. The Long-term investments section should precede Property, plant, and equipment. 9. Treasury stock is not an asset and should be shown in the stockholders’ equity section as a deduction. 10. Discount on bonds payable is not an asset and should be shown as a deduction from bonds payable. 11. Sinking fund should be reported in the long-term investments section. LO: 1, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 4.3 Criticisms of the balance sheet of the Sameed Brothers Corporation: 1. The basis for the valuation of marketable securities should be shown. Marketable securities are valued at fair value. In addition, they should be classified as either debt or equity and as either debt trading securities, debt available-for-sale securities, or debt held-to-maturity securities. 2. An allowance for doubtful accounts receivable is not indicated. 3. The basis for the valuation and the method of pricing for inventory are not indicated. 4. A stock investment in a subsidiary company is not ordinarily held to be sold within one year or the operating cycle, whichever is longer. As such, this account should not be classified as a current asset, but rather should be included under the heading “Investments.” The basis of valuation of the investment should be shown. 5. Treasury stock is not an asset. It should be presented as a deduction in the shareholders’ equity section of the balance sheet. The class of stock, number of shares, and basis of valuation should be indicated. 6. Buildings and land should be segregated. The Reserve for Depreciation should be shown as a subtraction from the Buildings account only. Also, the term “reserve for” should be replaced by “accumulated.” 7. Cash surrender value of life insurance would be more appropriately shown under the heading of “Investments.” 8. Reserve for Income Taxes should appropriately be entitled Income Tax Payable. 9. Customers’ Accounts with Credit Balances is an immaterial amount. As such, this account need not be shown separately. The $1,000 credit could readily be netted against Accounts Receivable without any material misstatement. 10. Unamortized Premium on Bonds Payable should be appropriately shown as an addition to the related Bonds Payable in the long-term liability section. The use of the term deferred credits is inappropriate. 11. Bonds Payable is inadequately disclosed. The interest rate, interest payment dates, and maturity date should be indicated. 12. Should have a Stockholders’ equity line below the Total liabilities line. 13. Additional disclosure relative to the Common Stock account is needed. This disclosure should include the number of shares authorized, issued, and outstanding. 14. Earned Surplus should appropriately be entitled Retained Earnings. Also, a separate heading should be shown for this account; it should not be shown under the heading “Common Stock.” A more appropriate heading would be “Shareholders’ or Stockholders’ Equity.” 15. Cash Dividends Declared should be disclosed on the retained earnings statement as a reduction of retained earnings. Dividends Payable, in the amount of $8,000, should be shown on the balance sheet among the current liabilities, assuming payment has not occurred. LO: 1 2, Bloom: C, Difficulty: Simple, Time: 20-25, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT 4.4 (a). The ethical issues involved are integrity and honesty in financial reporting, full disclosure, transparency, and the accountant’s professionalism. (b). While presenting property, plant, and equipment net of depreciation on the balance sheet may be acceptable under GAAP, it is inappropriate to attempt to hide information from financial statement users. Information must be useful, and the presentation Keene is considering would not be. Users would not grasp the age of plant assets and the company’s need to concentrate its future cash outflows on replacement of these assets. This information could be provided in a note disclosure. Because of the significant impact on the financial statements of the depreciation method(s) used, the following disclosures should be made. a. b. c. d.
Depreciation expense for the period. Balances of major classes of depreciable assets, by nature and function. Accumulated depreciation, either by major classes of depreciable assets or in total. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.
LO: 1, Bloom: E, Difficulty: Simple, Time: 20-25, AACSB: Ethics, Communication, AICPA AC: Reporting, AICPA PC: Communication Ethical Conduct
CT 4.5 Date President Kappeler, CEO Kappeler Corporation 125 Wall Street Middleton, Kansas 67458 Dear Mr. Kappeler: I have good news and bad news about the financial statements for the year ended December 31, 2025. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows, which best illustrates how these situations occurred simultaneously. If you look at the operating activities, you can see that no cash was generated by operations due to the increase in accounts receivable and inventory and reduction in accounts payable. In effect, these events caused net cash flow provided by operating activities to be lower than net income; they reduced your cash balance by $116,000. The corporation made significant investments in equipment and land. These were paid from cash reserves. These purchases used 75% of the company’s cash. In addition, the redemption of the bonds improved the equity of the corporation and reduced interest expense. However, it also used 25% of the corporation’s cash. It is normal to use cash for investing and financing activities. But when cash is used, it must also be replenished. Operations normally provide the cash for investing and financing activities. Since there is a finite amount of assets to sell and funds to borrow or raise from the sale of capital stock, operating activities are the only renewable source of cash. That is why it is important to keep the operating cash flows positive. Cash management requires careful and continuous planning.
CT 4.5 (Continued) There are several possible remedies for the current cash problem. First, prepare a detailed analysis of monthly cash requirements for the next year. Second, investigate the changes in accounts receivable and inventory and work to return them to more normal levels. Third, look for more favorable terms with suppliers to allow the accounts payable to increase without loss of discounts or other costs. Finally, since the land represents a long-term commitment without immediate plans for use, consider shopping for a low interest loan to finance the acquisition for a few years and return the cash balance to a more normal level. If you have additional questions or need one of our staff to address this problem, please contact me at your convenience. Sincerely yours, Partner in Charge LO: 2, Bloom: AN, Difficulty: Complex, Time: 40-50, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Codification Exercises CE4.1 (a) Current assets is used to designate cash and other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business. (b) Intangible assets are assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.) Clicking on the first link yields the following FASB ASC string: 350 Intangibles—Goodwill and Other > 10 Overall. (c) Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: a.
Readily convertible to known amounts of cash
b.
So near their maturity that they present insignificant risk of changes in value because of changes in interest rates.
Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment. For example, both a three-month U.S. Treasury bill and a three-year Treasury note purchased three months from maturity qualify as cash equivalents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three months. Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations). (d) Financing activities include obtaining resources from owners and providing them with a return on, and a return of, their investment; receiving restricted resources that by donor stipulation must be used for long-term purposes; borrowing money and repaying amounts borrowed, or otherwise settling the obligation; and obtaining and paying for other resources obtained from creditors on longterm credit. LO: 1,2, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE4.2 See FASC ASC 210-10-45 (Other Presentation Matters) Classification of Current Liabilities 45-5A
Total of current liabilities shall be presented in classified balance sheets.
45-6
The concept of current liabilities shall include estimated or accrued amounts that are expected to be required to cover expenditures within the year for known obligations the amount of which can be determined only approximately (as in the case of provisions for accruing bonus payments) or where the specific person or persons to whom payment will be made cannot as yet be designated (as in the case of estimated costs to be incurred in connection with guaranteed servicing or repair of products already sold).
CE4.2 (Continued) 45-7
Section 470-10-45 includes guidance on various debt transactions that may result in current liability classification. These transactions are the following: a. b. c.
Due on demand loan agreements Callable debt agreements Short-term obligations expected to be refinanced.
LO: 1, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, Technology, AICPA BB: None AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE4.3 The following discussion is provided at 235-10-50 Disclosure > Accounting Policies Disclosure 50-1
Information about the accounting policies adopted by an entity is essential for financial statement users. When financial statements are issued purporting to present fairly the financial position, cash flows, and results of operations in accordance with generally accepted accounting principles (GAAP), a description of all significant accounting policies of the entity shall be included as an integral part of the financial statements. In circumstances where it may be appropriate to issue one or more of the basic financial statements without the others, purporting to present fairly the information given in accordance with GAAP, statements so presented also shall include disclosure of the pertinent accounting policies.
> Accounting Policies Disclosure in Interim Periods 50-2
The provisions of the preceding paragraph are not intended to apply to unaudited financial statements issued as of a date between annual reporting dates (for example, each quarter) if the reporting entity has not changed its accounting policies since the end of its preceding fiscal year.
> What to Disclose 50-3
Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to the appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. b. c.
A selection from existing acceptable alternatives Principles and methods peculiar to the industry in which the entity operations, even if such principles and methods are predominantly followed in that industry Unusual or innovative applications of GAAP.
> Examples of Disclosures 50-4
Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. b.
Basis of consolidation Depreciation methods
CE4.3 (Continued) c. d. e. f.
Amortization of intangibles Inventory pricing Accounting for recognition of profit on long-term construction-type contracts Recognition of revenue from franchising and leasing operations.
> Avoid Duplicate Details of Disclosures 50-5
Financial statement disclosure of accounting policies shall not duplicate details (for example, the composition of inventories or of plant assets) presented elsewhere as part of the financial statements. In some cases, the disclosure of accounting policies shall refer to related details presented elsewhere as part of the financial statements; for example, changes in accounting policies during the period shall be described with a cross-reference to the disclosure required by Topic 250.
> Format 50-6
This Subtopic recognizes the need for flexibility in matters of format (including the location) of disclosure of accounting policies provided that the entity identifies and describes its significant accounting policies as an integral part of its financial statements in accordance with the provisions of this Subtopic. Disclosure is preferred in a separate summary of significant accounting policies preceding the notes to financial statements, or as the initial note, under the same or a similar title.
LO: 3, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, Communication, Technology, AICPA BB: Nonne, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE4.4 The following section: 230-10-05 Overview and Background provides a discussion of the objectives of the Statement of Cash Flows. 05-1
The Statement of Cash Flows Topic presents standards for reporting cash flows in generalpurpose financial statements.
05-2
Specific guidance is provided on all of the following: a. b. c. d.
Classifying in the statement of cash flows of cash receipts and payments as either operating, investing, or financing activities Applying the direct method and the indirect method of reporting cash flows Presenting the required information about noncash investing and financing activity and other events Classifying cash receipts and payments related to hedging activities.
230-10-10 Objectives 10-1
The primary objective of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during a period.
CE4.4 (Continued) 10-2
The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, should help investors, creditors, and others (including donors) to do all of the following: a. b. c. d.
Assess the entity’s ability to generate positive future net cash flows Assess the entity’s ability to meet its obligations, its ability to pay dividends, and its needs for external financing Assess the reasons for differences between net income and associated cash receipts and payments Assess the effects on an entity’s financial position of both its cash and noncash investing and financing transactions during the period.
LO: 2, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: Knowledge, Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a)
Codification String: FASB ASC 235-10-05—Presentation > 235 Notes to Financial Statements > 10 Overall > 05 Overview and Background (Predecessor Standard – [APB 22])
(b)
Codification String: Presentation > 235 Notes to Financial Statements > 10 Overall > 05 Overview and Background 05-3 The accounting policies of an entity are the specific accounting principles and the methods of applying those principles that are judged by the management of the entity to be the most appropriate in the circumstances to present fairly financial position, cash flows, and results of operations in accordance with generally accepted accounting principles (GAAP) and that, accordingly, have been adopted for preparing the financial statements.
(c)
Codification String: Presentation > 235 Notes to Financial Statements > 10 Overall > 50 Disclosure 50-3 Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to the appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. b. c.
A selection from existing acceptable alternatives. Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry. Unusual or innovative applications of GAAP.
Codification Research Case (Continued) (d)
50-4 Codification String: Presentation > 235 Notes to Financial Statements > 10 Overall > 05 Background Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. b. c. d. e. g.
Basis of consolidation Depreciation methods Amortization of intangibles Inventory pricing Accounting for recognition of profit on long-term construction-type contracts Recognition of revenue from franchising and leasing operations.
LO: 3, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: Knowledge Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CHAPTER 5 Accounting and the Time Value of Money Assignment Classification Table (By Topic) Topics
Questions
1.
Present value concepts.
1, 2, 3, 5, 9, 17
2.
Use of tables.
13, 14
3.
Present and future value problems:
Brief Exercises
Exercises
Problems
1
a. Unknown future amount.
7, 19
1, 5, 13
2, 3, 4, 7
b. Unknown payments.
10, 11, 12
6, 12, 15, 17
8, 16, 17
2, 6
4, 9
10, 15
2
c. Unknown number of periods. d. Unknown interest rate.
15, 18
3, 11, 16
9, 10, 11, 14
2, 7
e. Unknown present value.
8, 19
2, 7, 8, 10, 14
3, 4, 5, 6, 8, 12, 17, 18, 19
1, 4, 7, 9, 13, 14
4.
Value of a series of irregular deposits; changing interest rates.
5.
Valuation of leases, pensions, bonds; choice between projects.
6
6.
Deferred annuity.
16
7.
Expected cash flows.
4
*8.
Technology tools
* This material covered in the appendix.
3, 5, 8
15
18, 19
7, 12, 13, 14, 15
3, 5, 6, 8, 9, 10, 11, 12, 13, 14, 15
20, 21, 22
13, 14, 15
23, 24, 25
16
Assignment Classification Table (By Learning Objective) Learning Objectives
Questions
Brief Exercises
Exercises
Problems
1.
Describe the fundamental concepts related to the time value of money.
1, 2, 3, 5, 6
2.
Solve future and present value of 1 problems.
7, 8, 17
1, 2, 3, 4, 7, 8
2, 3, 6, 9, 10, 15
1, 2, 3, 5, 7, 9, 10
3.
Solve future value of ordinary and annuity due problems.
9, 11, 12, 13, 17
5, 6, 9, 13
3, 4, 6, 15, 16
2, 7
4.
Solve present value of ordinary and annuity due problems.
10, 14, 15, 16, 17, 18
10, 11, 12, 14, 16, 17
3, 4, 5, 6, 11, 12, 17, 18, 19
1, 2, 3, 4, 5, 7, 8, 9, 10, 13, 14
5.
Solve present value problems related to deferred annuities, bonds, and expected cash flows.
4, 19
15
7, 8, 13, 14, 20, 21, 22
6, 11, 12, 13, 14, 15
18,19
23, 24, 25
16
*6. Solve time value of money problems using Excel and financial calculators.
* This material covered in the appendix.
1, 2
Assignment Characteristics Table
Item
Description
Level of Difficulty
Time (minutes)
E5.1 E5.2 E5.3 E5.4 E5.5 E5.6 E5.7 E5.8 E5.9 E5.10 E5.11 E5.12 E5.13 E5.14 E5.15 E5.16 E5.17 E5.18 E5.19 E5.20 E5.21 E5.22 *E5.23 *E5.24 *E5.25
Using interest tables. Simple and compound interest computations. Computation of future values and present values. Computation of future values and present values. Computation of present value. Future value and present value problems. Computation of bond prices. Computations for a retirement fund. Unknown rate. Unknown periods and unknown interest rate. Evaluation of purchase options. Analysis of alternatives. Computation of bond liability. Computation of pension liability. Investment decision. Retirement of debt. Computation of amount of rentals. Least costly payoff. Least costly payoff. Expected cash flows. Expected cash flows and present value. Fair value estimate. Computing number of periods. Solve for interest rate. Solving for present and future values.
Simple Simple Simple Moderate Simple Moderate Moderate Simple Moderate Simple Moderate Simple Moderate Moderate Moderate Simple Simple Simple Simple Simple Moderate Moderate Moderate Moderate Moderate
5–10 5–10 10–15 15–20 10–15 15–20 12–17 10–15 5–10 10–15 10–15 10–15 15–20 15–20 15–20 10–15 10–15 10–15 10–15 5–10 15–20 15–20 15–20 15–20 15–20
P5.1 P5.2 P5.3 P5.4 P5.5 P5.6 P5.7 P5.8 P5.9 P5.10 P5.11 P5.12 P5.13 P5.14 P5.15 *P5.16
Various time value situations. Various time value situations. Analysis of alternatives. Evaluating payment alternatives. Analysis of alternatives. Purchase price of a business. Time value concepts applied to solve business problems. Analysis of alternatives. Analysis of business problems. Analysis of lease vs. purchase. Pension funding. Pension funding. Expected cash flows and present value. Expected cash flows and present value. Fair value estimate. Future value of single sum and annuity.
Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Complex Complex Complex Moderate Moderate Moderate Complex Moderate
15–20 15–20 20–30 20–30 20–25 25–30 30–35 20–30 30–35 30–35 25–30 20–25 20–25 20–25 20–25 15-20
Answers to Questions 1. Money has value because with it one can acquire assets and services and discharge obligations. The holding, borrowing or lending of money can result in costs or earnings. And the longer the time period involved, the greater the costs or the earnings. The cost or earning of money as a function of time is the time value of money. Accountants must have a working knowledge of compound interest, annuities, and present value concepts because of their application to numerous types of business events and transactions which require proper valuation and presentation. These concepts are applied in the following areas: (1) stock-based compensation, (2) environmental liabilities, (3) pensions and other postretirement benefits, (4) long-term assets, (5) leases, (6) notes receivable and payable, (7) business combinations, and (8) disclosures. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
2. Some situations in which present value measures are used in accounting include: (a) Notes receivable and payable—these involve single sums (the face amounts) and may involve annuities if there are periodic interest payments. (b) Leases—involve measurement of assets and obligations based on the present value of annuities (lease payments) and single sums (if there are residual values and/or bargain purchase options to be paid at the conclusion of the lease). (c) Pensions and other deferred compensation arrangements—involve discounted future annuity payments that are estimated to be paid to employees upon retirement (may be annuities or single sum and annuities). (d) Bond pricing—the price of bonds payable is comprised of the present value of the principal or face value of the bond plus the present value of the annuity of interest payments. (e) Long-term assets—evaluating various long-term investments or assessing whether an asset is impaired requires determining the present value of the estimated cash flows associated with an investment or long-term asset (may be single sums and/or an annuity). LO: 1, 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
3. Interest is the payment for the use of money. It may represent a cost or earnings depending upon whether the money is being borrowed or loaned. The earning or incurring of interest is a function of the time, as well as the amount of money, and the risk involved (risk may be reflected in the interest rate). Simple interest is computed on the amount of the principal only, while compound interest is computed on the amount of the principal plus any accumulated interest. Compound interest involves interest on interest while simple interest does not. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
4. The interest rate generally has three components: (a) Pure rate of interest—This is the amount a lender would charge if there were no possibilities of default and no expectation of inflation. (b) Expected inflation rate of interest—Lenders recognize that in an inflationary economy, they are being paid back with less valuable (future) dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high. (c) Credit risk rate of interest—The U.S. government has little or no credit risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, depending upon its financial stability, profitability, etc. can have a low or a high credit risk. Accountants must have knowledge about these components because these components are essential in identifying an appropriate interest rate for a given company or investor at any given moment. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 5 (Continued) 5. (a) (b) (c) (d)
Present value of an ordinary annuity at 8% for 10 periods (Table 5.4). Future value of 1 at 8% for 10 periods (Table 5.1). Present value of 1 at 8% for 10 periods (Table 5.2). Future value of an ordinary annuity at 8% for 10 periods (Table 5.3).
LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
6. He should choose quarterly compounding, because the balance in the account on which interest will be earned will be increased more frequently, thereby resulting in more interest earned on the investment. This is shown in the following calculation: Semiannual compounding, assuming the amount is invested for 2 years: n = 4 (2 x 2) $1,500 X (FVF 4, 4%) = $1,500 x 1.16986 = $1,755 Table 5.1 i = 4% (8% ÷ 2) Quarterly compounding, assuming the amount is invested for 2 years: n = 8 (2 x 4) $1,500 X (FVF 8, 2%) = $1,500 x 1.17166 = $1,757 Table 5.1 i = 2% (8% ÷ 4) Thus, with quarterly compounding, Jose could earn $2 more. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
7. $26,898 = $20,000 x 1.34489 (future value factor of 1 at 21/2% for 12 periods). Table 5.1 LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
8. $44,671 = $80,000 x .55839 (present value factor of 1 at 6% for 10 periods). Table 5.2 LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
9. An annuity involves (1) periodic payments or receipts, called rents, (2) of the same amount, (3) spread over equal intervals, (4) with interest compounded once each interval. Rents occur at the end of the intervals for ordinary annuities while the rents occur at the beginning of each of the intervals for annuities due. LO: 3, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
10. Amount paid each year = $40,000 *(present value factor of an ordinary annuity at 12% for 4 *3.03735 years). Table 5.4 Amount paid each year = $13,169.37. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
11. Amount deposited each year = $200,000 (**future value factor of an ordinary annuity at 10% for **4.64100 4 years). Table 5.4 Amount deposited each year = $43,094.16. LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
12. Amount deposited each year = $200,000 [future value factor of an annuity due at 10% for 4 years 5.10510 (4.64100 x 1.10)]. Table 5.3 Amount deposited each year = $39,176.51. LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 5 (Continued)
13. The process for converting the future value of an annuity due using the future value of an ordinary annuity interest table is to multiply the corresponding future value of the ordinary annuity by one plus the interest rate. For example, the factor for the future value of an annuity due for 4 years at 12% is equal to the factor for the future value of an ordinary annuity times 1.12. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
14. The basis for converting the present value of an ordinary annuity table to the present value of an annuity due table involves multiplying the present value of an ordinary annuity factor by one plus the interest rate. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
15. Present value = present value of an ordinary annuity of $25,000 for 20 periods at ? percent. $245,000
= present value of an ordinary annuity of $25,000 for 20 periods at ? percent.
Present value of an ordinary annuity for 20 periods at ? percent = $245,000 = 9.8. $25,000 The factor 9.8 is closest to 9.81815 in the 20 period, 8% column (Table 5.4). LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
16.
4.96764 Present value of ordinary annuity at 12% for eight periods. (Table 5.4) (2.40183) Present value of ordinary annuity at 12% for three periods. (Table 5.4) 2.56581 Present value of ordinary annuity at 12% for eight periods, deferred three periods. The present value of the five rents is computed as follows: 2.56581 X $20,000 = $51,316.
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
17. (a) (b) (c) (d)
Present value of an annuity due. Present value of 1. Future value of an annuity due. Future value of 1.
LO: 2, 3, 4, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
18. $27,600 = PV of an ordinary annuity of $6,900 for five periods at ? percent. $27,600 = PV of an ordinary annuity for five periods at ? percent. $6,900 4.0 = PV of an ordinary annuity for five periods at ? (3.99271 in Table 5.4) 4.0 = approximately 8%. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
19. The IRS argues that the future reserves should be discounted to present value. The result would be smaller reserves and therefore less of a charge to income. As a result, income would be higher and income taxes may, therefore, be higher as well. LO: 5, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Brief Exercises Brief Exercise 5.1 8% annual interest i = 8% PV = $15,000
FV = ?
0
1
2
3
n=3 FV = $15,000 (FVF3, 8%) FV = $15,000 (1.25971) FV = $18,896 8% annual interest, compounded semi-annually i = 4% (.08 ÷ 2) PV = $15,000
0
FV = ?
1
2
3
4
5
n = 6 (3 yrs. x 2) FV = $15,000 (FVF6, 4%) FV = $15,000 (1.26532) FV = $18,980 LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
6
Brief Exercise 5.2 12% annual interest
i = 12% PV = ?
FV = $25,000
0
1
2 n=4
3
4
PV = $25,000 (PVF4, 12%) PV = $25,000 (.63552) PV = $15,888
12% annual interest, compounded quarterly i = 3% (.12 ÷ 4) PV = ?
0
FV = $25,000
1
2
14
15
n = 16 (4 yrs. X 4) PV = $25,000 (PVF16, 3%) PV = $25,000 (.62317) PV = $15,579 LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
16
Brief Exercise 5.3 i=? PV = $30,000
0
1
FV = $150,000
2
19
20
21
n = 21 FV = PV (FVF21, i)
PV = FV (PVF21, i) OR
$150,000 = $30,000 (FVF21, i)
$30,000 = $150,000 (PVF21, i)
FVF21, i = 5.0000
PVF21, i = .20000
i = 8% approximately
i = 8% approximately
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.4 i = 5% PV = $10,000
FV = $17,100
0
? n=?
FV = PV (FVFn, 5%)
PV = FV (PVFn, 5%) OR
$17,100 = $10,000 (FVFn, 5%)
$10,000 = $17,100 (PVFn, 5%)
FVFn, 5% = 1.71000
PVFn, 5% = .58480
n = 11 years (approx.)
n = 11 years (approx.)
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.5 First payment today (Annuity Due) i = 6% R=
FV–AD =
$8,000 $8,000 $8,000
0
1
$8,000 $8,000
2
18
19
?
20
n = 20 FV–AD = $8,000 (FVF–OA20, 6%) 1.06 FV–AD = $8,000 (36.78559) 1.06 FV–AD = $311,942
First payment at year-end (Ordinary Annuity) i = 6% FV–OA = ? $8,000 $8,000 $8,000
$8,000 $8,000
0
1
2
18
19
n = 20 FV–OA = $8,000 (FVF–OA20, 6%) FV–OA = $8,000 (36.78559) FV–OA = $294,285 LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
20
Brief Exercise 5.6 i = 5%
0
R=?
?
?
FV–OA = ? $250,000
1
2
8
9
10
n = 10 $250,000 = R (FVF–OA10, 5%) $250,000 = R (12.57789) $250,000 =R 12.57789 R = $19,876 LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.7 8% annual interest i = 8% PV = ?
0
FV = $300,000
1
2
3
4
n=5 PV = $300,000 (PVF5, 8%) PV = $300,000 (.68058) PV = $204,174 LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
5
Brief Exercise 5.8 With quarterly compounding, there will be 20 (5 x 4) quarterly compounding periods, at 1/4 the interest rate (.08 ÷ 4 = 2%): PV = $300,000 (PVF20, 2%) PV = $300,000 (.67297) PV = $201,891 LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.9 i = 5% FV–OA = R=
$100,000
$9,069 $9,069
0
1
$9,069
2
n n=?
$100,000 = $9,069 (FVF–OAn, 5%) $100,000 FVF–OAn, 10% = = 11.0266 $9,069 Therefore, n = 9 years (approximately) LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.10 First withdrawal at year-end – ordinary annuity i = 8% PV–OA = R = ? $30,000 $30,000
0
1
$30,000 $30,000 $30,000
2
8
9
10
n = 10 PV–OA = $30,000 (PVF–OA10, 8%) PV–OA = $30,000 (6.71008) PV–OA = $201,302 First withdrawal immediately – annuity due i = 8% PV–AD = ? R= $30,000 $30,000 $30,000
0
1
$30,000 $30,000
2
8
9
n = 10 PV–AD = $30,000 (PVF–AD10, 8%) PV–AD = $30,000 (7.24689) PV–AD = $217,407 LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
10
Brief Exercise 5.11 i=? PV = $793.15
R= $75
$75
$75
$75
$75
0
1
2
10
11
12
n = 12 $793.15 = $75 (PVF–OA12, i) $793.15 PVF12, i = = 10.57533 $75 Therefore, i = 2% per month or 24% (12 x 2%) per year. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.12 i = 4% PV = $300,000 R = ?
0
1
?
?
?
?
2
18
19
20
n = 20 $300,000 = R (PVF–OA20, 4%) $300,000 = R (13.59033) $300,000 =R 13.59033 R = $22,075 LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.13 i = 6% R= $30,000 $30,000
$30,000 $30,000 $30,000
12/31/25 12/31/26 12/31/27
12/31/30 12/31/31 12/31/32 n=8
FV–OA = $30,000 (FVF–OA8, 6%) FV–OA = $30,000 (9.89747) FV–OA = $296,924 LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.14 i = 8% PV–OA =
R=
?
0
$25,000 $25,000
1
2
3
4
5
n=4
$25,000 $25,000
6
11
12
n=8
PV–OA = $25,000 (PVF–OA12–4, 8%)
PV–OA = $25,000 (PVF–OA8, 8%)(PVF4, 8%) OR
PV–OA = $25,000 (7.53608 – 3.31213)
PV–OA = $25,000 (5.74664)(.73503)
PV–OA = $105,599
PV–OA = $105,599
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.15 i = 8% PV = ? PV–OA = R = ? $140,000 $140,000
0
1
$2,000,000 $140,000 $140,000 $140,000*
2
8
9
10
n = 10 $2,000,000 (PVF10, 8%) = $2,000,000 (.46319) = $ 926,380 $140,000* (PVF–OA10, 8%) = $140,000 (6.71008) = 939,411 $1,865,791 *($2,000,000 x .07) LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.16 PV–OA = $20,000 $4,727.53 $4,727.53
0
1 $20,000 (PV–OA6, i%) (PV–OA6, i%) Therefore, i%
2
$4,727.53 $4,727.53
5
6
= $4,727.53 (PV–OA6, i%) = $20,000 ÷ $4,727.53 = 4.23054 = 11%
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 5.17 PV–AD = $20,000 $? $?
$?
$?
0
2
5
1
6
$20,000 = Payment (PV–AD6, 11%) $20,000 ÷ (PV–AD6, 11%) = Payment $20,000 ÷ 4.6959 = $4,259 LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 5.18 The future value is $42,076.55. In Excel:
Calculator Solution:
LO: 6, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 5.19 The present value is $35,649.31. Excel Solution:
Calculator Solution:
LO: 6, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 5.1 (5–10 minutes)
1. a. b. c. 2. a. b. c.
(a) Rate of Interest 9% 3% (.12 ÷ 4) 5% (.10 ÷ 2)
(b) Number of Periods 9 20 (5 x 4) 30 (15 x 2)
9%
25 30 28
5% (.10 ÷ 2) 3% (.12 ÷ 4)
LO: 1, Bloom: C, Difficulty: Simple, Time: 5-10, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 5.2 (5–10 minutes) (a)
Simple interest of $1,600 ($20,000 x .08) per year x 8 Principal Total withdrawn
(b)
Interest compounded annually—Future value of 1 @ 8% for 8 periods Total withdrawn
(c)
Interest compounded semiannually—Future value of 1 @ 4% (.08 ÷ 2) for 16 (8 x 2) periods Total withdrawn
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.3 (10–15 minutes) (a)
$7,000 (FVF 5, 8%) = $7,000 x 1.46933 = $10,285.
(b)
$7,000 (PVF 8, 6%) = $7,000 x .62741 = $4,392.
(c)
$7,000 (FVF-OA 15,10%) = $7,000 x 31.77248 = $222,407.
(d)
$7,000 (PVF-OA 20,5%) = $7,000 x 12.46221 = $87,235.
LO: 2, 3, 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$12,800 20,000 $32,800 1.85093 x $20,000 $37,019
1.87298 x $20,000 $37,460
Exercise 5.4 (15–20 minutes) (a)
Future value of an ordinary annuity of $4,000 a period for 20 periods at 8% $183,047.84 ($4,000 x 45.76196) Factor (1 + .08) x 1.08 Future value of an annuity due of $4,000 a period at 8% $197,692
(b)
Present value of an ordinary annuity of $2,500 for 30 periods at 5% Factor (1 + .05) Present value of annuity due of $2,500 for 30 periods at 5%
(c)
(d)
Future value of an ordinary annuity of $2,000 a period for 15 periods at 10% Factor (1 + 10) Future value of an annuity due of $2,000 a period for 15 periods at 10% Present value of an ordinary annuity of $1,000 for 6 periods at 9% Factor (1 + .09) Present value of an annuity date of $1,000 for 6 periods at 9%
$38,431.13 ($2,500 x 15.37245) x 1.05 $40,353 (Or see Table 5.5 which gives $40,352.68) $63,544.96 ($2,000 x 31.77248) x 1.10 $69,899
$4,485.92 ($1,000 x 4.48592) x 1.09
$4,890
(Or see Table 5.5)
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.5 (10–15 minutes) (a)
$30,000 (PVF–OA 8, 12%) = $30,000 x 4.96764 = $149,029.
(b)
$30,00 (PVF–OA 16, 9%) = $30,000 x 8.31256 = $249,377. (5.65022*– 4.11141**) x $30,000 = $46,164. *(PVF–OA 10, 12%) **(PVF–OA 6, 12%)
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.6 (15–20 minutes) (a)
(b)
(c)
Future value of $12,000 @ 5% for 10 years ($12,000 x 1.62889) =
$19,547
Future value of an ordinary annuity of $600,000 at 10% for 15 years ($600,000 x 31.77248) Deficiency ($20,000,000 – $19,063,488)
$19,063,488 $936,512
$70,000 discounted at 4% for 10 years: $70,000 x .67556* = *(PVF 10, 4%) Accept the bonus of $55,000 now.
$47,289
LO: 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.7 (12–17 minutes) (a)
$100,000 x .55526* + $5,000 x 11.11839** *(PVF15, 4%)
= =
$ 55,526 55,592 $111,118
**(PVF–OA 15, 4%)
(b)
$100,000 x .48102* (PVF15, 5%) + $5,000 x 10.37966** (PVF–OA 15, 5%)
= =
$ 48,102 51,898 $100,000
(c)
$100,000 x .41727* + $5,000 x 9.71225**
= =
$41,727 48,561 $90,288
*(PVF15, 6%)
**(PVF–OA 15, 6%)
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.8 (10–15 minutes) (a)
(b)
Present value of an ordinary annuity of 1 for 4 periods @ 8% Annual withdrawal Required fund balance on June 30, 2028 Fund balance at June 30, 2028 $66,243 Future value of an ordinary annuity at 8% 4.50611 for 4 years Amount of each of the four contributions is $14,701.
3.31213 x $20,000 $66,243 = $14,701
LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.9 (10 minutes) The rate of interest is determined by dividing the future value by the present value and then finding the factor in the FVF table with n = 2 that approximates that number: or $123,210 = $100,000 (FVF2, i%) $100,000 = $123,210 (PVF2, i%) $123,210 ÷ $100,000 = (FVF2, i%) $100,000 ÷ $123,210 = PFVF2, i%) 1.2321 = (FVF2, i%) .81162 = (PVF2, i%) —reading across the n = 2 row reveals that i = 11%. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.10 (10–15 minutes) (a)
The number of interest periods is calculated by first dividing the future value of $1,000,000 by $92,296, which is 10.83471—the value $1.00 would accumulate to, at 10% for the unknown number of interest periods. The factor 10.83471 or its approximate is then located in the Future Value of 1 Table by reading down the 10% column to the 25-period line; thus, 25 is the unknown number of years Mike must wait to become a millionaire.
(b)
The unknown interest rate is calculated by first dividing the future value of $1,000,000 by the present investment of $182,696, which is 5.47357—the amount $1.00 would accumulate to, in 15 years at an unknown interest rate. The factor or its approximate is then located in the Future Value of 1 Table by reading across the 15-period line to the 12% column; thus, 12% is the interest rate Sally must earn on her investment to become a millionaire.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.11 (10–15 minutes) (a)
Total interest = Total payments—Amount owed today $162,745 (10 x $16,274.53) – $100,000 = $62,745.
(b)
Rizzo should borrow from the bank, since the 9% rate is lower than the manufacturer’s 10% rate determined below. PV–OA10, i% = $100,000 ÷ $16,274.53 = 6.14457—Inspection of the 10-period row reveals a rate of 10%.
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.12 (10–15 minutes) Building A—PV = $600,000. Building B— Rent x (PV of annuity due of 25 periods at 12%) = PV $69,000 x 8.78432 = PV $606,118 = PV Building C— Rent (PV of ordinary annuity of 25 periods at 12%) = PV $7,000 x 7.84314 = PV $54,902 = PV Cash purchase price PV of rental income Net present value
$650,000 – 54,902 $595,098
Answer: Lease Building C since the present value of its net cost is the smallest. LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.13 (15–20 minutes) Time diagram: Hincapie, Inc. i = 5% (.10 ÷ 2)
PV = ? PV–OA = ?
*$110,000
0
$110,000 $110,000
1
2
Principal $2,000,000 interest $110,000 $110,000 $110,000
3 28 n = 30 (15 x 2) *Interest = ($2,000,000 x .11 x ½)
29
30
Formula for the interest payments: PV–OA = R (PVF–OAn, i) PV–OA = *$110,000 (PVF–OA30, 5%) PV–OA = $110,000 (15.37245) PV–OA = $1,690,970 Formula for the principal: PV = FV (PVFn, i) PV = $2,000,000 (PVF30, 5%) PV = $2,000,000 (0.23138) PV = $462,760 The selling price of the bonds = PV of Interest Payments + PV of Principal = $1,690,970 + $462,760 = $2,153,730. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.14 (15–20 minutes) Time diagram: i = 8% R= PV–OA = ?
0
1
$700,000
2 n = 15
15
16 n = 10
$700,000 $700,000
24
25
Formula: PV–OA = R (PVF–OAn, i) PV–OA = $700,000 (PVF–OA25–15, 8%) PV–OA = $700,000 (10.67478 – 8.55948) PV–OA = $700,000 (2.11530) PV–OA = $1,480,710 OR Time diagram: i = 8% R= PV–OA = ?
0 1 FV(PVn, i)
$700,000
2
15 16 (PV–OAn, i)
$700,000 $700,000
24
25
Exercise 5.14 (Continued) (i)
Present value of the expected annual pension payments at the end of the 10th year: PV–OA = R (PVF–OAn, i) PV–OA = $700,000 (PVF–OA10, 8%) PV–OA = $700,000 (6.71008) PV–OA = $4,697,056*
(ii)
Present value of the expected annual pension payments at the beginning of the current year: PV = FV (PVFn, i) PV = $4,697,056* (PVF15,8%) PV = $4,697,056 x 0.31524 PV = $1,480,700
The company’s pension obligation (liability) is $1,480,700. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.15 (15–20 minutes) (a) i = 8% PV = $1,000,000
0
FV = $1,999,000
1
2
or FVF(n, 8%) = $1,999,000 ÷ $1,000,000 = 1.999
n=? PVF(n, 8%) = $1,000,000 ÷ $1,999,000 = .50025
reading down the 8% column, 1.999 (Table 5.1) corresponds to 9 periods. (b)
and .50025 (Table 5.2)
By setting aside $300,000 now, Andrew can gradually build the fund to an amount to establish the foundation. PV = $300,000
0 FV
FV = ?
1
2
8
9
= $300,000 (FVF9, 8%) = $300,000 (1.999) = $599,700—Thus, the amount needed from the annuity: $1,999,000 – $599,700 = $1,399,300.
0
$?
$?
$? FV = $1,399,300
1
2
8
9
Payments = FV ÷ (FV–OA9, 8%) = $1,399,300 ÷ 12.48756 = $112,056 LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.16 (10–15 minutes) Amount to be repaid on March 1, 2028. Time diagram: i = 3% per six months (.06 ÷ 2) PV = $70,000
3/1/23
FV = ?
3/1/24
3/1/25
3/1/31
3/1/32
n = 20 six-month periods
Formula: FV = PV (FVFn, i) FV = $70,000 (FVF20, 3%) FV = $70,000 (1.80611) FV = $126,428 Amount of annual contribution to retirement fund. Time diagram: R R=?
R ?
3/1/28 3/1/29
i = 5% R R ? ?
3/1/30
R ?
3/1/31 3/1/32
FV–AD = $126,428
3/1/33
3/1/33
Exercise 5.16 (Continued) 1. 2. 3. 4.
Future value of ordinary annuity of 1 for 5 periods at 5% Factor (1 + .5) *Future value of an annuity due of 1 for 5 periods at 5% Periodic rent ($126,428 ÷ 5.8019*) (*Rounded)
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.17 (10–15 minutes) Time diagram: i = 11% R PV–OA = $365,755 ?
R ?
R ?
0
24
25
1 n = 25
Formula:
PV–OA = R (PV–OAn, i) $365,755 = R (PVF–OA25, 11%) $365,755 = R (8.42174) R = $365,755 ÷ 8.42174 R = $43,430
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
5.52563 x 1.05000 5.8019 $21,791
Exercise 5.18 (10–15 minutes) Time diagram: i = 8% PV–OA = ? $300,000
0
$300,000
1
2
$300,000 $300,000 $300,000
13
14
15
n = 15 Formula:
PV–OA = R (PVF–OAn, i) PV–OA = $300,000 (PVF–OA15, 8%) PV–OA = $300,000 (8.55948) R = $2,567,844
The recommended method of payment would be the 15 annual payments of $300,000, since the present value of those payments ($2,567,844) is less than the alternative immediate cash payment of $2,600,000. LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 5.19 (10–15 minutes) Time diagram: i = 8% PV–AD = ? R= $300,000 $300,000 $300,000
0
1
$300,000 $300,000
2
13
14
15
n = 15 Formula: Using Table 5.4
Using Table 5.5
PV–AD = R (PVF–OAn, i)
PV–AD = R (PVF–ADn, i)
PV–AD = $300,000 (8.55948 X 1.08)
PV–AD = $300,000 (PVF–AD15, 8%)
PV–AD = $300,000 (9.24424)
PV–AD = $300,000 (9.24424)
PV–AD = $2,773,272
PV–AD = $2,773,272
The recommended method of payment would be the immediate cash payment of $2,600,000, since that amount is less than the present value of the 15 annual payments of $300,000, ($2,773,272). LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 5.20 (15–20 minutes) Expected Cash Flow Probability Cash Estimate x Assessment = Flow (a) $ 4,800 20% $ 960 6,300 50% 3,150 7,500 30% 2,250 Total Expected Value $ 6,360 (b) $ 5,400 7,200 8,400
(c) $(1,000) 3,000 5,000
30% 50% 20% Total Expected Value
$ 1,620 3,600 1,680
10% 80% 10% Total Expected Value
$ (100) 2,400 500
$ 6,900
$ 2,800
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.21 (10–15 minutes) Estimated Cash Probability Expected Outflow x Assessment = Cash Flow $200 10% $ 20 450 30% 135 600 50% 300 750 10% 75 x PV Factor, n = 2, i = 6% = Present Value $ 530 x 0.89000 = $472 LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 5.22 (15–20 minutes) (a)
This exercise determines the present value of an ordinary annuity or expected cash flows as a fair value estimate. Cash flow Estimate x $ 380,000 630,000 750,000
Probability Expected Assessment = Cash Flow 20% $ 76,000 50% 315,000 30% 225,000 x PV-OA Factor, n = 8, I = 8% =
Present
Value $ 616,000 x 5.74664 = $3,539,930 The fair value estimate of the trade name exceeds the carrying value; thus, no impairment is recorded. (b)
This fair value is based on unobservable inputs—Killroy’s own data on the expected future cash flows associated with the trade name. This fair value estimate is considered Level 3, as discussed in Chapter 1.
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*Exercise 5.23 (15-20 minutes) The number of periods is 26 years. The Excel solution:
The calculator solution:
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*Execise 5.24 (15-20 minutes) The interest rate is 7.88%. Excel solution:
The calculator solution:
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
* Exercise 5.25 (15-20 minutes) a) The future value is $477,270.99. Excel solution:
Calculator solution:
b) The present value is $82,142.97. Excel solution:
Calculator solution:
c) The rate is 6.30% Excel solution:
Calculator solution:
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, nalytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Problems Problem 5.1 (Time 15–20 minutes) Purpose—to present an opportunity for the student to determine how to use the present value tables in various situations. Each of the situations presented emphasizes either a present value of 1 or a present value of an ordinary annuity situation. Two of the situations will be more difficult for the student because a noninterest-bearing note and bonds are involved. Problem 5.2 (Time 15–20 minutes) Purpose—to present an opportunity for the student to determine solutions to four present and future value situations. The student is required to determine the number of years over which certain amounts will accumulate, the rate of interest required to accumulate a given amount, and the unknown amount of periodic payments. The problem develops the student’s ability to set up present and future value equations and solve for unknown quantities. Problem 5.3 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of the costs of competing contracts. The student is required to decide which contract to accept. Problem 5.4 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of two lottery payout alternatives. The student is required to decide which payout option to choose. Problem 5.5 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to determine which of four insurance options results in the largest present value. The student is required to determine the present value of options which include the immediate receipt of cash, an ordinary annuity, an annuity due, and an annuity of changing amounts. The student must also deal with interest compounded quarterly. This problem is a good summary of the application of present value techniques. Problem 5.6 (Time 25–30 minutes) Purpose—to present an opportunity for the student to determine the present value of a series of deferred annuities. The student must deal with both cash inflows and outflows to arrive at a present value of net cash inflows. A good problem to develop the student’s ability to manipulate the present value table factors to efficiently solve the problem. Problem 5.7 (Time 30–35 minutes) Purpose—to present the student an opportunity to use time value concepts in business situations. Some of the situations are fairly complex and will require the student to think a great deal before answering the question. For example, in one situation a student must discount a note and in another must find the proper interest rate to use in a purchase transaction. Problem 5.8 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of an ordinary annuity and annuity due for three different cash payment situations. The student must then decide which cash payment plan should be undertaken.
Time and Purpose of Problems (Continued) Problem 5.9 (Time 30–35 minutes) Purpose—to present the student with the opportunity to work three different problems related to time value concepts: purchase versus lease, determination of fair value of a note, and appropriateness of taking a cash discount. Problem 5.10 (Time 30–35 minutes) Purpose—to present the student with the opportunity to assess whether a company should purchase or lease. The computations for this problem are relatively complicated. Problem 5.11 (Time 25–30 minutes) Purpose—to present the student an opportunity to apply present value to retirement funding problems, including deferred annuities. Problem 5.12 (Time 20–25 minutes) Purpose—to provide the student an opportunity to explore the ethical issues inherent in applying time value of money concepts to retirement plan decisions. Problem 5.13 (Time 20–25 minutes) Purpose—to present the student an opportunity to compute expected cash flows and then apply present value techniques to determine a warranty liability. Problem 5.14 (Time 20–25 minutes) Purpose—to present the student an opportunity to compute expected cash flows and then apply present value techniques to determine the fair value of an asset. Problems 5.15 (Time 20–25 minutes) Purpose—to present the student an opportunity to estimate fair value by computing expected cash flows and then applying present value techniques to value an asset retirement obligation. * Problems 5.16 (Time 15–20 minutes) Purpose—to present the student an opportunity to solve present value problems using Excel and calculator tools.
Solutions to Problems Problem 5.1
(a)
Given no established fair value for the building, the fair value of the note would be used to estimate the fair value of the building. Time diagram: i = 9% PV = ?
1/1/25
FV = $240,000
1/1/26
1/1/27
1/1/28
n=3 Formula: PV = FV (PVFn, i) PV = $240,000 (PVF3, 9%) PV = $240,000 (.77218) PV = $185,323
Cash equivalent selling price of building ...................... Less: Book value ($250,000 – $100,000) ....................... Gain on disposal of the building ...............................
$185,323 150,000 $ 35,323
Problem 5.1 (Continued) (b)
Time diagram: i = 11%
PV–OA = ? $27,000
$27,000
1/1/25
1/1/27
1/1/26
$27,000
1/1/34
Principal $300,000 (300 x $1,000) Interest $27,000 ($300,000 x .09)
1/1/35
n = 10 Present value of the principal FV (PVF10, 11%) = $300,000 (.35218) ....................
$105,654
Present value of the interest payments
(c)
R (PVF–OA10, 11%) = $27,000 (5.88923) ...............
159,009
Combined present value (purchase price) ................
$264,663
Time diagram: i = 8% PV–OA = ? $4,000
0
1
$4,000
$4,000
$4,000
$4,000
2
8
9
10
n = 10 Formula: PV–OA = R (PVF–OAn,i) PV–OA = $4,000 (PVF–OA10, 8%) PV–OA = $4,000 (6.71008) PV–OA = $26,840 (cost of machine)
Problem 5.1 (Continued) (d)
Time diagram: i = 12% PV–OA = ? $20,000 $5,000
0
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
2
3
4 n=8
5
6
7
8
1
Formula: PV–OA = R (PVF–OAn,i) PV–OA = $5,000 (PVF–OA8, 12%) PV–OA = $5,000 (4.96764) PV–OA = $24,838 Cost of tractor = $20,000 + $24,838 = $44,838 (e)
Time diagram: i = 11% PV–OA = ? $120,000 $120,000
0
1
$120,000 $120,000
2
8
9
n=9 Formula: PV–OA = R (PVF–OAn, i) PV–OA = $120,000 (PVF–OA9, 11%) PV–OA = $120,000 (5.53705) PV–OA = $664,446 LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.2
(a)
Time diagram: FV –OA = $90,000
i = 8%
0
R R=?
R ?
R ?
R ?
R ?
R ?
R ?
R ?
1
2
3
4 n=8
5
6
7
8
Formula:
FV–OA = R (FVF–OAn,i) $90,000 = R (FVF–OA8, 8%) $90,000 = R (10.63663) R = $90,000 ÷ 10.63663 R = $8,461
(b)
Time diagram: i = 8% R R=?
R ?
R ?
R ?
40
41
42
64 n = 25
FV –AD = 500,000
65
Problem 5.2 (Continued) 1. 2. 3. 4.
(c)
Future value of an ordinary annuity of 1 for 25 periods at 8% ................................................ Factor (1 + .08) ...................................................... *Future value of an annuity due of 1 for 25 periods at 8% .....................................................
73.10594 x 1.0800 78.95442
Periodic rent ($500,000 ÷ 78.95442).....................
$6,333
Time diagram: i = 9% PV = $20,000
0
FV = $47,347
1
2
3
n
Future value approach
Present value approach
FV = PV (FVFn, i)
PV = FV (PVFn, i) or
$47,347 = $20,000 (FVFn, 9%) FVFn,9%
= $47,347 ÷ $20,000 = 2.36735
2.36735 is approximately the value of $1 invested at 9% for 10 years.
$20,000 = $47,347 (PVFn, 9%) PVFn, 9%
= $20,000 ÷ $47,347 = .42241
.42241 is approximately the present value of $1 discounted at 9% for 10 years.
Problem 5.2 (Continued) (d)
Time diagram: i=? PV = $19,553
0
FV = $27,600
1
2 n=4
3
4
Future value approach
Present value approach
FV = PV (FVFn, i)
PV = FV (PVFn, i) or
$27,600 = $19,553 (FVF4, i)
FVF4, i
= $27,600 ÷ $19,553 = 1.41155
1.41158 is the value of $1 invested at 9% for 4 years.
$19,553 = $27,600 (PVF4, i)
PVF4, i
= $19,553 ÷ $27,600 = .70844
.70843 is the present value of $1 discounted at 9% for 4 years.
LO: 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.3 Time diagram (Bid A): i = 9% $69,000 PV–OA = R = ?
3,000
3,000
3,000
3,000
69,000
3,000
3,000
3,000
3,000
0
0
1
2
3
4
5 n=9
6
7
8
9
10
Present value of initial cost 12,000 x $5.75 = $69,000 (incurred today) ...................
$ 69,000
Present value of maintenance cost (years 1–4) 12,000 x $.25 = $3,000 R (PVF–OA 4, 9%) = $3,000 (3.23972) .............................
9,719
Present value of resurfacing FV (PVF5, 9%) = $69,000 (.64993)....................................
44,845
Present value of maintenance cost (years 6–9) R (PVF–OA 9–5, 9%) = $3,000 (5.99525 – 3.88965) ..........
6,317
Present value of outflows for Bid A ...............................
$129,881
Problem 5.3 (Continued) Time diagram (Bid B): i = 9% $126,000 PV–OA = R = ?
1,080
1,080
1,080
1,080
1,080
1,080
1,080
1,080
1,080
0
0
1
2
3
4
5
6
7
8
9
10
n=9 Present value of initial cost 12,000 x $10.50 = $126,000 (incurred today)...........
$126,000
Present value of maintenance cost 12,000 x $.09 = $1,080 R (PVF–OA9, 9%) = $1,080 (5.99525) ..........................
6,475
Present value of outflows for Bid B ...........................
$132,475
Bid A should be accepted since its present value is lower. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.4
Lump sum alternative: Present Value = $500,000 x (1 – .46) = $270,000. Annuity alternative: Payments = $36,000 x (1 – .25) = $27,000. Present Value = Payments (PV–AD20, 8%) = $27,000 (10.60360) = $286,297. Long should choose the annuity payout; its present value is $16,297 ($286,297 – $270,000) greater. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.5 (a)
The present value of $55,000 cash paid today is $55,000.
(b)
Time diagram: i = 21/2% per quarter PV–OA =
R=
?
$4,000
0
1
$4,000
$4,000
2 18 n = 20 quarters (5 x 4)
$4,000
$4,000
19
20
Formula: PV–OA = R (PVF–OAn, i) PV–OA = $4,000 (PVF–OA20, 21/2%) PV–OA = $4,000 (15.58916) PV–OA = $62,357 (c)
Time diagram: i = 21/2% per quarter $18,000 PV–AD = R = $1,800
$1,800
0
1
$1,800
$1,800
2 38 n = 40 quarters (10 x 4)
$1,800
39
Formula: PV–AD = R (PVF–ADn, i) PV–AD = $1,800 (PVF–AD40, 21/2%) PV–AD = $1,800 (25.73034) PV–AD = $46,315 The present value of option (c) is $18,000 + $46,315, or $64,315.
40
Problem 5.5 (Continued) (d)
Time diagram: i = 21/2% per quarter PV–OA = ? PV–OA = R = ? $4,000
0
R= $1,500 $4,000
1 11 n = 12 quarters
$1,500
$1,500 $1,500
$4,000
12
13
14 n = 25 quarters
36
37
Formulas: PV- OA = R (PVF–OAn,i)
PV–OA = R (PVF–OAn,i)
PV-OA = $4,000 (PVF–OA12, 21/2%)
PV–OA = $1,500 (PVF–OA37–12, 21/2%)
PV–OA = $4,000 (10.25776)
PV–OA = $1,500 (23.95732 – 10.25776)
PV–OA = $41,031*
PV–OA = $20,549**
The present value of option (d) is $41,031* + $20,549**, or $61,580. Present values: (a)
$55,000.
(b)
$62,357.
(c)
$64,315.
(d)
$61,580.
Option (c) is the best option, based upon present values alone. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
5-46 © 2022 WILEY Copyright
Problem 5.6
© 2022 WILEY Manual Copyright Kieso, Intermediate 18/e,Instructor SolutionsUse Only) Accounting, Manual Kieso, Intermediate 18/e, Solutions Accounting, (For
Time diagram: i = 6% PV–OA = ? R = ($39,000)
0
($39,000) $18,000 $18,000 $68,000 $68,000 $68,000 $68,000 $38,000 $38,000 $38,000
1
5
6
10 11
12
29 30 31
39 40
n=5
n=5
n = 20
n = 10
(0 – $30,000 – $9,000)
($60,000 – $30,000 – $12,000)
($110,000 – $30,000 – $12,000)
($80,000 – $30,000 – $12,000)
Formulas: PV–OA = R (PVF–OAn, i)
PV–OA = R (PVF–OAn, i)
PV–OA = R (PVF–OAn, i)
PV–OA = R (PVF–OAn, i)
PV–OA = ($39,000)(PVF–OA5, 6%)
PV–OA = $18,000 (PVF–OA10-5, 6%)
PV–OA = $68,000 (PVF–OA30–10, 6%)
PV–OA = $38,000 (PVF–OA40–30, 6%)
PV–OA = ($39,000)(4.21236)
PV–OA = $18,000 (7.36009 – 4.21236) PV–OA = $68,000 (13.76483 – 7.36009) PV–OA = $38,000 (15.04630 – 13.76483)
PV–OA = ($164,282)
PV–OA = $18,000 (3.14773)
PV–OA = $68,000 (6.40474)
PV–OA = $38,000 (1.28147)
PV–OA = $56,659
PV–OA = $435,522
PV–OA = $48,696
Present value of future net cash inflows:
Only) (For Instructor Use 5-49
$(164,282) 56,659 435,522 48,696 $ 376,595 Stacy McGill should accept no less than $376,596 for her vineyard business. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.7 (a)
Time diagram (alternative one): i=? PV–OA = $600,000
R= $80,000
$80,000
$80,000
$80,000
$80,000
1
2
10
11
12
0
n = 12
Formulas: PV–OA = R (PVF–OAn, i) $600,000 = $80,000 (PVF–OA12, i) PVF–OA12, i = $600,000 ÷ $80,000 PVF–OA12, i = 7.50
7.50 is the approximate present value of an annuity factor of $1 for 12 years discounted at approximately 8%.
Time diagram (alternative two): i=? PV = $600,000
0
FV = $1,900,000
1
2
11 n = 12
12
Problem 5.7 (Continued) Future value approach
Present value approach
FV = PV (FVFn, i)
PV = FV (PVFn, i) or
$1,900,000 = $600,000 (FVF12, i)
$600,000 = $1,900,000 (PVF12, i)
FVF12, I
= $1,900,000 ÷ $600,000
PVF12, i = $600,000 ÷ $1,900,000
FVF12, I
= 3.16667
PVF12, i = .31579
3.16667 is the approximate future value factor of $1 invested at
.31579 is the approximate present value factor of $1 discounted
10% for 12 years.
at 10% for 12 years.
Dubois should choose alternative two since it provides a higher rate of return. (b)
Time diagram: i=? ($824,150 – $200,000) PV–OA = R = $624,150 $76,952
0
1
$76,952
$76,952
8 9 n = 10 six-month periods
$76,952
10
Problem 5.7 (Continued) Formulas: PV–OA = R (PVF–OAn, i) $624,150 = $76,952 (PVF–OA10, i) PV–OA10, i = $624,150 ÷ $76,952 PV–OA10, i = 8.11090
8.11090 is the present value of a 10-period annuity of $1 discounted at 4%. The interest rate is 4% semi-annually or 8% annually. (c)
Time diagram: i = 5% per six months (.10 ÷ 2)
PV = ? PV–OA = R= ? $32,000
0
1
$32,000
$32,000
$32,000 $32,000 ($800,000 X 8% X 6/12)
2 8 9 10 n = 10 six-month periods [(7 – 2) X 2]
Formulas: PV–OA = R (PVF–OAn, i)
PV = FV (PVFn, i)
PV–OA = $32,000 (PVF–OA10, 5%) PV = $800,000 (PVF10, 5%) PV–OA = $32,000 (7.72173) PV–OA = $247,095*
PV = $800,000 (.61391) PV = $491,128**
Combined present value (amount received on sale of note): $247,095* + $491,128** = $738,223
Problem 5.7 (Continued) (d)
Time diagram (future value of $200,000 deposit) i = 21/2% per quarter (.10 ÷ 4)
PV = $200,000
FV = ?
12/31/25
12/31/26
12/31/34
12/31/35
n = 40 quarters (10 x 4) Formula: FV = PV (FVFn, i) FV = $200,000 (FVF40, 2 1/2%) FV = $200,000 (2.68506) FV = $537,012 Amount to which quarterly deposits must grow: $1,300,000 – $537,012 = $762,988. Time diagram (future value of quarterly deposits) i = 21/2% per quarter R R=?
12/31/25
R ?
R ?
R ?
R ?
12/31/26
12/31/34
n = 40 quarters
R ?
R ?
FV = $762,988 R R ? ?
12/31/35
Problem 5.7 (Continued)
Formulas:
FV–OA = R (FVF–OAn, i) $762,988 = R (FVF–OA40, 2 1/2%) $762,988 = R (67.40255) R = $762,988 ÷ 67.40255 R = $11,320
LO: 2, 3, 4, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.8 Vendor A:
$ 18,000 Payment Xx 6.14457 (PV of ordinary annuity 10%, 10 periods) $ 110,602 + 55,000 down payment + 10,000 maintenance contract $ 175,602 total cost from Vendor A
Vendor B:
$ 9,500 semiannual payment x 18.01704 (PV of annuity due 5% (.10 ÷ 2), 40 periods) $ 171,162
Vendor C:
$ 1,000 x 3.79079 (PV of ordinary annuity of 5 periods, 10%) $ 3,791 PV of first 5 years of maintenance $ 2,000 [PV of ordinary annuity 15 per., 10% (7.60608) – x 3.81529 PV of ordinary annuity 5 per., 10% (3.79079)] $ 7,631 PV of next 10 years of maintenance $ x $
3,000 [(PV of ordinary annuity 20 per., 10% (8.51356) – .90748 PV of ordinary annuity 15 per., 10% (7.60608)] 2,722 PV of last 5 years of maintenance
Total cost of press and maintenance Vendor C: $ 150,000 cash purchase price 3,791 maintenance years 1–5 7,631 maintenance years 6–15 2,722 maintenance years 16–20 $ 164,144 The press should be purchased from Vendor C, since the present value of the cash outflows for this option is the lowest of the three options. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.9 (a)
Time diagram for the first ten payments: i = 10%
PV–AD = ? R= $800,000 $800,000 $800,000 $800,000
0
1
2
$800,000 $800,000 $800,000
3
7
8
9
10
n = 10 Formula for the first ten payments: PV–AD = R (PVF–ADn, i) PV–AD = $800,000 (PVF–AD10, 10%) PV–AD = $800,000 (6.75902) PV–AD = $5,407,216a
Formula for the last ten payments: or PV–OA = R (PVF–OAn, i) PV–AD = R (PVF–ADn, i) PV–OA = $400,000 (PVF–OA19 – 9, 10%)
PV–AD = $400,000 (PVF–OA20 – 10, 10%)
PV–OA = $400,000 (8.36492 – 5.75902)
PV–AD = $400,000 (9.36492 – 6.75902)
PV–OA = $400,000 (2.6059)
PV–AD = $400,000 (2.6059)
PV–OA = $1,042,360b
PV–AD = $1,042,360
a
The present value of an ordinary annuity is used here, not the present value of an annuity due.
Problem 5.9 (Continued) The total cost for leasing the facilities is: $5,407,216a + $1,042,360b = $6,449,576. OR Time diagram for the last ten payments: i = 10% PV = ?
0
R=
1
2
$400,000
9
FVF x (PVFn, i)
10 R x (PVF–OAn, i)
Formulas for the last ten payments: (i)
Present value of the last ten payments: PV–OA = R (PVF–OAn, i) PV–OA = $400,000 (PVF–OA10, 10%) PV–OA = $400,000 (6.14457) PV–OA = $2,457,828
$400,000 $400,000 $400,000
17
18
19
Problem 5.9 (Continued) (ii) Present value of the last ten payments at the beginning of current year: PV = FV (PVFn, i) PV = $2,457,828 (PVF9, 10%) PV = $2,457,828 (.42410) PV = $1,042,365* *$5 difference due to rounding. Cost for leasing the facilities $5,407,216 + $1,042,365 = $6,449,581 Since the present value of the cost for leasing the facilities, $6,449,576, is less than the cost for purchasing the facilities, $7,200,000, McDowell Enterprises made the correct decision to lease the facilities. (b)
Time diagram: i = 11%
PV–OA = ? R= $15,000 $15,000 $15,000
0
1
2
3
$15,000 $15,000 $15,000 $15,000
6
n=9
7
8
9
Problem 5.9 (Continued) Formula: PV–OA = R (PVF–OAn, i) PV–OA = $15,000 (PVF–OA9, 11%) PV–OA = $15,000 (5.53705) PV–OA = $83,056 The fair value of the note is $83,056. (c)
Time diagram: Amount paid = $792,000
0
10
30 Amount paid = $800,000
Cash discount = $800,000 x .01 = $8,000 Net payment = $800,000 – $8,000 = $792,000 If the company decides not to take the cash discount, then the company can use the $792,000 for an additional 20 days. The implied interest rate for postponing the payment can be calculated as follows: (i)
Implied interest for the period from the end of the discount period to the due date: Cash discount lost if not paid within the discount period Net payment being postponed = $8,000/$792,000 = 0.01010
Problem 5.9 (Continued) (ii) Convert the implied interest rate to annual basis: Daily interest = 0.010101/20 = 0.00051 Annual interest = 0.00051 x 365 = 18.62% Since McDowell’s cost of funds, 10%, is less than the implied interest rate for cash discount, 18.62%, it should continue the policy of taking the cash discount. LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.10
1.
Purchase.
Time diagrams:
Installments i = 10% PV–OA = ? R= $350,000
$350,000
$350,000
$350,000
$350,000
1
2
3 n=5
4
5
0
Property taxes and other costs
i = 10% PV–OA = ? R= $56,000 $56,000
0
1
2
$56,000
9
n = 12
$56,000 $56,000 $56,000
10
11
12
Problem 5.10 (Continued) Insurance i = 10% PV–AD = ? R= $27,000 $27,000 $27,000
0
1
$27,000 $27,000 $27,000
2
9
10
11
12
n = 12
Salvage Value i = 10% PV = ?
0
FV = $500,000
1
2
9
n = 12 Formula for installments: PV–OA = R (PVF–OAn, i) PV–OA = $350,000 (PVF–OA5, 10%) PV–OA = $350,000 (3.79079) PV–OA = $1,326,777
10
11
12
Problem 5.10 (Continued) Formula for property taxes and other costs: PV–OA = R (PVF–OAn, i) PV–OA = $56,000 (PVF–OA12, 10%) PV–OA = $56,000 (6.81369) PV–OA = $381,567 Formula for insurance: PV–AD = R (PVF–ADn, i) PV–AD = $27,000 (PVF–AD12, 10%) PV–AD = $27,000 (7.49506) PV–AD = $202,367 Formula for salvage value: PV = FV (PVFn, i) PV = $500,000 (PVF12, 10%) PV = $500,000 (0.31863) PV = $159,315
Problem 5.10 (Continued) Present value of net purchase costs: Down payment........................................................ Installments ............................................................ Property taxes and other costs ............................. Insurance ................................................................ Total costs .............................................................. Less: Salvage value .............................................. Net costs .................................................................
2.
$ 400,000 1,326,777 381,567 202,367 2,310,711 159,315 $2,151,396
Lease. Time diagrams: Lease payments i = 10% PV–AD = ? R=
$270,000 $270,000 $270,000
0
1
2
$270,000 $270,000
10
11
12
n = 12 Interest lost on the deposit i = 10% PV–OA = ? R=
$10,000 $10,000
0
1
2
$10,000 $10,000 $10,000
10
n = 12
11
12
Problem 5.10 (Continued) Formula for lease payments: PV–AD = R (PVF–ADn, i) PV–AD = $270,000 (PVF–AD12, 10%) PV–AD = $270,000 (7.49506) PV–AD = $2,023,666 Formula for interest lost on the deposit: Interest lost on the deposit per year = $100,000 (10%) = $10,000 PV–OA = R (PVF–OAn, i) PV–OA = $10,000 (PVF–OA12, 10%) PV–OA = $10,000 (6.81369) PV–OA = $68,137* Cost for leasing the facilities = $2,023,666 + $68,137 = $2,091,803 Dunn Inc. should lease the facilities because the present value of the costs for leasing the facilities, $2,091,803, is less than the present value of the costs for purchasing the facilities, $2,151,396. *OR: $100,000 – ($100,000 X .31863a) = $68,137 a [PV12, 10%] LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.11 (a)
Annual retirement benefits.
Jean–current salary
$ 48,000 x 2.56330 (future value of 1, 24 periods, 4%) 123,038 annual salary during last year of work x .50 retirement benefit % $ 61,519 annual retirement benefit
Colin–current salary
$ 36,000 x 3.11865 (future value of 1, 29 periods, 4%) 112,271 annual salary during last year of work x .40 retirement benefit % $ 44,908 annual retirement benefit
Anita–current salary
$ 18,000 x 2.10685 (future value of 1, 19 periods, 4%) 37,923 annual salary during last year of work x .40 retirement benefit % $ 15,169 annual retirement benefit
Gavin–current salary
$ 15,000 x 1.73168 (future value of 1, 14 periods, 4%) 25,975 annual salary during last year of work x .40 retirement benefit % $ 10,390 annual retirement benefit
Problem 5.11 (Continued) (b)
Fund requirements after 15 years of deposits at 12%. Jean will retire 10 years after deposits stop. $ 61,519 annual plan benefit [PV of an annuity due for 30 periods – PV of an x 2.69356 annuity due for 10 periods (9.02181 – 6.32825)] $ 165,705
Colin will retire 15 years after deposits stop. $ 44,908 annual plan benefit x 1.52839 [PV of an annuity due for 35 periods – PV of an annuity due for 15 periods (9.15656 – 7.62817)] $ 68,637
Anita will retire 5 years after deposits stop. $ 15,169 annual plan benefit x 4.74697 [PV of an annuity due for 25 periods – PV of an annuity due for 5 periods (8.78432 – 4.03735)] $ 72,007
Gavin will retire the same day after deposits stop. $ 10,390 annual plan benefit x 8.36578 (PV of an annuity due for 20 periods) $ 86,920
Problem 5.11 (Continued) $165,705 Jean 68,637 Colin 72,007 Anita 86,920 Gavin $393,269 Required fund balance at the end of the 15 years of deposits. (c)
Required annual beginning-of-the-year deposits at 12%: Deposit x (future value of an annuity due for 15 periods at 12%) = FV Deposit x (37.27972 x 1.12) = $393,269 Deposit = $393,269 ÷ 41.75329 Deposit = $9,419.
LO: 5, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.12 (a)
The time value of money would suggest that NET Life’s discount rate was substantially higher than First Security’s. The actuaries at NET Life are making different assumptions about inflation, employee turnover, life expectancy of the workforce, future salary, and wage levels, return on pension fund assets, etc. NET Life may operate at lower gross and net margins and it may provide fewer services.
(b)
As the controller of STL, Brokaw assumes a fiduciary role to the present and future retirees of the corporation. As a result, he is responsible for ensuring that the pension assets are adequately funded and are adequately protected from most controllable risks. At the same time, Brokaw is responsible for the financial condition of STL. In other words, he is obligated to find ethical ways of increasing the profits of STL, even if it means switching pension funds to a less costly plan. At times, Brokaw’s responsibility to retirees and his efforts to increase short-term profitability can be in conflict, especially if Brokaw is a member of a professional group such as CPAs or CMAs.
(c)
If STL switched to NET Life The primary beneficiaries of Brokaw’s decision would be the corporation and its many stockholders by virtue of reducing 8 million dollars of annual pension costs. The present and future retirees of STL may be negatively affected by Brokaw’s decision because the chance of losing a future benefit may be increased by virtue of higher risks (as reflected in the discount rate and NET Life’s weaker reputation). The corporation and its shareholders could ultimately be hurt too. This is a short-term versus long-term perspective problem.
Problem 5.12 (Continued) If STL stayed with First Security In the short run, the primary beneficiaries of Brokaw’s decision would be the employees and retirees of STL given the lower risk pension asset plan. STL and its many stakeholders could be negatively affected by Brokaw’s decision to stay with First Security because of the company’s inability to trim 8 million dollars from its operating expenses. Then again, damage STL’s reputation and its future liability to make up shortfalls in its pension plan could ultimately hurt shareholders too. LO: 5, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, Ethics, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: Communication, Professional Demeanor
Problem 5.13
Cash Flow Probability Estimate x Assessment = Expected Cash Flow 2026 $2,500 20% $ 500 4,000 60% 2,400 5,000 20% 1,000 x PV Factor, n = 1, I = 5% Present Value $3,900 x 0.95238 = $ 3,714 2027
2028
$3,000 5,000 6,000
30% 50% 20%
$ 900 2,500 1,200
$4,000 6,000 7,000
30% 40% 30%
$1,200 2,400 2,100
x PV Factor, n = 2, I = 5% Present Value $4,600 x 0.90703 = $ 4,172
x PV Factor, n = 3, I = 5% Present Value $5,700 x 0.86384 = $ 4,924 Total Estimated Liability $12,810
LO: 4, 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.14
Cash Flow Probability Estimate x Assessment = Expected Cash Flow 2026 $6,000 40% $2,400 9,000 60% 5,400 x PV Factor, n = 1, I = 6% Present Value $7,800 x 0.94340 = $ 7,359 2027
$ (500) 2,000 4,000
Scrap Value Received at the End of 2027 $
500 900
20% 60% 20%
$ (100) 1,200 800
50% 50%
$ 250 450
x PV Factor, n = 2, I = 6% Present Value $1,900 x 0.89000 = $ 1,691
x PV Factor, n = 2, I = 6% Present Value $ 700 x 0.89000 = $ 623 Estimated Fair Value $9,673
LO: 4, 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: None
Problem 5.15 (a)
The expected cash flows to meet the asset retirement obligation represent a deferred annuity. Developing a fair value estimate requires determining the present value of the annuity of expected cash flows to be paid in three years and then determine the present value of that amount today. Cash Flow Estimate x $15,000 22,000 25,000 30,000
Probability Assessment = Expected Cash Flow 10% $ 1,500 30% 6,600 50% 12,500 10% 3,000 x PV-OA Factor, n = 3, I = 5% Present Value (deferred 10 yrs) $23,600 x 2.72325 = $64,269
The value today of the annuity payments to commence in ten years is: $ 64,269 Present value of annuity x .61391 PV of a lump sum to be paid in 10 periods. $ 39,455 Alternatively, the present value of the deferred annuity can be computed as follows: $ 23,600 Expected cash outflows x 1.67184 [PV of an ordinary annuity for 13 periods – PV of an ordinary annuity for 10 periods (9.39357 – 7.72173)] $ 39,455 (b)
This fair value estimate is based on unobservable inputs—Murphy’s own data on the expected future cash flows associated with the obligation to restore the site. This fair value estimate is considered Level 3, as discussed in Chapter 1.
LO: 5, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: Communication
*Problem 5.16 a) The future value is $190,193.49.
Excel solution:
Calculator solution:
b) The future value is $193,575.74. Excel solution:
Calculator Solution:
c) The present value is $331,505.45. Excel solution:
Calculator solution:
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis, AICPA PC: Communication
UYJ 5.1 Financial Reporting Problem (a)
1.
Long-lived assets, goodwill
For impairment of goodwill and long-lived assets, fair value is determined using a discounted cash flow analysis.
(b)
2.
Short-term and long-term debt
3.
Postretirement benefit plans
4.
Employee stock ownership plans
(1) The following rates are disclosed in the accompanying notes: Debt Weighted-Average Effective Interest Rate At December 31 Short-Term Long-Term
2020 .70% 2.3%
2019 .50% 2.4%
Financial Reporting Problem (Continued) Benefit Plans Pension Benefits United States 2020 2019 Assumptions used to determine net periodic benefit cost. Discount rate Expected return on assets
1.5% 6.6%
1.9% 6.6%
Stock-Based Compensation Assumptions Weighted average interest rate used in Stock Option Valuation
2020 1.3%
Other Retiree Benefits 2020 2019
3.1% 8.4%
3.7% 8.3%
2019 2.6%
(2) There are different rates for various reasons: 1. The maturity dates—short-term vs. long-term. 2. The security or lack of security for debts—mortgages and collateral vs. unsecured loans. 3. Fixed rates and variable rates. 4. Issuances of securities at different dates when differing market rates were in effect. 5. Different risks involved or assumed. 6. Foreign currency differences—some investments and payables are denominated in different currencies. LO: 1, 5, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 5.2 Financial Statement Analysis Case (a)
(b)
(c)
Cash inflows of $375,000 less cash outflows of $125,000 = Net cash flows of $250,000. $250,000 x 2.48685* = $621,713 *(PVF–OA3, 10%) Cash inflows of $275,000 less cash outflows of $155,000 = Net cash flows of $120,000. $120,000 x 2.48685* = $298,422 *(PVF–OA3,10%) The estimate of future cash flows is very useful. It provides an understanding of whether the value of gas and oil properties is increasing or decreasing from year to year. Although it is an estimate, it does provide an understanding of the direction of change in value. Also, it can provide useful information to record a write-down of the assets.
LO: 1, 4, 5, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
UYJ 5.3 Accounting, Analysis, and Principles Accounting (a)
The present value of the note is presumably equal to the fair value of the inventory. The note has 20 semi-annual periods to maturity. $679,517 = $50,000 x PVF-OA20,i PVF-OA20,i = $679,517 ÷ $50,000 PVF-OA20,i = 13.59034 Searching across the interest rate columns on the 20-period row reveals that the interest rate is 4% semi-annually or 8 percent annually.
(b)
Johnson should initially record the note at its fair value, $679,517.
Analysis If interest rates increase, the fair value of the note will decline. This is because the remaining cash flows are being discounted at a higher rate. That is, the present value of the future cash flows is less at a higher discount rate.
Principles Fair value versus historical cost potentially involves a trade-off between the primary qualities of relevance and faithful representation. The fair values of various assets (and liabilities) is potentially more relevant to financial statement readers. However, it is often a more subjective measure than historical cost. Thus, fair value may not be as neutral and as free from error as historical cost. Fair value is more subjective because it often must be estimated, requiring assumptions about discount rates and, as later chapters illustrate, about the amounts and timing of future cash flows. LO: 1, 4, 5, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Codification Exercises CE5.1 (a) According to the Master Glossary, present value is a tool used to link uncertain future amounts (cash flows or values) to a present amount using a discount rate (an application of the income approach). Present value techniques differ in how they adjust for risk and in the type of cash flows they use. (b) The discount rate adjustment technique is a present value technique that uses a risk-adjusted discount rate and contractual, promised, or most likely cash flows. LO: 1, Bloom: K, Difficulty: Moderate, Time: 10-15, AACSB: Knowledge, Communication, Technology, AICPA BB: None, AICPA AC: Research, Technology & Tools, AICPA PC: Communication
CE5.2 (a) See 350 Intangibles—Goodwill and Other > 20 Goodwill > 50 Disclosure > Goodwill Impairment Loss > Information for Each Period for Which a Statement of Financial Position Is Presented > Goodwill Impairment Loss 50-2 For each goodwill impairment loss recognized, all of the following information shall be disclosed in the notes to the financial statements that include the period in which the impairment loss is recognized: a. A description of the facts and circumstances leading to the impairment. b. The amount of the impairment loss and the method of determining the fair value of the associated reporting unit (whether based on quoted market prices, prices of comparable businesses, a present value or other valuation technique, or a combination thereof). c. If a recognized impairment loss is an estimate that has not yet been finalized (see paragraphs 350-20-35-18 through 19), that fact and the reasons therefore and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss. LO: 1, 5, Bloom: K, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, Communication, Technology, AICPA BB: None, AICPA AC: Research, Technology & Tools, AICPA PC: Communication
CE5.3 Interest cost includes interest recognized on obligations having explicit interest rates, interest imputed on certain types of payables in accordance with Subtopic 835-30, and interest related to a capital lease determined in accordance with Subtopic 840-30. With respect to obligations having explicit interest rates, interest cost includes amounts resulting from periodic amortization of discount or premium and issue costs on debt. According to the discussion at 835 Interest> 30 Imputation of Interest 05-1
This Subtopic addresses the imputation of interest.
05-2
Business transactions often involve the exchange of cash or property, goods, or services for a note or similar instrument. When a note is exchanged for property, goods, or services in a bargained transaction entered into at arm’s length, there should be a general presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds. That presumption, however, must not permit the form of the transaction to prevail over its economic substance and thus would not apply if interest is not stated, the stated interest rate is unreasonable, or the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the value of the note at the date of the transaction. The use of an interest rate that varies from prevailing interest rates warrants evaluation of whether the face amount and the stated interest rate of a note or obligation provide reliable evidence for properly recording the exchange and subsequent related interest.
05-3
This Subtopic provides guidance for the appropriate accounting when the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange. This circumstance may arise if the note is non-interest-bearing or has a stated interest rate that is different from the rate of interest appropriate for the debt at the date of the transaction. Unless the note is recorded at its present value in this circumstance, the sales price and profit to a seller in the year of the transaction and the purchase price and cost to the buyer are misstated, and interest income and interest expense in subsequent periods are also misstated.
LO: 1, 5, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, Communication, Technology, AICPA BB: None, AICPA AC: Research, Technology & Tools, AICPA PC: Communication
Codification Research Case Search strings: “present value”, present and value, Present value $, “best estimate”, “estimated cash flow”, “expected cash flow”, “fresh-start measurement”, “interest methods of allocation” (a) Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements (FASB 2000). (b) See Appendix B: APPLICATIONS OF PRESENT VALUE IN FASB STATEMENTS AND APB OPINIONS, CON7, Par. 119 119. . . . The accompanying table is presented to assist readers in understanding the differences between the conclusions reached in this Statement and those found in FASB Statements and APB Opinions that employ present value techniques in recognition, measurement, or amortization (period-to-period allocation) of assets and liabilities in the statement of financial position. Some examples are: • Debt payable and related premium or discount • Asset acquired by incurring liabilities in a business combination—“An asset acquired by incurring liabilities is recorded at cost—that is, at the present value of the amounts to be paid” (paragraph 67(b)). • Interest on Receivables and Payables—Note exchanged for property, goods, or services. • Capital lease or operating lease— . . . The lessee’s incremental borrowing rate is used unless (a) the lessor’s implicit rate can be determined and (b) the implicit rate is less than the incremental borrowing rate. • Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Lease . . . Origination fees and costs are reflected over the life of the loan as an adjustment of the yield on the net investment in the loan.
Codification Research Case (Continued) • Employers’ Accounting for Postretirement Benefits Other Than Pensions . . . Effective settlement rate—“. . . as opposed to ‘settling’ the obligation, which incorporates the insurer’s risk factor, ‘effectively settling’ the obligation focuses only on the time value of money and ignores the insurer’s cost for assuming the risk of experience losses” (paragraph 188). • Accounting for the Impairment of Long-Lived Assets and for LongLived Assets to Be Disposed Of . . . The objective is to estimate the fair value of the impaired asset. . . . (c) 1. CON7, Glossary of terms: Best estimate: The single most-likely amount in a range of possible estimated amounts; in statistics, the estimated mode. In the past, accounting pronouncements have used the term best estimate in a variety of contexts that range in meaning from “unbiased” to “most likely.” This Statement uses best estimate in the latter meaning, as distinguished from the expected amounts described below. 2. CON7, Glossary of terms: Estimated Cash Flow and Expected Cash Flow: In the past, accounting pronouncements have used the terms estimated cash flow and expected cash flow interchangeably. In this Statement: Estimated cash flow refers to a single amount to be received or paid in the future. Expected cash flow refers to the sum of probability-weighted amounts in a range of possible estimated amounts; the estimated mean or average. 3. CON7, Glossary of terms: Fresh-Start Measurements: Measurements in periods following initial recognition that establishes a new carrying amount unrelated to previous amounts and accounting conventions. Some fresh-start measurements are used every period, as in the reporting of some marketable securities at fair value under FASB Statement No.115, Accounting for Certain Investments in Debt and Equity Securities. In other situations, fresh-start measurements are prompted by an exception or “trigger,” as in a remeasurement of assets under FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.
Codification Research Case (Continued) 4. CON7, Glossary of terms: Interest Methods of Allocation: Reporting conventions that use present value techniques in the absence of a fresh-start measurement to compute changes in the carrying amount of an asset or liability from one period to the next. Like depreciation and amortization conventions, interest methods are grounded in notions of historical cost. The term interest methods of allocation refers both to the convention for periodic reporting and to the several approaches to dealing with changes in estimated future cash flows. Note to instructor: The concepts statements are not in the codification. Thus, the references to previous FASB standards above do not have codification sections indicated. A good extension of this research case would have students track down codification references for the items above. LO: 1, 5, Bloom: K, Difficulty: Simple, Time: 25-30, AACSB: Knowledge, Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
CHAPTER 6 Cash and Receivables Assignment Classification Table (By Topic) Topics
Questions
1.
Accounting for cash.
2.
Brief Exercises
Critical Thinking
Exercises
Problems
1, 2, 3, 4, 22, 1 23
1, 2
1
Accounting for accounts receivable, bad debts, other allowances.
5, 6, 7, 8, 9, 10, 11, 12, 13, 14
2, 3, 4, 5, 6
3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 16
2, 3, 4, 5, 6
1, 2, 3, 4, 9, 10
3.
Accounting for notes receivable.
15, 16
7, 8
13, 14
7, 8, 9
2, 4, 5, 6, 7, 8
4.
Assignment and factoring of accounts receivable.
17, 18, 19
9, 10, 11, 12, 13
12, 15, 16, 17, 18, 19, 21
10, 11
2, 5, 7
5.
Analysis of receivables.
20, 21
14
20, 21
*6.
Petty cash and bank reconciliations.
23
15, 16, 17
22, 23, 24, 25
12, 13, 14
*7.
Allowance estimate using expected cash flow.
24, 25
18
26, 27
15
*This material is covered in an Appendix to the chapter.
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Indicate how to report cash and related items.
1, 2, 3, 4, 22
1
1, 2
1
2.
Define receivables and explain accounting issues related to their recognition.
5, 6
2, 3, 4
3, 4, 5, 6, 12, 16
6
2, 4, 9
3.
Explain accounting issues related to valuation of accounts receivable.
7, 8, 9, 10, 11, 12, 13, 14
5, 6
7, 8, 9, 10, 11, 12, 16
2, 3, 4, 5, 6
1, 3, 9, 10
4.
Explain accounting issues related to recognition and valuation of notes receivable.
15, 16
7, 8
13, 14
7, 8, 9
4, 6, 7, 8
5.
Explain additional accounting issues related to accounts and notes receivable.
17, 18, 19, 20, 21
9, 10, 11, 12, 13, 14
12, 14, 15, 16, 17, 18, 19, 20, 21
10, 11
2, 5, 7
*6.
Explain common techniques employed to control cash.
23
15, 16, 17
22, 23, 24, 25
12, 13, 14
*7.
Describe the estimation of the allowance based on expected cash flows.
24, 25
18
26, 27
15
Assignment Characteristics Table
Item
Description
Level of Difficulty
Time (minutes)
E6.1 E6.2 E6.3 E6.4 E6.5 E6.6 E6.7 E6.8 E6.9 E6.10 E6.11 E6.12 E6.13 E6.14 E6.15 E6.16 E6.17 E6.18 E6.19 E6.20 E6.21 *E6.22 *E6.23 *E6.24 *E6.25 *E6.26 *E6.27
Determining cash balance. Determining cash balance. Financial statement presentation of receivables. Determining ending accounts receivable. Recording sales gross and net. Recording sales transactions. Recording bad debts. Recording bad debts. Computing bad debts and preparing journal entries. Bad-debt reporting. Bad debts—aging. Journalizing various receivable transactions. Note transactions at unrealistic interest rates. Notes receivable with unrealistic interest rate. Assigning accounts receivable. Journalizing various receivable transactions. Transfer of receivables with recourse. Transfer of receivables with recourse. Transfer of receivables without recourse. Analysis of receivables. Transfer of receivables. Petty cash. Petty cash. Bank reconciliation and adjusting entries. Bank reconciliation and adjusting entries. Expected cash flows. Expected cash flows.
Moderate Moderate Moderate Simple Simple Moderate Moderate Simple Simple Simple Simple Simple Simple Moderate Simple Simple Simple Moderate Simple Moderate Moderate Simple Simple Moderate Simple Moderate Moderate
10–15 10–15 10–15 10–15 15–20 5–10 10–15 5–10 8–10 10–12 8–10 15–20 10–15 20–25 10–15 15–18 10–15 15–20 10–15 10–15 10–15 5–10 10–15 15–20 15–20 15–25 15–25
P6.1 P6.2 P6.3 P6.4 P6.5 P6.6 P6.7 P6.8 P6.9 P6.10 P6.11 *P6.12 *P6.13 *P6.14 *P6.15
Determine proper cash balance. Bad-debt reporting. Bad-debt reporting—aging. Bad-debt reporting. Bad-debt reporting. Journalize various accounts receivable transactions. Notes receivable with realistic interest rate. Notes receivable journal entries. Comprehensive receivables problem. Assigned accounts receivable—journal entries. Income effects of receivables transactions. Petty cash, bank reconciliation. Bank reconciliation and adjusting entries. Bank reconciliation and adjusting entries. Expected cash flows.
Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate
20–25 20–25 20–30 25–35 20–30 25–35 30–35 30–35 40–50 25–30 20–25 20–25 20–30 20–30 30–40
Assignment Characteristics Table (Continued) Item
Description
CT6.1 CT6.2 CT6.3 CT6.4 CT6.5 CT6.6 CT6.7
Bad-debt accounting. Various receivable accounting issues. Bad-debt reporting issues. Basic note and accounts receivable transactions. Sale of notes receivable. Zero-interest-bearing note receivable. Reporting of notes receivable, interest, and sale of receivables. Accounting for zero-interest-bearing note. Receivables management. Bad-debt reporting, ethics.
CT6.8 CT6.9 CT6.10
Level of Difficulty
Time (minutes)
Simple Simple Moderate Moderate Moderate Moderate Moderate
10–15 15–20 25–30 25–30 20–25 20–30 25–30
Moderate Moderate Moderate
25–30 25–30 25–30
Answers to Questions 1. Cash normally consists of coins and currency on hand, bank deposits, and various kinds of orders for cash such as bank checks, money orders, travelers’ checks, demand bills of exchange, bank drafts, and cashiers’ checks. Balances on deposit in banks that are subject to immediate withdrawal are properly included in cash. Money market funds that provide checking account privileges may be classified as cash. There is some question as to whether deposits not subject to immediate withdrawal are properly included in cash or whether they should be set out separately. Savings accounts, certificates of deposit, and time deposits fall in this latter category. Unless restrictions on these kinds of deposits are such that they cannot be converted (withdrawn) within one year or the operating cycle of the entity, whichever is longer, they are properly classified as current assets. At the same time, they may well be presented separately from other cash and the restrictions as to convertibility reported. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
2. (a) Cash. (b) Investments. (c) Temporary investments. (d) Accounts receivable. (e) Accounts receivable, a loss if uncollectible. (f) Other assets if not expendable, cash if expendable for goods and services in the foreign country. (g) Receivable if collection expected within one year; otherwise, other asset.
(h) Investments, possibly other assets. (i) Cash. (j) Trading securities. (k) Cash. (l) Cash. (m) Postage expense, or prepaid expense, or supplies inventory. (n) Receivable from employee if the company is to be reimbursed; otherwise, prepaid expense.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
3. A compensating balance is that portion of any demand deposit maintained by a corporation that constitutes support for existing borrowing arrangements of a corporation with a lending institution. A compensating balance representing a legally restricted deposit held against short-term borrowing arrangements should be stated separately among the cash and cash equivalent items. A restricted deposit held as a compensating balance against long-term borrowing arrangements should be separately classified as a noncurrent asset in either the investments or other assets section. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
4. Restricted cash for debt redemption would be reported in the long-term asset section, probably in the investments section. Another alternative is the other assets section. Given that the debt is longterm, the restricted cash should also be reported as long-term. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
5. The seller normally uses trade discounts to avoid frequent changes in its catalogs, to quote different prices for different quantities purchased, and to hide the true invoice price from competitors. Trade discounts are not recorded in the accounts because the price finally quoted is generally an accurate statement of the fair market value of the product on that date. In addition, no subsequent changes can occur to affect this value from an accounting standpoint. With a cash discount, the buyer receives a choice, and events after the original transaction dictate that additional entries may be needed. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 6 (Continued) 6. Two methods of recording accounts receivable are: 1. Record receivables and sales gross (without regard to discount). 2. Record receivables and sales net of discount. The net method is desirable from a theoretical standpoint because it values the receivable at its net realizable value. In addition, recording the sales at net provides a better assessment of the revenue that was recognized from the sale of the product. If the purchasing company fails to take the discount, then the company should reflect this amount as income. The gross method for receivables and sales is used in practice normally because it is expedient, and its use does not generally have any significant effect on the presentation of the financial statements. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
7.
When companies sell a product with a sales allowance for possible dissatisfaction or other issues, they should record the accounts receivable and related revenue at the amount of consideration expected to be received. The use of a Sales Returns and Allowances account is helpful to management because it highlights the problems associated with inferior merchandise, inefficiencies in filling orders, or delivery or shipment mistakes. Thus, since management must estimate expected allowances to be granted in the future, which affects the final transaction price, sales allowances result in variable consideration.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
8. The basic problems that relate to the valuation of receivables are (1) the determination of the face value of the receivable, (2) the probability of future collection of the receivable, and (3) the length of time the receivable will be outstanding. The determination of the face value of the receivable is a function of the trade discount, cash discount, and certain allowance accounts such as the Allowance for Sales Returns and Allowances. LO: 3, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
9. The theoretical superiority of the allowance method over the direct write-off method of accounting for bad debts is two-fold. First, since revenue is considered to be recognized at the point of sale on the assumption that the resulting receivables are valid liquid assets merely awaiting collection, periodic income will be overstated to the extent of any receivables that eventually become uncollectible. The proper matching of revenue and expense requires that gross sales in the income statement be partially offset by a charge to bad debt expense that is based on an estimate of the receivables arising from gross sales that will not be converted into cash. Second, accounts receivable on the balance sheet should be stated at the net amount expected to be collected. The allowance method accomplishes this by deducting from gross receivables the allowance for doubtful accounts. The latter is derived from the charges for bad debt expense on the income statement. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
10. The percentage of receivables method based on an aging schedule calculates each year’s debit to the expense account and credit to the allowance account by evaluating the collectibility of open accounts receivable at the close of the year. An analysis of the accounts according to their due dates is a common procedure. For each of the age categories established in the analysis, average percentage rates may be developed based on past experience and applied to the accounts in the respective age categories. This method may also utilize individual analysis for some accounts, especially those that are considerably past due, in arriving at estimated uncollectible receivables. Based on the foregoing analysis, the balance in the valuation account is then adjusted to the amount estimated to be uncollectible.
Questions Chapter 6 (Continued) This method of providing for uncollectible accounts is quite accurate for purposes of reporting accounts receivable at the net amount expected to be collected in the balance sheet. From the standpoint of the income statement, however, the aging method may not match accurately bad debt expenses with the sales which caused them because the charge to bad debt expense is not based on sales. The accuracy of both the charge to bad debt expense and the reported value of receivables depends on the current estimate of uncollectible accounts. The accuracy of the expense charge, however, is additionally dependent upon the timing of actual write-offs. Other methods that companies may use employ estimates based on historical loss ratios for customers with different credit ratings as a basis for estimating uncollectible accounts. Or, a company may utilize a probability-weighted discounted cash flow model (as illustrated in Chapter 6) to estimate expected credit losses. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
11. A major part of accounting is the measurement of financial data. Estimates of uncollectibility should be recognized so that receivables are reported at the net amount expected to be collected and for accounting to provide useful information on a periodic basis. The very existence of accounts receivable is based on the decision that a credit sale is an objective indication that revenue should be recognized. The alternative is to wait until the debt is paid in cash. If revenue is to be recognized and an asset recorded at the time of a credit sale, the need for fairness in the statements requires that both expenses and the asset be adjusted for the estimated amounts of the asset that experience indicates will not be collected. The argument may be persuasive that the evidence supporting write-offs permits a more accurate decision than that which supports the allowance method. The latter method, however, is “objective” in the sense in which accountants use the term and is justified by the need for fair presentation of receivables and income. The direct write-off method is not wholly objective; it requires the use of judgment in determining when an account has become uncollectible. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
12. The allowance method has three essential features: 1. Companies estimate uncollectible accounts receivable and compare the new estimate to the current balance in the allowance account. 2. Companies debit estimated increases in uncollectibles to Bad Debt Expense and credit them to Allowance for Doubtful Accounts, a contra asset account, through an adjusting entry at the end of each period. 3. When companies write off a specific customer account, they debit actual uncollectibles to Allowance for Doubtful Accounts and credit that amount to Accounts Receivable. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
13. The receivable due from Bernstein Company should be written off to an appropriately named loss account and reported in the income statement as part of income from operations. In this case, classification as an unusual item would seem appropriate. The loss may properly be reduced by the portion of the allowance for doubtful accounts at the end of the preceding year that was allocable to the Bernstein Company account. Estimates for doubtful accounts are based on a firm’s prior bad debt experience with due consideration given to changes in credit policy and forecasted general or industry business conditions. The purpose of the allowance method is to anticipate only that amount of bad debt expense which can be reasonably forecasted in the normal course of events. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 6 (Continued) 14. If the direct write-off method is used, the only alternative is to debit Cash and credit a revenue account entitled Uncollectible Amounts Recovered. If the allowance method is used, then the accountant would debit Accounts Receivable and credit the Allowance for Doubtful Accounts. An entry is then made to credit the customer’s account and debit Cash upon receipt of the remittance. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
15. The journal entry on Lombard’s books would be: Notes Receivable ............................................................................. Discount on Notes Receivable ($1,000,000 - $640,000) ............. Sales Revenue............................................................................
1,000,000 360,000 640,000*
*Assumes that seller is a dealer in this property. If not, Land might be credited, and a loss on sale of $50,000 would be recognized with a debit entry. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
16. Imputed interest is the interest ascribed or attributed to a situation or circumstance which is void of a stated or otherwise appropriate interest factor. Imputed interest is the result of a process of interest rate estimation called imputation. An interest rate is imputed for notes receivable when (1) no interest rate is stated for the transaction, or (2) the stated interest rate is unreasonable, or (3) the stated face amount of the note is materially different from the current cash price for the same or similar items or from the current market value of the debt instrument. In imputing an appropriate interest rate, consideration should be given to the prevailing interest rates for similar instruments of issuers with similar credit ratings, the collateral, and restrictive covenants. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
17. A company might sell receivables because money is tight and access to normal credit is not available or prohibitively expensive. Also, a company may have to sell its receivables, instead of borrowing, to avoid violating existing lending arrangements. In addition, billing and collection of receivables are often time-consuming and costly. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
18. The financial components approach is used when receivables are sold but there is continuing involvement by the seller in the receivable. Examples of continuing involvement are recourse provisions or continuing rights to service the receivable. A transfer of receivables should be recorded as a sale when the following three conditions are met: (a) The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors). (b) The transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets. (c) The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 6 (Continued) 19. Recourse is a guarantee from Moon that if any of the sold receivables are uncollectible, Moon will pay the factor for the amount of the uncollectible account. This recourse obligation represents continuing involvement by Moon after the sale. Under the financial components model, the estimated fair value of the recourse obligation will be reported as a liability on Moon’s balance sheet. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
20. Several acceptable solutions are possible depending upon assumptions made as to whether certain items are collectible within the operating cycle or not. The following illustrates one possibility: Current Assets Accounts receivable—Trade (of which accounts in the amount of $75,000 has been assigned as security for loans payable) ($523,000 + $75,000) ........................................................................................ Federal income tax refund receivable .................................................................. Advance payments on purchases ........................................................................ Non-Trade receivables Advance to subsidiary ......................................................................................... Other Assets Travel advance to employees .............................................................................. Notes receivable past due plus accrued interest ..................................................
$598,000 15,500 61,000 45,500 22,000 47,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
21. The accounts receivable turnover is computed by dividing net sales by average net receivables outstanding during the year. This ratio is used to assess the liquidity of the receivables. It measures the number of times, on average, receivables are collected during the period. It provides some indication of the quality of the receivables and how successful the company is in collecting its outstanding receivables. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
22. Because the restricted cash cannot be used by Woodlawn to meet current obligations, it should not be reported as a current asset—it should be reported in investments or other assets. Thus, although this item has cash in its label, it should not be reflected in liquidity measures, such as the current or acid-test ratios. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*23. (1)
The general checking account is the principal bank account of most companies and frequently the only bank account of small companies. Most if not all transactions are cycled through the general checking account, either directly or on an imprest basis.
(2)
Imprest bank accounts are used to disburse cash (checks) for a specific purpose, such as dividends, payroll, commissions, or travel expenses. Money is deposited in the imprest fund from the general fund in an amount necessary to cover a specific group of disbursements.
(3)
Lockbox accounts are local post office boxes to which a multi-location company instructs its customers to mail remittances. A local bank is authorized to empty the box daily and credit the company’s accounts for collections.
LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 6 (Continued) *24. A loan is considered impaired when it is probable that the creditor will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan. If a loan is considered impaired, the loss due to impairment should be measured as the difference between the investment in the loan and the expected future cash flows discounted at the loan’s historical effective interest rate. The loss is recorded on the books of the creditor. The debtor would not be aware of the entry made by the creditor and would not make an entry until settlement or if a modification of terms resulted. LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*25. Companies commonly evaluate loans (long-term notes receivable) for collectibility based on an analysis of the expected contractual cash flows. They then apply discounted expected cash flow methods to measure the allowance to report the loan at the net amount expected to be collected. The allowance for doubtful accounts and related bad debt expense on a loan or note receivable can be estimated as the difference between the investment in the loan (generally the principal plus accrued interest or amortized cost) and the expected future cash flows discounted at the loan’s historical effective-interest rate. LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Brief Exercises Brief Exercise 6.1 Cash in bank—savings account ............................... Cash on hand ............................................................. Checking account balance ....................................... Cash to be reported ...................................................
$68,000 9,300 17,000 $94,300
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.2 June 1 June 12
Accounts Receivable......................... Sales Revenue ..........................
50,000
Cash ($50,000 - $1,500) ..................... Sales Discounts ($50,000 x .03) ........ Accounts Receivable ................
48,500 1,500
50,000
50,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.3 June 1 June 12
Accounts Receivable......................... Sales Revenue ..........................
48,500*
Cash ................................................... Accounts Receivable ................
48,500
48,500
48,500
*[$50,000 – ($50,000 X .03)] = $48,500 LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.4 (a)
Accounts Receivable........................... Sales Revenue ............................
9,000 9,000
Brief Exercise 6.4 (Continued) (b) (c)
Sales Returns and Allowances ......... Accounts Receivable ................
700
Sales Returns and Allowances ......... Refund Liability ........................
200
700 200
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.5 Bad Debt Expense .................................................... Allowance for Doubtful Accounts ..................
17,600 17,600
[($250,000 X .08) – $2,400] LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.6 (a)
(b)
Bad Debt Expense ......................................... Allowance for Doubtful Accounts [(.10 X $250,000) + $1,900] ................
26,900
Bad Debt Expense ......................................... Allowance for Doubtful Accounts ($24,600 – $2,400) ..............................
22,200
26,900
22,200
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.7 11/1/25
Notes Receivable .................................. Sales Revenue .............................
30,000*
12/31/25 Interest Receivable ............................... Interest Revenue ($30,000* X .06 X 2/12) ..............
300
30,000
300
Brief Exercise 6.7 (Continued) 5/1/26
Cash ($30,000 + $300 + $600) ............... Notes Receivable ......................... Interest Receivable ...................... Interest Revenue ($30,000 X .06 X 4/12) .................
30,900 30,000 300 600
LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.8 Notes Receivable .................................................... Discount on Notes Receivable ..................... ($20,000 - $16,529a) Cash ...............................................................
20,000
Discount on Notes Receivable .............................. Interest Revenue ($16,529a X .10)………….
1,653b
Discount on Notes Receivable .............................. Interest Revenue [($16,529a + $1,653b) X .10] .........................
1,818
Cash ................................................................................. ................................................................................. Notes Receivable ........................................................................
20,000
3,471 16,529a 1,653
1,818
LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
20,000
Brief Exercise 6.9 Chung, Inc. Cash ($750,000 - $20,000) .............................................................................. .............................................................................. Interest Expense ($1,000,000 X .02) .................... Notes Payable .............................................
730,000 20,000 750,000
Seneca National Bank Notes Receivable ................................................. Cash ($750,000 - $20,000) .......................... Interest Revenue ($1,000,000 X .02) ..........
750,000 730,000 20,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.10 Wood Cash ($150,000 − $9,000* − $3,000**) .............................................................................. .............................................................................. Receivable from Factor ....................................... Loss on Sale of Receivables ............................... Accounts Receivable..................................
138,000 9,000* 3,000** 150,000
*.06 X $150,000 = $9,000 **.02 X $150,000 = $3,000 Engram Accounts Receivable ........................................... Due to Customer (Wood)............................ Interest Revenue ......................................... Cash ($150,000 - $9,000 - $3,000)...............
150,000***
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
9,000* 3,000** 138,000
Brief Exercise 6.11 Wood Cash ($150,000 - $9,000 - $3,000) .............................................................................. .............................................................................. Receivable from Factor ....................................... Loss on Sale of Receivables............................... Accounts Receivable ................................. Recourse Liability.......................................
138,000 9,000* 10,500** 150,000 7,500
*.06 X $150,000 = $9,000 **.02 X $150,000 = $3,000 + $7,500 = $10,500 LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.12 Cash ($250,000 – $12,500a - $10,000b)................. Receivable from Factor ($250,000 X .04) ............ Loss on Sale of Receivables............................... Accounts Receivable ................................. Recourse Liability.......................................
227,500 10,000b 20,500* 250,000 8,000c
*[($250,000 X .05)a + $8,000c] LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.13 The entry for the sale now would be: Cash ($250,000 – $12,500 - $10,000) ..................................................................... Receivable from Factor ($250,000 X .04) ............ Loss on Sale of Receivables............................... Account Receivable ................................... Recourse Liability.......................................
227,500 10,000 16,500* 250,000 4,000
*[($250,000 X .05) + $4,000] This lower estimate for the recourse liability reduces the amount of the loss—this will result in higher income in the year of the sale. Arness’s liabilities will be lower by $4,000. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 6.14 The accounts receivable turnover is computed as follows: Net Sales $12,442,000,000 = = 13.34 times Average Trade Receivables (net) ($912,000,000 + $953,000,000) 2
The days outstanding (average collection period) for accounts receivable in days is 365 days Accounts Receivable Turnover
=
365 = 27.36 days 13.34
As indicated by these ratios, General Mills’ accounts receivable turnover appears quite strong. LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 6.15 Petty Cash ..................................................................... Cash .....................................................................
200
Supplies ........................................................................ Miscellaneous Expense ............................................... Cash Over and Short [$185 – ($94 + $87)]................... Cash ($200 – $15) ................................................
94 87 4
200
185
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 6.16 (a) (b) (c) (d) (e)
Added to balance per bank statement (1) Deducted from balance per books (4) Added to balance per books (3) Deducted from balance per bank statement (2) Deducted from balance per books (4)
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 6.17 (b) (c)
(e)
Office Expense ..................................................... Cash .............................................................
25
Cash ............................................................................... ............................................................................... Interest Revenue .........................................
31
Accounts Receivable ........................................... Cash .............................................................
377
25
31 377
Thus, all “Balance per books” adjustments in the reconciliation require a journal entry. LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 6.18 National American Bank (Creditor): Bad Debt Expense ..................................................... Allowance for Doubtful Accounts......................
225,000
LO: 7, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
225,000
Solutions to Exercises Exercise 6.1 (10–15 minutes) (a) Cash includes the following: 1. Commercial savings account— First National Bank of Yojimbo 1. Commercial checking account— First National Bank of Yojimbo 2. Money market fund—Volonte 5. Petty cash 11. Commercial Paper (cash equivalent) 12. Currency and coin on hand Cash reported on December 31, 2025, balance sheet (b)
$ 600,000 900,000 5,000,000 1,000 2,100,000 7,700 $8,608,700
Other items classified as follows: 3. Travel advances (reimbursed by employee)* should be reported as receivable—employee in the amount of $180,000. 4. Cash restricted in the amount of $1,500,000 for the retirement of long-term debt should be reported as a noncurrent asset identified as “Cash restricted for retirement of long-term debt.” 6. An IOU from Marianne Koch should be reported as an account receivable in the amount of $190,000. 7. The bank overdraft of $110,000 should be reported as a current liability.** 8. Certificates of deposits of $500,000 each should be classified as temporary investments. 9. Postdated check of $125,000 should be reported as an accounts receivable. 10. The compensating balance of $500,000 requirement does not affect the balance in cash. A note disclosure indicating the arrangement and the amounts involved should be described in the notes.
Exercise 6.1 (Continued) *If not to be reimbursed, charge to prepaid expense. **If cash is present in another account in the same bank on which the overdraft occurred, offsetting is required. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.2 (10–15 minutes) 1.
Cash balance of $925,000. Only the checking account balance should be reported as cash. The certificate of deposit of $1,400,000 should be reported as a temporary investment, the cash advance to the subsidiary of $980,000 should be reported as a non-trade receivable, and the utility deposit of $180 should be identified as a non-trade receivable from the gas company.
2.
Cash balance is $584,650 computed as follows: Checking account balance Overdraft Petty cash Coins and currency
$600,000 (17,000) 300 1,350 $584,650
Cash held in a bond sinking fund of $200,000 is restricted. Assuming that the bonds are noncurrent, the restricted cash is also reported as noncurrent.
Exercise 6.2 (Continued) 3.
Cash balance is $599,800 computed as follows: Checking account balance Certified check from customer
$590,000 9,800 $599,800
The post-dated check of $11,000 should be reported as an account receivable. Cash restricted due to compensating balance of $100,000 should be described in a note indicating the type of arrangement and amount. Postage stamps on hand of $620 are reported as part of supplies or prepaid expenses. 4.
Cash balance is $85,000 computed as follows: Checking account balance Money market mutual fund
$37,000 48,000 $85,000
The NSF check received from the customer should be reported as an account receivable. 5.
Cash balance is $700,900 computed as follows: Checking account balance Cash advance received from customer
$700,000 900 $700,900
Cash restricted for future plant expansion of $500,000 should be reported as a noncurrent asset. Short-term Treasury bills of $180,000 should be reported as a temporary investment. Cash advance received from a customer of $900 should also be reported as a liability; cash advance of $7,000 to company executive should be reported as a receivable; refundable deposit of $26,000 paid to the federal government should be reported as a receivable. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.3 (10–15 minutes) Current assets Accounts receivable: Customers accounts (of which accounts in the amount of $40,000 have been pledged as security for a bank loan) Installment accounts collectible due in 2026 Installment accounts collectible due after December 31, 2026,* Other** ($2,640 + $1,500)
$79,000 23,000 34,000
$136,000 4,140
Non-trade receivables Advance to a subsidiary company
$140,140
81,000
*This classification assumes that these receivables are collectible within the operating cycle of the business. **These items could be separately classified, if considered material. LO: 2, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.4 (10–15 minutes) Computation of cost of goods sold: Merchandise purchased Less: Ending inventory Cost of goods sold
$320,000 90,000 $230,000
Exercise 6.4 (Continued) Selling price = 1.4 (Cost of goods sold) = 1.4 ($230,000*) = $322,000 Sales on account Less: Collections Uncollected balance Balance per ledger Apparent shortage
$322,000 198,000 124,000 82,000 $ 42,000 —Enough for a new car
LO: 2, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.5 (15–20 minutes) (a) (1) June 3 Accounts Receivable—Chester ................. Sales Revenue ...................................
3,000
June 12 Cash ($3,000 - $60) ..................................................................... ..................................................................... Sales Discounts ($3,000 X .02) ................... Accounts Receivable—Chester ........
2,940
(2) June 3 Accounts Receivable—Chester ................. Sales Revenue ($3,000 X .98) ............
2,940
June 12 Cash ............................................................. Accounts Receivable—Chester ........
2,940
3,000
60 3,000
2,940
2,940
Exercise 6.5 (Continued) (b)
July 29 Cash ......................................................... 3,000 Accounts Receivable—Chester .... 2,940 Sales Discounts Forfeited ............. 60* *($3,000 X .02) (Note to instructor: Sales discounts forfeited could have been recognized at the time the discount period lapsed. The company, however, would probably not record this forfeiture until final cash settlement.)
LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.6 (5–10 minutes) July 1
July 10
July 17
July 30
Accounts Receivable ................................ Sales Revenue ................................. Sales Returns and Allowances ................ Refund Liability………………….......
20,000
Cash ($20,000 - $600) ................................ Sales Discounts ($20,000 X .03) ............... Accounts Receivable ......................
19,400 600
Accounts Receivable ................................ Sales Revenue .................................
200,000
Cash .................................................................... .................................................................... Accounts Receivable ......................
200,000
20,000 1,300 1,300
20,000
200,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
200,000
Exercise 6.7 (10–15 minutes) (a)
Bad Debt Expense ...................................... Allowance for Doubtful Accounts .....
Step 1: Step 2:
(b)
Step 2:
3,000
.05 X $100,000 = $5,000 (desired credit balance in allowance account) $5,000 – $2,000 = $3,000 (required credit entry to bring allowance account to $5,000 credit balance)
Bad Debt Expense ...................................... Allowance for Doubtful Accounts .....
Step 1:
3,000
6,500 6,500
.05 X $100,000 = $5,000 (desired credit balance in allowance account) $5,000 + $1,500 = $6,500 (required credit entry to bring allowance account to $5,000 credit balance)
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.8 (5-10 minutes) (a)
Allowance for Doubtful Accounts .................. Accounts Receivable..............................
6,000 6,000
(b)
Accounts Receivable Less: Allowance for Doubtful Accounts Net amount expected to be collected
$800,000 40,000 $760,000
(c)
Accounts Receivable ($800,000 - $6,000) Less: Allowance for Doubtful Accounts ($40,000 - $6,000) Net amount expected to be collected
$794,000 34,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$760,000
Exercise 6.9 (8–10 minutes) (a)
(b)
Bad Debt Expense ........................................... Allowance for Doubtful Accounts.......... [($90,000 X .04) + $1,750]
5,350
Bad Debt Expense ........................................... Allowance for Doubtful Accounts.......... [($90,000 X .05) – $1,700]
2,800b
5,350
2,800
LO: 3, Bloom: AP, Difficulty: Simple, Time: 8-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.10 (10–12 minutes) (a)
The direct write-off approach used by Dickinson is not theoretically justifiable even though required for income tax purposes. The direct write-off method does not match expenses with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet.
(b)
Bad Debt Expense – ($77,000 X .12) = $9,240 Bad Debt Expense – Direct Write-Off = $31,330 ($7,800 + $6,700 + $7,000 + $9,830) Assuming accounts written off were for sales in a prior year, net income would be $22,090 ($31,330 – $9,240) higher under the percentage-of-receivables approach.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-12, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 6.11 (8–10 minutes) Balance 1/1 ($700 – $155) 4/12 (#2412) [($1,710 – $1,000 – $300*)] 11/18 (#5681) [($2,000 – $1,250)]
$ 545 Over one year 410 Eight months and 19 days 750 One month and 13 days $1,705
*($790 – $490) Since later invoices have been paid in full, all three of these amounts should be investigated to determine why Hopkins Co. has not paid them. The amounts in the beginning balance and #2412 should be of particular concern. LO: 3, Bloom: AP, Difficulty: Simple, Time: 8-10, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 6.12 (15–20 minutes) 7/1 Accounts Receivable—Harding Co. .................... Sales Revenue ($8,000 X .98) ......................
7,840
7/5 Cash [$9,000 - $810] ...................................................................... Loss on Sale of Receivables ($9,000 x .09) ......... Accounts Receivable ($9,000 X .98) ........... Sales Discounts Forfeited ($9,000 x .02) .....
8,190
7,840
810 8,820 180
(Note: It is possible that the company already recorded the Sales Discounts Forfeited. In this case, the credit to Accounts Receivable would be for $9,000. The same point applies to the next entry as well.)
Exercise 6.12 (Continued) 7/9
7/11
Accounts Receivable .................................. Sales Discounts Forfeited ($9,000 X .02)...................................
180
Cash ($6,000 - $360) .................................... Interest Expense ($6,000 X .06) .................. Notes Payable .....................................
5,640 360
Account Receivable—Harding Co. ............. Sales Discounts Forfeited.................. ($8,000 X .02)
160
180
6,000
160
This entry may be made the next time financial statements are prepared or it may be recorded on 12/29 when Harding Company’s receivable is adjusted. 12/29 Allowance for Doubtful Accounts .............. Accounts Receivable—Harding Co. .... [$7,840 + $160 = $8,000; $8,000 – (.10 X $8,000) = $7,200]
7,200
LO: 2, 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
7,200
Exercise 6.13 (10–15 minutes) 1.
7/1/25
Notes Receivable ................................ Discount on Notes Receivable . Land............................................ Gain on Disposal of Land ......... ($700,000 – $590,000)
1,101,460 401,460 590,000 110,000
Computation of the discount $1,101,460 Face value of note .63552 Present value of 1 for 4 periods at 12% 700,000 Present value of note 1,101,460 Face value of note $ 401,460 Discount on notes receivable 2.
7/1/25
Notes Receivable ................................ Discount on Notes Receivable . Service Revenue ........................
400,000.00 178,836.32 221,163.68
Computation of the present value of the note: Maturity value $400,000.00 Present value of $400,000 due in 8 years at 12%—$400,000 X .40388 $161,552.00 Present value of $12,000 ($400,000 X .03) payable annually for 8 years at 12% annually—$12,000 X 4.96764 59,611.68 Present value of the note 221,163.68 Discount on notes receivable $178,836.32 LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.14 (20–25 minutes) (a)
Notes Receivable ............................................ Discount on Notes Receivable .............. ($200,000 - $165,290*) Service Revenue ....................................
200,000 34,710 165,290*
*Computation of present value of note: PV of $200,000 due in 2 years at 10% $200,000 X .82645 = $165,290 (b)
Discount on Notes Receivable ....................... Interest Revenue ...................................
16,529** 16,529
$165,290* X .10 = $16,529** (c)
Discount on Notes Receivable ....................... Interest Revenue ....................................
18,181*** 18,181
***($34,710 – $16,529) or [($165,290 + $16,529) X .10] Cash .......................................................................... .......................................................................... Notes Receivable ..................................
200,000
200,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.15 (10–15 minutes) (a)
Cash ($200,000 - $8,000*) ............................... Interest Expense ($400,000 x .02) .................. Notes Payable ........................................
192,000 8,000* 200,000
(b)
Cash ................................................................ Accounts Receivable.............................
350,000 350,000
Exercise 6.15 (Continued) (c)
Notes Payable .............................................. Interest Expense .......................................... Cash ($200,000 + $5,000)....................
200,000 5,000* 205,000
*($200,000 X .10 X 3/12) LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.16 (15–18 minutes) 1.
2.
3.
4.
Cash ($25,000 - $2,500) ................................ Loss on Sale of Receivables ........................ ($25,000 X .10) Accounts Receivable ...........................
22,500 2,500
Cash ($55,000 - $4,400) ................................ Interest Expense ($55,000 X .08) .................. Notes Payable ......................................
50,600 4,400
Bad Debt Expense ........................................ Allowance for Doubtful Accounts....... [($82,000 X .05) + $2,120]
6,220
Bad Debt Expense ........................................ Allowance for Doubtful Accounts....... ($5,800 – $1,100)
4,700
25,000
55,000
6,220
LO: 2, 3, 5, Bloom: AP, Difficulty: Simple, Time: 15-18, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
4,700
Exercise 6.17 (10–15 minutes) Computation of net proceeds: Cash received Less: Recourse liability Net proceeds
$160,000 1,000 $159,000
Computation of gain or loss: Carrying value Net proceeds Loss on sale of receivables
$200,000 159,000 $ 41,000
The following journal entry would be made: Cash .................................................................. Loss on Sale of Receivables ........................... Recourse Liability .................................... Accounts Receivable ...............................
$160,000 41,000 1,000 200,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.18 (15–20 minutes) (a) To be recorded as a sale, all of the following conditions would be met: (1) The transferred asset has been isolated from the transferor (put beyond the reach of the transferor and its creditors). (2) The transferees have obtained the right to pledge or to exchange either the transferred assets or beneficial interests in the transferred assets. (3) The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.
Exercise 6.18 (Continued) (b) Computation of net proceeds: Cash received [$175,000 X (1 - .04 - .02)] Receivable from factor ($175,000 X .04) Less: Recourse liability Net proceeds
$164,500 7,000
Computation of gain or loss: Carrying value Net proceeds Loss on sale of receivables The following journal entry would be made: August 15 Cash ............................................................ Receivable from Factor .............................. Loss on Sale of Receivables ..................... Recourse Liability .............................. Accounts Receivable .........................
$171,500 2,000 $169,500
$175,000 169,500 $ 5,500
164,500 7,000 5,500 2,000 175,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.19 (10–15 minutes) (a) July 1
Cash ($300,000 - $12,000 - $4,500) ....... Receivable from Factor ......................... Loss on Sale of Receivables ................. Accounts Receivable....................
283,500 12,000* 4,500** 300,000
Exercise 6.19 (Continued) (b) July 1
Accounts Receivable ............................ Due to Customer (JFK Corp.)...... Interest Revenue .......................... Cash ($300,000 - $12,000 - $4,500) ....
300,000 12,000* 4,500** 283,500
**(.04 X $300,000) = $12,000 **(.015 X $300,000) = $4,500 LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.20 (10–15 minutes) (a) Accounts Receivable ........................................ Sales Revenue ..........................................
100,000
Cash ............................................................................ ............................................................................ Accounts Receivable ...............................
70,000
(b)
Accounts Receivable Turnover Net Sales Average Accounts Receivable (net)
= =
100,000
70,000 Net Sales
Average Accounts Receivable (net)
$100,000 = 3.33 times ($15,000 + $45,000*)/2 *$15,000 + $100,000 – $70,000
Days to collect accounts receivable (c)
=
365 = 109.61 days 3.33
Jones Company’s accounts receivable turnover has declined significantly. That is, it is turning receivables 3.33 times a year and collections on receivables took 110 days. In the prior year, the turnover was almost double (6.0) and collections took only 61 days. This is a bad trend in liquidity. Jones should consider offering early payment discounts and/or tightened credit and collection policies.
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 6.21 (10-15 minutes) (a) Cash [$25,000 X (1 – .09)] ................................................................... Receivable from Factor ..................................... Loss on Sale of Accounts Receivable ............. Accounts Receivable ............................... Recourse Liability ....................................
22,750b 1,250a 2,200d 25,000 1,200
Computation of cash received Accounts receivable .................................. Less: Receivable from factor (.05 X $25,000) ........................ Finance charge (.04 X $25,000)
$25,000 1,250a 1,000 $22,750b
Cash received ...................................... Computation of net proceeds (cash and other assets received, less any liabilities incurred) Cash received ............................................. Receivable from factor ............................... Less: Recourse liability ............................. Net proceeds........................................
$22,750b 1,250a
Computation of loss Carrying (Book) value ................................ Less: Net proceeds .................................... Loss on sale of receivables ................ (b)
Accounts Receivable Turnover
Net Sales Average Accounts Receivable (net)
$24,000 1,200 $22,800c
$25,000 22,800c $ 2,200d
Net Sales Average Accounts Receivable (net)
=
$100,000 = 5.71 times ($15,000 + $20,000*)/2
=
*($15,000 + $100,000 – $70,000 – $25,000) Days to collect accounts receivable =
365 = 63.92 days 5.71
Exercise 6.21 (Continued) With the factoring transaction, Jones Company’s turnover ratio still declines but by less than in the earlier exercise. While Jones’ collections have slowed, by factoring the receivables, Jones can convert them to cash. The cost of this approach to converting receivables to cash is captured in the Loss on Sale of Accounts Receivable account. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 6.22 (5–10 minutes) 1.
2.
3.
April 1 Petty Cash ................................................ Cash.................................................
200
April 10 Freight-In (or Inventory) .......................... Supplies Expense .................................... Postage Expense ..................................... Accounts Receivable—Employees......... Miscellaneous Expense........................... Cash Over and Short ($173 - $171) ......... Cash ($200 – $27)............................ *[($60 + $25 + $33 + $17 + $36) - $173]
60 25 33 17 36 2*
April 20 Petty Cash ................................................ Cash.................................................
100
200
173
LO: 6, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
100
*Exercise 6.23 (10–15 minutes) Accounts Receivable—Employees ..................... 74.00 ($40.00 + $34.00) Owner’s Drawings** ............................................. 170.00 Office Supplies Expense ...................................... 14.35 Postage Expense ($20.00 – $2.90) ....................... 17.10 Prepaid Postage ................................................... 2.90 Cash Over and Short ............................................ 6.45* Cash ($300.00 – $15.20) .............................. *[($74.00 + $170.00 + $14.35 + $17.10 + $2.90) - $284.80] **Note: This debit might also be made to the capital account.
284.80
LO: 6, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 6.24 (15–20 minutes) (a)
Angela Lansbury Company Bank Reconciliation July 31
Balance per bank statement, July 31 Add: Deposits in transit Deduct: Outstanding checks Correct cash balance, July 31
$8,650 2,350a (1,100)b $9,900
Balance per books, July 31 Add: Collection of note Less: Bank service charge NSF check Correct cash balance, July 31
$9,250 1,000 $ 15 335
(350) $9,900
*Exercise 6.24 (Continued) Computation of deposits in transit Deposits per books Deposits per bank in July Less deposits in transit (June) Deposits mailed and received in July Deposits in transit, July 31
$5,810 $5,000 (1,540) (3,460) $2,350a
Computation of outstanding checks Checks written per books $3,100 Checks cleared by bank in July $4,000 Less outstanding checks (June)* (2,000) Checks written and cleared in July (2,000) Outstanding checks, July 31 $1,100b *Assumed to clear bank in July (b) Cash ($1,000 - $15 - $335) ................................. Office Expenses—bank service charges ......... Accounts Receivable ........................................ Notes Receivable ......................................
650 15 335
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
1,000
*Exercise 6.25 (15–20 minutes) (a)
Logan Bruno Company Bank Reconciliation, August 31, 2025 County National Bank
Balance per bank statement, August 31, 2025 Add: Cash on hand Deposits in transit
$ 8,089 $ 310 3,800
4,110
Deduct: Outstanding checks
12,199 1,050
Correct cash balance
$11,149
Balance per books, August 31, 2025 ($10,050 + $35,000 – $34,903) Add: Note ($1,000a) and interest ($40b) collected
$10,147 1,040 11,187
Deduct: Bank service charges Understated check for supplies ($164.50 - $146.50) Correct cash balance
$ 20 18
(b) Cash .......................................................................... Notes Receivable............................................. Interest Revenue ............................................. (To record collection of note and interest)
1,040
38 $11,149
1,000 40
*Exercise 6.25 (Continued) Office Expense—bank service charges .................. Cash ................................................................. (To record August bank charges)
20
Supplies Expense ..................................................... Cash ................................................................. (To record error in recording check for supplies)
18
20
18
(c) The correct cash balance of $11,149 would be reported in the August 31, 2025, balance sheet. LO: 6, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 6.26 (15-25 minutes) (a)
Journal entry to record issuance of loan by Paris Bank: December 31, 2025 Notes Receivable ..................................................... 100,000 Discount on Notes Receivable ..................... ($100,000 - $62,092a) Cash................................................................
37,908 62,092
$100,000 X Present value of 1 for 5 periods at 10% $100,000 X .62092 = $62,092a (b)
Note Amortization Schedule (Before Impairment)
Date 12/31/25 12/31/26 12/31/27
Cash Received (0%) $0 0
Interest Revenue (10%) $6,209 6,830
Increase in Carrying Amount
Carrying Amount of Note
$6,209 6,830
$62,092 68,301 75,131
*Exercise 6.26 (Continued) Computation of the impairment loss: Carrying amount of investment (12/31/27)................. Less: Present value of $75,000 due in 3 years at 10% ($75,000 X .75132) ................................ Loss due to impairment ..............................................
$75,131 56,349 $18,782
The entry to record the loss by Paris Bank is as follows: Bad Debt Expense .................................................... Allowance for Doubtful Accounts ..................
18,782 18,782
Note: Iva Majoli Company, the debtor, makes no entry because it still legally owes $100,000. LO: 7, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 6.27 (15-25 minutes) (a) Cash received by Conchita Martinez Company on December 31, 2025: Present value of principal of $1,000,000 due in 5 years at 12% ($1,000,000 X .56743) ..................... Present value of interest of $100,000* ($1,000,000 X .10) due in 5 years at 12% ($100,000 X 3.60478) ................................................. Cash received .............................................................. (b)
$567,430 360,478 $927,908
Note Amortization Schedule (Before Impairment)
Date 12/31/25 12/31/26 12/31/27
Cash Received (10%) $100,000 100,000
Interest Revenue (12%) $111,349 112,711
Increase in Carrying Amount
Carrying Amount of Note
$11,349 12,711
$927,908 939,257 951,968
*Exercise 6.27 (Continued) (c) Loss due to impairment: Carrying amount of loan (12/31/27) ................ $951,968b Less: Present value of $600,000 due in 3 years at 12% ($600,000 X .71178) ..... $427,068 Present value of $100,000 payable annually for 3 years at 12% ($100,000 X 2.40183) ..... 240,183 667,251 Loss due to impairment .................................. $284,717 LO: 7, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Time and Purpose of Problems Problem 6.1 (Time 20–25 minutes) Purpose—provides the student with an understanding of the balance sheet effect that occurs when the cash book is left open. In addition, the student is asked to adjust the present balance sheet to an adjusted balance sheet, reflecting the proper cash presentation. Problem 6.2 (Time 20–25 minutes) Purpose—provides the student with the opportunity to determine various items related to accounts receivable and the allowance for doubtful accounts. Five independent situations are provided. Problem 6.3 (Time 20–30 minutes) Purpose—provides a short problem related to the aging of accounts receivable. The appropriate balance for doubtful accounts must be determined. In addition, the manner of reporting accounts receivable on the balance sheet must be shown. Problem 6.4 (Time 25–35 minutes) Purpose—the student prepares an analysis of the changes in the allowance for doubtful accounts and supports it with an aging schedule. Problem 6.5 (Time 20–30 minutes) Purpose—a short problem that must be analyzed to make the necessary correcting entries. It is not a pencil-pushing problem but requires a great deal of conceptualization. A good problem for indicating the types of adjustments that might occur in the receivables area. Problem 6.6 (Time 25–35 minutes) Purpose—provides the student with a number of business transactions related to accounts receivable that must be journalized. Recoveries of receivables and write-offs are the types of transactions presented. The problem provides a good cross-section of a number of accounting issues related to receivables. Problem 6.7 (Time 30–35 minutes) Purpose—provides the student with a simple note receivable problem with no imputation of interest. Problem 6.8 (Time 30–35 minutes) Purpose—provides the student with a problem requiring the imputation of interest. The student is required to make journal entries on a series of dates when note installments are collected. A relatively straightforward problem. Problem 6.9 (Time 40–50 minutes) Purpose—the student calculates the current portion of long-term receivables and interest receivable, and prepares the long-term receivables section of the balance sheet. Then the student prepares a schedule showing interest income. The problem includes interest-bearing and zero-interest-bearing notes and an installment receivable. Problem 6.10 (Time 25–30 minutes) Purpose—a short problem involving the reporting problems associated with the assignment of accounts receivable. The student is required to make the journal entries necessary to record an assignment. A straightforward problem. Problem 6.11 (Time 20–25 minutes) Purpose—provides the student the opportunity to determine the income statement effects of receivables transactions.
Time and Purpose of Problems (Continued) *Problem 6.12 (Time 20–25 minutes) Purpose—provides the student with the opportunity to do the accounting for petty cash and a bank reconciliation. *Problem 6.13 (Time 20–30 minutes) Purpose—provides the student with the opportunity to prepare a bank reconciliation that is reconciled to a corrected balance. Traditional types of adjustments are presented. Journal entries are also required. *Problem 6.14 (Time 20–30 minutes) Purpose—provides the student with the opportunity to prepare a bank reconciliation that goes from balance per bank to corrected balance. Traditional types of adjustments are presented such as deposits in transit, bank service charges, NSF checks, and so on. Journal entries are also required. *Problem 6.15 (Time 30–40 minutes) Purpose—provides the student with a loan situation that requires entries by both the debtor and the creditor and an analysis of the loss on impairment.
Solutions to Problems Problem 6.1
(a) December 31 (1) Accounts Receivable ($17,640 + $360) .... Sales Revenue ........................................... Cash .................................................. Sales Discounts................................
18,000 28,000 45,640 360
December 31 (2) Cash .................................................................... .................................................................... Purchase Discounts .................................. Accounts Payable ............................ (b)
22,200 250 22,450 Per Balance After Sheet Adjustment
Current assets Cash ($39,000 – $45,640 + $22,200) .... Accounts Receivable ($42,000 + $18,000) ......................... Inventory .............................................. Total ................................................
$ 39,000
$ 15,560
42,000 67,000 (1) 148,000
60,000 67,000 142,560
Current liabilities Accounts payable ($45,000 + $22,450) .......................... 45,000 Other current liabilities ....................... 14,200 Total ................................................ (2) 59,200 Working capital .................................... (1) – (2) $ 88,800
67,450 14,200 81,650 $ 60,910
Current ratio............................................... (1) ÷ (2) 2.5 to 1
1.75 to 1
LO: 1, Bloom: AN, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 6.2
1. Accounts receivables .......................................................... Percentage estimate ............................................................ Allowance needed ............................................................... Allowance (Dr)....................................................................... Bad Debt Expense................................................................
$
2. Accounts receivable ............................................................ Amounts estimated to be uncollectible.............................. Net realizable value..............................................................
$1,750,000 (180,000) $1,570,000
3. Allowance for doubtful accounts 1/1/25 ............................. Collection of accounts written off in prior years ............... Customer accounts written off in 2025 .............................. Bad debt expense for 2025…………………………………… Allowance for doubtful accounts 12/31/25 .........................
$
$
17,000 8,000 (30,000) 57,000 52,000
4. Bad debt expense for 2025.................................................. Customer accounts written off as uncollectible during 2025....................................................................... Allowance for doubtful accounts balance 12/31/25...........
$
84,000
$
(24,000) 60,000
Accounts receivable, net of allowance for doubtful accounts ...................................................... Allowance for doubtful accounts balance 12/31/25........... Accounts receivable, before deducting allowance for doubtful accounts .................................... 5. Accounts receivable ............................................................ Percentage estimate ............................................................ Bad debt expense, before adjustment ............................... Allowance for doubtful accounts (debit balance).............. Bad debt expense, as adjusted ........................................... LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$
53,000 7% 3,710 4,000 7,710
$ 950,000 60,000 $1,010,000 $ 310,000 3% 9,300 14,000 $ 23,300
Problem 6.3 (a)
The Allowance for Doubtful Accounts should have a balance of $45,000 at year-end. The supporting calculations are shown below:
Expected Days Account Percentage Outstanding Amount Uncollectible 0–15 days $300,000 1 - .98 = .02 16–30 days 100,000 1 - .90 = .10 31–45 days 80,000 1 - .85 = .15 46–60 days 40,000 1 - .80 = .20 61–75 days 20,000 1 - .55 = .45 Balance for Allowance for Doubtful Accounts
Estimated Uncollectible $ 6,000 10,000 12,000 8,000 9,000 $45,000a
The accounts which have been outstanding over 75 days ($15,000) and have zero probability of collection would be written off immediately by debing Allowance for Doubtful Accounts for $15,000 and crediting Accounts Receivable for $15,000. These accounts are not considered when determining the proper amount for the Allowance for Doubtful Accounts. (b)
Accounts receivable ($555,000 – $15,000) ........................ Less: Allowance for doubtful accounts ........................... Accounts receivable (net) ..................................................
(c)
The year-end bad debt adjustment would decrease before-tax income $20,000 as computed below: Estimated amount required in the Allowance for Doubtful Accounts ...................................................... Balance in the account after write-off of uncollectible accounts but before adjustment ($40,000 – $15,000) ..... Required charge to expense ................................................
$540,000 45,000 $495,000
$45,000 25,000 $20,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 6.4 (a)
FORTNER CORPORATION Analysis of Changes in the Allowance for Doubtful Accounts For the Year Ended December 31, 2025
Balance at January 1, 2025.............................................. Provision for doubtful accounts ..................................... Recovery in 2025 of bad debts written off previously ...
$130,000 180,000 15,000 325,000 150,000
Deduct write-offs for 2025 ($90,000 + $60,000) .............. Balance at December 31, 2025, before change in accounting estimate ................................................ Increase due to change in accounting estimate during 2025 ($263,600 – $175,000) .............................. Balance at December 31, 2020, adjusted (Schedule 1)..
175,000 88,600 $263,600*
Schedule 1 Computation of Allowance for Doubtful Accounts at December 31, 2025 Aging Category Nov.–Dec. July–Oct. Jan.–June Prior to 1/1/20
Balance
%
$1,080,000 650,000 420,000 90,000(a)
2 10 25 80
Doubtful Accounts $ 21,600 65,000 105,000 72,000 $263,600*
(a) $150,000 – $60,000 (b) The journal entry to record this transaction is as follows: Bad Debt Expense ........................................ Allowance for Doubtful Accounts ........... (To increase the allowance for doubtful accounts at December 31, 2025, resulting from a change in accounting estimate)
88,600
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
88,600
Problem 6.5 Bad Debt Expense .................................................. Accounts Receivable .................................... (To correct bad debt expense and write off accounts receivable)
3,240
Accounts Receivable ............................................. Unearned Sales Revenue .............................. (To reclassify credit balance in accounts receivable)
4,840
Allowance for Doubtful Accounts ......................... Accounts Receivable .................................... (To write off $3,700 of uncollectible accounts)
3,700
3,240
4,840
3,700
(Note to instructor: Many students will not make this entry at this point. Because $3,700 is totally uncollectible, a write-off immediately seems most appropriate. The remainder of the solution, therefore, assumes that the student made this entry.) Allowance for Doubtful Accounts ......................... Bad Debt Expense ......................................... (To reduce allowance for doubtful account balance)
7,279.64
Balance ($8,750 + $18,620 – $3,240 – $3,700) ........ Corrected balance (see below) ............................... Adjustment...............................................................
$20,430.00 13,150.36a $ 7,279.64
7,279.64
Age
Balance
Aging Schedule
Under 60 days 60–90 days 91–120 days Over 120 days
$172,342 141,330 ($136,490 + $4,840) 36,684 ($39,924 – $3,240) 19,944 ($23,644 – $3,700)
1% 3% 6% 25%
$ 1,723.42 4,239.90 2,201.04 4,986.00 $13,150.36a
Problem 6.5 (Continued) If the student did not make the entry to record the $3,700 write-off earlier, the following would change in the problem. After the adjusting entry for $7,279.64, an entry would have to be made to write off the $3,700. Balance ($8,750 + $18,620 – $3,240) ............... Corrected balance (see below) ....................... Adjustment .......................................................
$24,130.00 16,850.36b $ 7,279.64
Age
Balance
Aging Schedule
Under 60 days 60–90 days 91–120 days Over 120 days
$172,342 141,330 36,684 23,644
1% 3% 6% —
$ 1,723.42 4,239.90 2,201.04 8,686.00* $16,850.36b
*$3,700 + (25% X $19,944) LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 6.6 –1– Cash ($138,000 - $1,200) .......................................... Sales Discounts ($60,000 X.02) ............................... Accounts Receivable ......................................
136,800 1,200
–2– Accounts Receivable ............................................... Allowance for Doubtful Accounts ..................
5,300
Cash .......................................................................... Accounts Receivable ...................................... –3– Allowance for Doubtful Accounts ........................... Accounts Receivable ...................................... –4– Bad Debt Expense .................................................... Allowance for Doubtful Accounts .................. *($17,300 + $5,300 – $17,500 = $5,100; $20,000 – $5,100 = $14,900)
138,000
5,300 5,300 5,300 17,500 17,500 14,900
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
14,900*
Problem 6.7 10/1/25 12/31/25
Notes Receivable................................... Sales Revenue ..............................
120,000
Interest Receivable................................ Interest Revenue ..........................
2,400*
120,000 2,400
*$120,000 X .08 X 3/12 = $2,400 10/1/26
Cash ....................................................... Interest Receivable ($9,600 - $7,200) .. Interest Revenue ..........................
9,600* 2,400 7,200**
*$120,000 X .08 = $9,600 **$120,000 X .08 X 9/12 = $7,200 12/31/26 10/1/27
Interest Receivable................................ Interest Revenue ..........................
2,400
Cash ....................................................... Interest Receivable ($9,600 - $7,200) .. Interest Revenue ..........................
9,600*
Cash ....................................................... Notes Receivable .........................
120,000
2,400 2,400 7,200** 120,000
*$120,000 X .08 = $9,600 **$120,000 X .08 X 9/12 = $7,200 Note: Entries at 10/1/26 and 10/1/27 assume reversing entries were not made on January 1, 2026, and January 1, 2027. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 6.8 (a)
Date
12/31/25 12/31/26 12/31/27 12/31/28 12/31/29
a
December 31, 2025 Schedule of Note Discount Amortization Cash Received
Interest Revenue (11%)
Decrease Carrying Amount
(1)
(2)
(1) - (2)
— $20,000 20,000 20,000 20,000
— a $6,825 5,376 3,768 1,982
Carrying Amount of Note $62,049 b 48,874 34,250 18,018 —
$13,175 14,624 16,232 18,018
$6,825 = $62,049 X .11 $48,874 = $62,049 + $6,825 – $20,000
b
Cash ...................................................................... Notes Receivable .................................................. Discount on Notes Receivable ................... ($80,000 - $62,049) Service Revenue ..........................................
40,000 80,000 17,951 102,049
To record revenue at the present value of the note plus the immediate cash payment: PV of $20,000 annuity at 11% for 4 years ($20,000 X 3.10245)............ $ 62,049 Down payment ................................... 40,000 Capitalized value of services ............ $102,049 (b)
December 31, 2026 Cash ........................................................................... Notes Receivable.............................................. Discount on Notes Receivable ................................. Interest Revenue ..............................................
20,000 20,000 6,825 6,825
Problem 6.8 (Continued) (c)
December 31, 2027 Cash........................................................................... Notes Receivable ............................................. Discount on Notes Receivable ................................ Interest Revenue..............................................
(d)
December 31, 2028 Cash........................................................................... Notes Receivable ............................................. Discount on Notes Receivable ................................ Interest Revenue..............................................
(e)
December 31, 2029 Cash........................................................................... Notes Receivable ............................................. Discount on Notes Receivable ................................ Interest Revenue..............................................
20,000 20,000 5,376 5,376 20,000 20,000 3,768 3,768 20,000 20,000 1,982
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
1,982
Problem 6.9 (a)
BRADDOCK INC. Long-Term Receivables Section of Balance Sheet December 31, 2025
9% note receivable from sale of division, due in annual installments of $500,000 to May 1, 2027, less current installment ............... 8% note receivable from officer, due Dec. 31, 2027, collateralized by 10,000 shares of Braddock, Inc., common stock with a fair value of $450,000 (10,000 X $45)...... Zero-interest-bearing note from sale of patent, net of 12% imputed interest, due April 1, 2027........................................................ Installment contract receivable, due in annual installments of $45,125 to July 1, 2026, less current installment ..................................... Total long-term receivables............................ (b)
$ 500,000
(1)
400,000
86,873
(2)
110,275 $1,097,148
(3)
BRADDOCK INC. Selected Balance Sheet Balances December 31, 2025
Current portion of long-term receivables: Note receivable from sale of division .................. Installment contract receivable............................ Total current portion of long-term receivables ................................................... Accrued interest receivable: Note receivable from sale of division .................. Installment contract receivable............................ Total accrued interest receivable...................
$500,000 29,725
(1) (3)
$529,725
$ 60,000 7,700 $ 67,700
(4) (5)
Problem 6.9 (Continued) (c)
BRADDOCK INC. Interest Revenue from Long-Term Receivables For the Year Ended December 31, 2025
Interest revenue: Note receivable from sale of division ...................... Note receivable from sale of patent ......................... Note receivable from officer ..................................... Installment contract receivable from sale of land .. Total interest revenue for year ended 12/31/25 .
$105,000 7,173 32,000 7,700 $151,873
(6) (2) (7) (5)
Explanation of Amounts (1) Long-term Portion of 9% Note Receivable at 12/31/25 Face amount, 5/1/24 .............................................. Less: Installment received 5/1/25 ....................... Balance, 12/31/25 .................................................. Less: Installment due 5/1/26 ............................... Long-term portion, 12/31/25 .................................
$1,500,000 500,000 1,000,000 500,000 $ 500,000
(2) Zero-interest-bearing Note, Net of Imputed Interest at 12/31/25 Face amount 4/1/25 ............................................... Less: Imputed interest [$100,000 – ($100,000 X 0.797)] ................ Balance, 4/1/25 ...................................................... Add: Interest earned to 12/31/25 ($79,700 X .12 X 9/12) ................................ Balance, 12/31/25 ..................................................
$ 100,000 20,300 79,700 $
7,173 86,873
Problem 6.9 (Continued) (3)
(4)
(5)
(6)
(7)
Long-term Portion of Installment Contract Receivable at 12/31/25 Contract selling price, 7/1/25 ................................ Less: Down payment, 7/1/25 ................................ Balance, 12/31/25 ................................................... Less: Installment due, 7/1/26 [$45,125 – ($140,000 X .11)]........................ Long-term portion, 12/31/25 ..................................
$ 200,000 60,000 140,000 29,725 $ 110,275
Accrued Interest—Note Receivable, Sale of Division at 12/31/25 Interest accrued from 5/1 to 12/31/25 ($1,000,000 X .09 X 8/12) .....................................
$
60,000
Accrued Interest—Installment Contract at 12/31/25 Interest accrued from 7/1 to 12/31/25 ($140,000 X .11 X 1/2) ..........................................
$
7,700
$
45,000
Interest Revenue—Note Receivable, Sale of Division, for 2020 Interest earned from 1/1 to 5/1/25 ($1,500,000 X.09 X 4/12) ...................................... Interest earned from 5/1 to 12/31/25 ($1,000,000 X .09 X 8/12) ..................................... Interest income ...................................................... Interest Revenue—Note Receivable, Officer, for 2025 Interest earned 1/1 to 12/31/25 ($400,000 X .08) ...................................................
60,000 $ 105,000
$
LO: 4, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 6.10
32,000
July 1, 2025 Cash ($120,000 - $750) ..................................................... Interest Expense (.005 X $150,000) ................................. Notes Payable (.80 X $150,000) ..............................
119,250 750
July 31, 2025 Notes Payable ................................................................... Accounts Receivable ..............................................
80,000
Interest Expense ............................................................... Interest Payable [.005 X ($150,000 - $80,000)] ....... August 31, 2025 Notes Payable ($120,000 - $80,000) ................................. Cash* ................................................................................. Interest Expense [.005 X ($150,000 – $80,000 – $50,000)] ........................................................ Interest Payable ................................................................ Accounts Receivable .............................................. *Total cash collection ....................................................... Less: Interest payable (from previous entry) ................ Interest expense (current month) [.005 X ($150,000 – $80,000 – $50,000)] .......................... Notes payable (balance) ($120,000 – $80,000) ..... Cash collected ..................................................................
120,000
80,000 350 350 40,000 9,550 100 350 50,000 $50,000 (350) (100) (40,000) $ 9,550
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 6.11 SANDBURG COMPANY Income Statement Effects For the Year Ended December 31, 2025 Expenses resulting from accounts receivable assigned (Schedule 1) ............................................ Loss resulting from accounts receivable sold ($300,000 – $270,000) ..................................... Total expenses.....................................................
$22,320 30,000 $52,320
Schedule 1 Computation of Expense for Accounts Receivable Assigned Assignment expense: Accounts receivable assigned ........................... Advance by Keller Finance Company ................
$400,000 X .80 320,000 X .03
Interest expense ........................................................ Total expenses ..................................................... LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$ 9,600 12,720 $22,320
*Problem 6.12 (a)
(b)
May 10 Petty Cash................................................. Cash ...............................................
250.00
May 31 Postage Expense...................................... Supplies .................................................... Accounts Receivable (Employees) ......... Freight-Out................................................ Advertising Expense ................................ Miscellaneous Expense ........................... Cash ($250.00 – $26.40) .................
33.00 65.00 30.00 57.45 22.80 15.35
May 31 Petty Cash.................................................. Cash ................................................
50.00
Balances per bank: ................................................. Add: Cash on hand ................................................. Deposit in transit ............................................
250.00
223.60
50.00 $6,522 $ 246 3,000
Deduct: Checks outstanding .................................. Correct cash balance, May 31 ....................... Balance per books: ................................................. Add: Note receivable (collected with interest) .....
3,246 9,768 850 $8,918 $8,015* 930 8,945 27 $8,918
Deduct: Bank service charges .............................. Correct cash balance, May 31 ....................... *($8,850 + $31,000 – $31,835)
(c)
Cash ......................................................................... Notes Receivable ........................................... Interest Revenue ............................................
930
Office Expense (bank charges) .............................. Cash ................................................................
27
$8,918 + $300 (Petty Cash) = $9,218.
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
900 30 27
*Problem 6.13 (a)
AGUILAR CO. Bank Reconciliation June 30, 2025
Balance per bank, June 30 ........................................ Add: Deposits in transit............................................ Deduct: Outstanding checks.................................... Correct cash balance, June 30..................................
$4,150.00 3,390.00 (2,136.05) $5,403.95
Balance per books, June 30 ...................................... Add: Error in recording deposit ($90 – $60) ........... Error on check no. 747 ($582.00 – $58.20) ......................................... Note collection ($1,200 + $36).........................
$3,969.85
Deduct: NSF check ................................................... Error on check no. 742 ($491 – $419) ......... Bank service charges ($25 + $5.50) ...........
$
30.00 523.80 1,236.00 253.20 72.00 30.50
Correct cash balance, June 30..................................
1,789.80 5,759.65 (355.70) $5,403.95
(b) Cash ..................................................................... Accounts Receivable .................................... Accounts Payable ......................................... Notes Receivable .......................................... Interest Revenue ...........................................
1,789.80
Accounts Receivable .......................................... Accounts Payable ............................................... Office Expense (bank charges) .......................... Cash ...............................................................
253.20 72.00 30.50
30.00 523.80 1,200.00 36.00
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
355.70
*Problem 6.14 (a)
HASELHOF INC. Bank Reconciliation November 30
Balance per bank statement, November 30 .. Add: Cash on hand, not deposited ................... Deduct: Outstanding checks #1224.................................................... #1230.................................................... #1232.................................................... #1233.................................................... Correct cash balance, Nov. 30 .......................
$56,274.20 1,915.40 58,189.60
$
1,635.29 2,468.30 2,125.15 482.17
Balance per books, November 30 .................. Add: Bond interest collected by bank .............. Deduct: Bank charges not recorded in books ...... Customer’s check returned NSF.............. Correct cash balance, Nov. 30 ....................... *Computation of balance per books, November 30 Balance per books, October 31 ................ Add receipts for November ....................... Deduct disbursements for November ...... Balance per books, November 30 ........... 0
6,710.91 $51,478.69 $50,478.22* 1,400.00 51,878.22
$
27.40 372.13
$ 41,847.85 173,523.91 215,371.76 164,893.54 $ 50,478.22
399.53 $51,478.69
*Problem 6.14 (Continued) (b)
November 30 Cash .......................................................................... Interest Revenue .............................................
1,400.00
November 30 Office Expense (bank charges) ............................... Cash .................................................................
27.40
November 30 Accounts Receivable ............................................... Cash .................................................................
372.13
1,400.00
27.40
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
372.13
*Problem 6.15 (a)
The entries for the issuance of the note on January 1, 2025: The present value of the note is: $1,200,000 X .68058 (PVF5, 8%) = $816,700 (Rounded by $4). Botosan Company (Debtor): Cash ................................................................ Discount on Notes Payable ........................... Notes Payable ...........................................
816,700 383,300 1,200,000
National Organization Bank (Creditor): Notes Receivable ............................................ 1,200,000 Discount on Notes Receivable ................. Cash ...........................................................
383,300 816,700
(b) Schedule of Interest and Discount Amortization Effective-Interest Method $1,200,000 Note Issued to Yield 8%
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 Total
Cash Paid
$0 0 0 0 0 $0
Interest Expense (8%) $ 65,336* 70,563 76,208 82,305 88,888 $383,300
*$816,700 X .08 = $65,336. **$816,700 + $65,336 = $882,036.
Discount Amortized
$ 65,336 70,563 76,208 82,305 88,888 $383,300
Carrying Amount of Note $ 816,700 882,036** 952,599 1,028,807 1,111,112 1,200,000
*Problem 6.15 (Continued) (c)
The note can be considered to be impaired only when it is probable that, based on current information and events, National Organization Bank will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan.
(d) The loss is computed as follows: Carrying amount of loan (12/31/26) ......................... Less: Present value of $800,000 due in 3 years at 8% ............................................. Loss due to impairment ........................................... a
$952,599a 635,064b $317,535
See amortization schedule in answer (b). $800,000 X .79383 = $635,064.
b
December 31, 2026 National Organization Bank (Creditor): Bad Debt Expense ........................................... Allowance for Doubtful Accounts ............
317,535 317,535
Note: Botosan Company (Debtor) has no entry. LO: 7, Bloom: N/A, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Financial Reporting Problem UYJ6.1 (a)
P&G has $16,181 billion in cash and cash equivalents. As disclosed in the Consolidated Statement of Cash Flows, P&G indicates that in the year ended 6/30/20 cash was used for capital expenditures ($3,073 million), cash dividends ($7,789 million), purchase of treasury stock ($7,405), and reductions of long-term debt ($2,447 million).
(b)
As indicated in Note 1, the company’s products are sold in more than 180 countries and territories primarily through mass merchandisers, ecommerce, grocery stores, membership club stores, drug stores, department stores, distributors, wholesalers, baby stores, specialty beauty stores (including airport duty-free stores), high-frequency stores, pharmacies, electronics stores, and professional channels. P&G has on-the-ground operations in approximately 70 countries. In fact, in its segment note (Note 2), P&G indicates that 15% of its sales in 2020 were to a single large customer—Walmart, Inc. Thus, to the extent that its customers have credit profiles similar to Walmart Inc., it is reasonable that bad debt expense might not be material.
LO: 1, Bloom: AN, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Comparative Analysis Case UYJ6.2 (a)
Cash and cash equivalents: ($ millions) at year-end 2020: Coca-Cola, $6,795
PepsiCo, $8,185
Coca-Cola classifies cash equivalents as “time deposits and other investments that are highly liquid and have maturities of three months or less at the date of purchase.” PepsiCo classifies cash equivalents as “highly liquid investments with original maturities of three months or less.” (b)
Accounts receivable (net): Coca-Cola, $3,144
PepsiCo, $6,892 - $201 = $6,691
Allowance for doubtful accounts: Coca-Cola, Balance, $526 Percent of receivables, 14.33%* *[$526 / ($3,144 + $526)] (c)
PepsiCo, Balance, $201 Percent of receivables, 2.92%** ** [$201 / $6,892
Accounts receivable turnover and days outstanding for receivables: Coca-Cola $33,014 $3,144 + $3,971 2
= 9.28 times
365 ÷ 9.28 = 39.3 days
PepsiCo $70,372 $6,691 + $6,342*** 2
= 10.80 times
365 ÷ 10.80 = 33.8 days ***$6,447 - $105
PepsiCo’s turnover ratio is higher, resulting in fewer days in receivables. It is likely that these companies use similar receivables management practices. LO: 1, 2, 7, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Financial Statement Analysis Case
UYJ6.3 Financial Statement Analysis Case (a)
Cash may consist of funds on deposit at the bank, negotiable instruments such as money orders, certified checks, cashier’s checks, personal checks, bank drafts, and money market funds that provide checking account privileges.
(b)
Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near their maturity that they present insignificant risk from changes in interest rates. Generally, only investments with original maturities of 3 months or less qualify. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds.
(c)
A compensating balance is that portion of any cash deposit maintained by an enterprise that constitutes support for existing borrowing arrangements with a lending institution. A compensating balance representing a legally restricted deposit held against short-term borrowing arrangements should be stated separately among cash and cash equivalent items. A restricted deposit held as a compensating balance against long-term borrowing arrangements should be separately classified as a noncurrent asset in either the investments or other assets section.
(d)
Short-term investments are investments held temporarily in place of cash that can be readily converted to cash when current financing needs make such conversion desirable. Examples of short-term investments include stock, Treasury notes, and other short-term securities. The major differences between cash equivalents and short-term investments are (1) cash equivalents typically have shorter maturities (less than three months) whereas short-term investments either have longer maturities (e.g., short-term bonds) or no maturity date (e.g., stock), and (2) cash equivalents are readily convertible to known amounts of cash whereas a company may have a gain or loss when selling its short-term investments.
Financial Statement Analysis Case - UYJ6.3 (Continued) (e)
Occidental would record a loss of $30,000,000 as revealed in the following entry to record the transaction: Cash .................................................. Loss on Sale of Receivables ........... Accounts Receivable ............ Recourse Liability ..................
(f)
345,000,000 30,000,000 360,000,000 15,000,000
The transaction in (e) will decrease Occidental’s liquidity position. Current assets decrease by $15,000,000 and current liabilities are increased by $15,000,000 (for the recourse liability).
LO: 1, 6, 7, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Financial Statement Analysis Case: Microsoft UYJ6.4 Part 1 (a)
Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash and (b) so near their maturity that they present insignificant risk from changes in interest rates. Generally, only investments with original maturities of 3 months or less qualify. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds.
(b) (in millions) (1) Current ratio (2) Working capital
Microsoft $181,915 $72,310
= 2.52
$181,915 – $72,310 = $109,605
Oracle $52,140 $17,200
= 3.03
$52,140 – $17,200 = $34,940
Oracle’s current ratio is higher. Based on these measures, Oracle is more liquid. (c)
Yes, a company can have too many liquid assets. Liquid assets earn little or no return. Investors in companies like Microsoft are accustomed to returns of 30% on their investment. Thus, Microsoft’s large amount of liquid assets may eventually create a drag on its ability to meet investor expectations.
Financial Statement Analysis Case – UYJ6.4 (Continued) Part 2 Current Year (a)
Receivables Turnover
$143,015 = $143,015 = 4.65 times ($32,011 + $29,524)/2 $30,768
Or a collection period of 78.5 days (365 ÷ 4.65). (b)
(c)
Bad Debt Expense ................................................ Allowance for Doubtful Accounts ..............
560
Allowance for Doubtful Accounts ....................... Accounts Receivable ..................................
178
560 178
Accounts receivable is reduced by the amount of bad debts in the allowance account. This makes the denominator of the turnover ratio lower, resulting in a higher turnover ratio.
LO: 2, 3, 7, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Accounting, Analysis, and Principles UYJ6.5 ACCOUNTING (a)
Accounts Receivable: Beginning balance
$ 46,000
Credit sales during 2025
255,000
Collections during 2025
(228,000)
Charge-offs
(1,600)
Factored receivables
(10,000)
Ending balance
$ 61,400
Allowance for Doubtful Accounts: Beginning balance
$ 550
Charge-offs
(1,600)
2025 Bad Debt Expense*
2,585
Ending balance
$1,535
*2025 Bad Debt Expense is the amount needed to make the ending balance in the Allowance for Doubtful Accounts equal to $1,535 ($61,400 X .025). In other words, $550 – $1,600 + Bad Debt Expense = $1,535. Therefore, Bad Debt Expense = $1,535 + $1,600 – $550 = $2,585. (b)
Current assets section of December 31, 2025, The Flatiron Pub’s balance sheet: Cash Accounts receivable (net of $1,535 allowance for uncollectibles) Interest receivable Due from factor Note receivable Postage stamps Other current assets Total current assets
$ 5,575 59,865 50 200 5,000 110 3,925 $74,725
Accounting, Analysis, and Principles - UYJ6.5 (continued)
Calculations: Cash = $1,575 + $4,000a = $5,575 Accounts receivable, net = $61,400 – $1,535 = $59,865 Interest receivable = ($5,000 X 0.12)(1/12) = $50 Due from factor = ($10,000 X 0.02) = $200 Other current assets = $7,925 - $4,000a ANALYSIS (a)
2025 current ratio = $74,725 ÷ ($44,600 + $400) = 1.66 Accounts Receivable Turnover
$255,000 $255,000 = 4.84 times = [($46,000 – $550) + 59,865] $52,658 2
Both the current ratio (2024 = ($2,000 + $46,000 - $550 + $8,500) ÷ $37,000 = 1.51) and the accounts receivable turnover (4.37) suggest that Flatiron’s liquidity has improved in 2025 relative to 2024. (b)
With a secured borrowing, the receivables would stay on The Flatiron Pub’s books and a note payable would be recorded. This would reduce both the current ratio and accounts receivable turnover.
PRINCIPLES The expense recognition principle requires that bad debt expense should be recorded in the period of the sale. Otherwise, income will be overstated by the amount of bad debt expense. In addition, reporting the receivables net of the allowance provides a more representationally faithful reporting (at net realizable value) of this asset. LO: 1, 3, 6, 7, Bloom: SYN, Difficulty: Moderate, 20-25, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking Cases CT 6.1 (Time 10–15 minutes) Purpose—provides the student with the opportunity to discuss the deficiencies of the direct write-off method, the justification for the allowance method for estimating bad debts, and to explain the accounting for the recoveries of accounts written off previously. CT 6.2 (Time 15–20 minutes) Purpose—provides the student with the opportunity to discuss the accounting for cash discounts, trade discounts, and the factoring of accounts receivable. CT 6.3 (Time 25–30 minutes) Purpose—provides the student with the opportunity to discuss the advantages and disadvantages of handling reporting problems related to the Allowance for Doubtful Accounts balance. Recommendations must be made concerning whether some type of allowance approach should be employed, how collection expenses should be handled, and finally, the appropriate accounting treatment for recoveries. A very complete case that should elicit a good discussion of this issue. CT 6.4 (Time 25–30 minutes) Purpose—provides the student the opportunity to discuss when interest revenue from a note receivable is reported. In Part 2, the student is asked to contrast the estimation of bad debts based on credit sales with that based on the balance in receivables and to describe the reporting of the allowance account and the bad debts expense. CT 6.5 (Time 20–25 minutes) Purpose—provides the student with a discussion problem related to notes receivable sold without and with recourse. CT 6.6 (Time 20–30 minutes) Purpose—provides the student the opportunity to account for a zero-interest-bearing note exchanged for a unique machine. The student must consider valuation, financial statement disclosure, and factoring the note. CT 6.7 (Time 25–30 minutes) Purpose—provides the student the opportunity to calculate interest revenue on an interest-bearing note and a zero-interest-bearing note, and indicate how the notes should be reported on the balance sheet. The student discusses how to account for collections on assigned accounts receivable and how to account for factored accounts receivable. CT 6.8 (Time 25–30 minutes) Purpose—provides the student with a case related to the imputation of interest. One company has overstated its income by not imputing an interest element on the zero-interest-bearing note receivable that it received in the transaction. We have presented a short analysis to indicate what the proper solution should be. It is unlikely that the students will develop a journal entry with dollar amounts, but they should be encouraged to do so. CT 6.9 (Time 25–30 minutes) Purpose—provides the student with a case to analyze receivables irregularities, including a shortage. This is a good writing assignment. CT 6.10 (Time 25–30 minutes) Purpose—provides the student with a case to analyze ethical issues inherent in bad debt judgments.
Solutions to Critical Thinking Cases CT 6.1 (a) The direct write-off method overstates the trade accounts receivable on the balance sheet by reporting them at more than the net amount expected to be collected. Furthermore, because the write-off often occurs in a period after the revenues were generated, the direct write-off method does not match bad debt expense with the revenues generated by sales in the same period. (b) The allowance method estimates bad debts based on the balance in the trade accounts receivable account. The method focuses on the balance sheet and attempts to value the accounts receivable at the net amount expected to be collected. (c) The company should account for the collection of the specific accounts previously written off as uncollectible as follows: • •
Reinstatement of accounts by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. Collection of accounts by debiting Cash and crediting Accounts Receivable.
LO: 3, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 6.2 (a) 1. Kimmel should account for the sales discounts at the date of sale using the net method by recording accounts receivable and sales revenue at the amount of sales less the sales discounts available. Revenues should be recorded at the cash-equivalent (transaction) price at the date of sale. Under the net method, the sale is recorded at an amount that represents the cash-equivalent price at the date of the exchange (sale). 2. There is no effect on Kimmel’s sales revenues when customers do not take the sales discounts. Kimmel’s net income is increased by the amount of interest (discount) earned when customers do not take the sales discounts. (b) Trade discounts are neither separately recorded in the accounts nor separately reported in the financial statements. Therefore, the amount recorded as sales revenues and accounts receivable is net of trade discounts and represents the cash-equivalent price of the asset sold. (c) To account for the accounts receivable factored on August 1, 2020, Kimmel should decrease accounts receivable by the amount of accounts receivable factored, increase cash by the amount received from the factor, and record a loss. The difference between the cash received and the carrying amount of the receivables is a loss. Factoring of accounts receivable on a without recourse basis is equivalent to a sale. (d) Kimmel should report the face amount of the interest-bearing notes receivable and the related interest receivable for the period from October 1 through December 31 on its balance sheet as noncurrent assets. Both assets are due on September 30, 2022, which is more than one year from the date of the balance sheet.
CT 6.2 (Continued) Kimmel should report interest revenue from the notes receivable on its income statement for the year ended December 31, 2025. Interest revenue is equal to the amount accrued on the notes receivable at the appropriate rate for three months. Interest revenue is realized with the passage of time. Accordingly, interest revenue should be accounted for as an element of income over the life of the notes receivable. LO: 2, 6, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: Communication
CT6.3 (1) Allowances and charge-offs. Method (a) is recommended. In the case of this company which has a large number of relatively small sales transactions, it is practicable to give effect currently to the probable bad debt expense and to report receivables at net realizable value. Whenever practicable, it is advisable to accrue probable bad debt charges and apply them in the accounting periods in which credit quality decreases. If the percentage is based on actual long-run experience, the allowance balance is usually adequate to bring the accounts receivable in the balance sheet to realizable values. (2) Collection expenses. Method (a) or (b) is recommended. In the case of this company, one strong argument for method (a) is that it is advisable to have the Bad Debt Expense account show the full amount of expense relating to efforts to collect and failure to collect balances receivable. On the other hand, an argument can be made to debit the Allowance account on the theory that bad debts (including related expenses) are established at the time the allowance is first established. As a result, the allowance account already has anticipated these expenses, and therefore, as they occur, they should be charged against the allowance account. It should be noted that there is no “right answer” to this question. It would seem that alternatives (c) and (d) are not good alternatives because the expense is not identified with bad debts, which it should be. (3) Recoveries. Method (c) is recommended. This method treats the recovery as a correction of a previous write-off. It produces an allowance account that reflects the net experience with bad debts. Method (a) might be acceptable if the provision for bad debts were based on experience with losses without considering recoveries, but in this case, it would be advisable to use one account with a specific designation rather than the broad designation “other revenue.” As indicated in the textbook, recoveries are usually handled by reestablishing the receivable and allowance account and then payment recorded. Method (c) is basically that approach. LO: 3, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 6.4 Part 1 Since Wallace Company is a calendar-year company, six months of interest should be accrued on 12/31/25. The remaining interest revenue should be recognized on 6/30/26 when the note is collected. The rationale for this treatment is: the accrual basis of accounting provides more useful information than does the cash basis. Therefore, since interest accrues with the passage of time, interest earned on Wallace’s note receivable should be recognized over the life of the note, regardless of when the cash is received.
CT 6.4 (Continued) Part 2 (a) The allowance method based on the balance in accounts receivable is consistent with the expense recognition principle. It attempts to value accounts receivable at the amount expected to be collected and records bad debt expense in periods when credit quality decreases. The method is facilitated by preparing an aging schedule of accounts receivable and plugging bad debt expense with the adjustment necessary to bring the allowance account to the required balance. Alternatively, the ending balance in accounts receivable can be used to determine the required balance in the allowance account without preparing an aging schedule by using a composite percentage. Bad debt expense is determined in the same manner as when an aging schedule is used. (b) On Wallace’s balance sheet, the allowance for doubtful accounts is presented as a contra account to accounts receivable with the resulting difference representing the net accounts receivable (i.e., the net amount expected to be collected). Bad debt expense would generally be included on Wallace’s income statement with the other operating (selling/general and administrative) expenses for the period. However, theoretical arguments can be made for (1) reducing sales revenue by the bad debts adjustment in the same manner that sales returns and allowances and trade discounts are considered reductions of the amount to be received from sales of products or (2) classifying the bad debt expense as a financial expense. LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 6.5 (a) The appropriate valuation basis of a note receivable at the date of sale is its discounted (present value) of the future amounts receivable for principal and interest using the customer’s market rate of interest, if known or determinable, at the date of the equipment’s sale. (b) Corrs should increase the carrying amount of the note receivable by the effective-interest revenue recognized for the period February 1 to May 1, 2025. Corrs should account for the sale of the note receivable without recourse by increasing cash for the proceeds received, eliminating the carrying amount of the note receivable, and recognizing a loss (gain) for the resulting difference. This reporting is appropriate since the note’s carrying amount is correctly recorded at the date it was sold and the sale of a note receivable without recourse has occurred. Thus the difference between the cash received and the carrying amount of the note at the date it is sold is reported as a loss (gain). (c) 1. For notes receivable not sold, Corrs should recognize bad debt expense possibly using an aging analysis or a discounted cash flow estimation. The expense equals the adjustment required to bring the balance of the allowance for doubtful accounts equal to the estimated uncollectible amounts less the fair values of recoverable equipment. 2. For notes receivable sold with recourse, at the time of sale, Corrs would have recorded a recourse liability. This liability measures the estimated bad debts at the time of the sale and increases the loss on the sale. LO: 5, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 6.6 (a) 1. It was not possible to determine the machine’s fair value directly, so the sales price of the machine is reported at the note’s September 30, 2024, fair value. The note’s September 30, 2024, fair value equals the present value of the two installments discounted at the buyer’s September 30, 2024 market rate of interest. 2. Rolen reports 2024 interest revenue determined by multiplying the note’s carrying amount at September 30, 2024 times the buyer’s market rate of interest at the date of issue, times threetwelfths. Rolen should recognize that there is an interest factor implicit in the note, and this interest is recognized with the passage of time. Therefore, interest revenue for 2024 should include three months’ revenue. The rate used should be the market rate established by the original present value, and this is applied to the carrying amount of the note. (b) To report the sale of the note receivable with recourse, Rolen should decrease notes receivable by the carrying amount of the note, increase cash by the amount received, record a recourse liability for possible customer defaults (the recourse liability is reported on the balance sheet at 12/31/25) and report the difference as a loss or gain as part of income from continuing operations. (c) Rolen should decrease cash, increase notes (accounts) receivable past due for all payments caused by the note’s dishonor and eliminate the recourse liability. The note (accounts) receivable should be written down to its estimated recoverable amount (or an allowance for doubtful accounts established), and a loss on uncollectible notes should be recorded for the excess of this difference over the amount of the recourse liability previously recorded. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 6.7 (a) 1. For the interest-bearing note receivable, the interest revenue for 2025 should be determined by multiplying the principal (face) amount of the note by the note’s rate of interest by one-half (July 1, 2025, to December 31, 2025). Interest accrues with the passage of time, and it should be accounted for as an element of revenue over the life of the note receivable. 2. For the zero-interest-bearing note receivable, the interest revenue for 2025 should be determined by multiplying the carrying value of the note by the prevailing rate of interest at the date of the note by one-third (September 1, 2025, to December 31, 2025). The carrying value of the note at September 1, 2025, is the face amount discounted for two years at the prevailing interest rate from the maturity date of August 31, 2027, back to the issuance date of September 1, 2025. Interest, even if unstated, accrues with the passage of time, and it should be accounted for as an element of revenue over the life of the note receivable. (b) The interest-bearing note receivable should be reported at December 31, 2025, as a current asset at its principal (face) amount. The zero-interest-bearing note receivable should be reported at December 31, 2025, as a noncurrent asset at its face amount less the unamortized discount on the note at December 31, 2025. (c) Because the trade accounts receivable are assigned, Moresan should account for the subsequent collections on the assigned trade accounts receivable by debiting Cash and crediting Accounts Receivable. The cash collected should then be remitted to Indigo Finance until the amount advanced by Indigo is settled. The payments to Indigo Finance consist of both principal and interest with interest computed at the rate of 8% on the balance outstanding.
CT 6.7 (Continued) (d) Because the trade accounts receivable were factored on a without recourse basis, the factor is responsible for collection. On November 1, 2025, Moresan should credit Accounts Receivable for the amount of trade accounts receivable factored, debit Cash for the amount received from the factor, debit a Receivable from Factor for 5% of the trade accounts receivable factored, and debit Loss on Sale of Receivables for 3% of the trade accounts receivable factored. LO: 4, 5, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 6.8 The controller of Engone Company cannot justify the manner in which the company has accounted for the transaction in terms of sound financial accounting principles. Several problems are inherent in the sale of Henderson Enterprises stock to Bimini Inc. First, the issue of whether an arm’s-length transaction has occurred may be raised. The controller stated that the stock has not been marketable for the past six years. Thus, the recognition of revenue is highly questionable given the limited market for the stock; i.e., has an exchange occurred? Secondly, the collectibility of the note from Bimini is open to question. Bimini appears to have a liquidity problem due to its current cash squeeze. The lack of assurance about collectibility raises the question of whether revenue should be recognized. Central to the transaction is the issue of imputed interest. If we assume that an arm’s-length exchange has taken place, then the zero-interest-bearing feature masks the question of whether a gain, no gain or loss, or a loss occurred. For a gain to occur, the interest imputation must result in an interest rate of about 5% or less. To illustrate: Present value of an annuity of $1 at 5% for 10 years = 7.72173; thus, the present value of ten payments of $400,000 is $3,088,692. The cost of the investment is $3,000,000; thus, only an $88,692 gain is recognized at 5%. Selecting a more realistic interest rate (despite the controller’s ill-founded statements about “no cost” money since he/she is ignoring the opportunity cost) of 8% finds the present value of the annuity of $400,000 for ten periods equal to $2,684,032 ($400,000 X 6.71008). In this case, a loss of $315,968 must be recognized as illustrated by the following journal entry: Notes Receivable ................................................................................. Loss on Disposal of Investment ............................................................ Equity Investment (Henderson Stock) .................................... Discount on Notes Receivable ($4,000,000 - $2,684,032) .....
4,000,000 315,968 3,000,000 1,315,968
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, Reflective Thinking, AICPA BC: Problem Solving, AICPA AC: Reporting, AICPA PC: Communication
CT 6.9 To:
Mark Price, Branch Manager
From:
Accounting Major
Date:
October 3, 2025
Subject:
Discrepancy in the Accounts Receivable Account
While performing a routine test on accounts receivable balances today, I discovered a $2,000 discrepancy. I believe that this matter deserves your immediate attention. To compute the shortage, I determined that the accounts receivable balance should have been based on the amount of inventory that has been sold. When we opened for business this year, we purchased $360,000 worth of merchandise inventory, and this morning, the balance in this account was $90,000. The $270,000 ($360,000 - $90,000) difference plus the 40% markup indicates that sales on account totaled $378,000 [$270,000 + ($270,000 X .40)] to date. I subtracted the payments of $188,000 made on account this year and calculated the ending balance to be $190,000. However, the ledger shows a balance of $192,000. I realize that this situation is very sensitive and that we should not accuse any one individual without further evidence. However, to protect the company’s assets, we must begin an immediate investigation of this disparity. Aside from me, the only other employee who has access to the accounts receivable ledger is Kelly Collins, the receivables clerk. I will supervise Collins more closely in the future but suggest that we also employ an auditor to check into this situation. Note to Instructors: This situation could result from 1) Collins colluding with a customer, or 2) a lack of segregation of duties where Collins is also involved with collections. LO: 2, 3, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, Reflective Thinking, AICPA BC: Problem Solving, Professional Demeanor, AICPA AC: Reporting, AICPA PC: Communication
CT 6.10 (a)
(1) Steps to Improve Accounts Receivable Situation Establish more selective credit-granting policies, such as more restrictive credit requirements or more thorough credit investigations.
(2) Risks and Costs Involved This policy could result in lost sales and increased costs of credit evaluation. The company may be all but forced to adhere to the prevailing credit-granting policies of the industry.
CT 6.10 (Continued) (1) Steps to Improve (2) Risks and Costs Involved
Accounts Receivable Situation
Establish a more rigorous collection policy either through external collection agencies or by its own personnel. Charge interest on overdue accounts. Insist on cash on delivery (COD) or cash on order (COO) for new customers or poor credit risks.
This policy may offend current customers and thus risk future sales. Increased collection costs could result from this policy. This policy could result in lost sales and increased administrative costs.
(b) No, the controller should not be concerned with Marvin Company’s growth rate in estimating the allowance. The accountant’s proper task is to make a reasonable estimate of uncollectible accounts. In making the estimate, the controller should consider the previous year’s write-offs and also anticipate economic factors which might affect the company’s industry and influence Marvin’s current write-off. (c) Yes, the controller’s interest in disclosing financial information completely and fairly conflicts with the president’s economic interest in manipulating income to avoid undesirable demands from the parent company. Such a conflict of interest is an ethical dilemma. The controller must recognize the dilemma, identify the alternatives, and decide what to do. LO: 3, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, Reflective Thinking, AICPA BC: Problem Solving, Professional Demeanor, AICPA AC: Reporting, AICPA PC: Communication
Codification Exercises CE6.1 From the Master Glossary (a) Consistent with common usage, cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank’s granting of a loan by crediting the proceeds to a customer’s demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made. (b) Securitization is the process by which financial assets are transformed into securities. (c) Recourse is the right of a transferee of receivables to receive payment from the transferor of those receivables for any of the following: a. Failure of debtors to pay when due b. The effects of prepayments c. Adjustments resulting from defects in the eligibility of the transferred receivables. LO: 1, 2, 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication
CE6.2 According to the FASB ASC Subtopic 825-15 - Financial Instruments—Credit Losses: Recognition 825-15-25-1 At each reporting date, an entity shall recognize an allowance for expected credit losses on financial assets within the scope of this Subtopic. Expected credit losses are a current estimate of all contractual cash flows not expected to be collected. > Recognizing Changes in the Allowance for Expected Credit Losses 825-15-25-7 An entity shall recognize in the statement of financial performance (as a provision for credit loss) the amount of credit loss (or reversal) required to adjust the allowance for expected credit losses for the current period in the statement of financial position to that required under this Section. Thus, adjustments to the allowance reflect estimates of changes in expected future uncollectible accounts. LO: 2, 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication
CE6.3 According to FASB ASC 860-10-05 (Overview and Background) > Types of Transfers 05–6
Transfers of financial assets take many forms. This guidance provides an overview of the following types of transfers discussed in this Topic: a. Securitizations b. Factoring c. Transfers of receivables with recourse d. Securities lending transactions e. Repurchase agreements f. Loan participations g. Banker’s acceptances
>> Factoring 05–14 Factoring arrangements are a means of discounting accounts receivable on a nonrecourse, notification basis. Accounts receivable are sold outright, usually to a transferee (the factor) that assumes the full risk of collection, without recourse to the transferor in the event of a loss. Debtors are directed to send payments to the transferee. >> Transfers of Receivables with Recourse 05–15 In a transfer of receivables with recourse, the transferor provides the transferee with full or limited recourse. The transferor is obligated under the terms of the recourse provision to make payments to the transferee or to repurchase receivables sold under certain circumstances, typically for defaults up to a specified percentage. >> Securities Lending Transactions 05–16 Securities lending transactions are initiated by broker-dealers and other financial institutions that need specific securities to cover a short sale or a customer’s failure to deliver securities sold. Securities custodians or other agents commonly carry out securities lending activities on behalf of clients. >> Repurchase Agreements 05–19 Government securities dealers, banks, other financial institutions, and corporate investors commonly use repurchase agreements to obtain or use short-term funds. Under those agreements, the transferor (repo party) transfers a security to a transferee (repo counterparty or reverse party) in exchange for cash and concurrently agrees to reacquire that security at a future date for an amount equal to the cash exchanged plus a stipulated interest factor. Instead of cash, other securities or letters of credit sometimes are exchanged. Some repurchase agreements call for the repurchase of securities that need not be identical to the securities transferred. >> Loan Participations 05–22 In certain industries, a typical customer’s borrowing needs often exceed its bank’s legal lending limits. To accommodate the customer, the bank may participate the loan to other banks (that is, transfer under a participation agreement a portion of the customer’s loan to one or more participating banks).
CE6.3 (Continued) >> Banker’s Acceptances 05–24 Banker’s acceptances provide a way for a bank to finance a customer’s purchase of goods from a vendor for periods usually not exceeding six months. Under an agreement between the bank, the customer, and the vendor, the bank agrees to pay the customer’s liability to the vendor upon presentation of specified documents that provide evidence of delivery and acceptance of the purchased goods. The principal document is a draft or bill of exchange drawn by the customer that the bank stamps to signify its acceptance of the liability to make payment on the draft on its due date. LO: 2, 4, Bloom: K, Difficulty: Simple, 15-20, AACSB: Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication
CE6.4 According to FASB ASC 210-20-45 > Right of Setoff Criteria 45-1
A right of setoff exists when all of the following conditions are met: a. Each of two parties owes the other determinable amounts. b. The reporting party has the right to set off the amount owed with the amount owed by the other party. c. The reporting party intends to set off. d. The right of setoff is enforceable at law.
45-2
A debtor having a valid right of setoff may offset the related asset and liability and report the net amount.
45-3
If the parties meet the criteria specified in paragraph 210-20-45-1, specifying currency or interest rate requirements is unnecessary. However, if maturities differ, only the party with the nearer maturity could offset because the party with the longer term maturity must settle in the manner that the other party selects at the earlier maturity date.
45-4
If a party does not intend to set off even though the ability to set off exists, an offsetting presentation in the statement of financial position is not representationally faithful.
45-5
Acknowledgment of the intent of set off by the reporting party and, if applicable, demonstration of the execution of the setoff in similar situations meet the criterion of intent.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication
Codification Research Case (a) Transfer of receivables is addressed in FASB ASC 860-10: Codification String: Broad Transactions > 860 Transfers and Servicing > 10 Overall > 05 Background > The predecessor literature can be accessed by clicking on “PrinterFriendly with sources” and then retrieve the previous standard at www.fasb.org/st/ The previous statement that addressed transfers of receivables: Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (September 2000). (b) Definitions: (Codification String: Broad Transaction > 860 Transfers and Servicing > 10 Overall > 20 Glossary) Transfer The conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset. A transfer includes the following: a. Selling a receivable b. Putting a receivable into a securitization trust c. Posting a receivable as collateral. A transfer excludes the following: a. The origination of a receivable b. Settlement of a receivable c. The restructuring of a receivable into a security in troubled debt restructuring. Recourse The right of a transferee of receivables to receive payment from the transferor of those receivables for any of the following: a. Failure of debtors to pay when due b. The effects of prepayments Codification Research Case (Continued)
c. Adjustments resulting from defects in the eligibility of the transferred receivables. Collateral Personal or real property in which a security interest has been given. LO: 4, Bloom: K, Difficulty: Moderate, Time: 10-15, AACSB: Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication
CHAPTER 7 Valuation of Inventories: A Cost-Basis Approach Assignment Classification Table (By Topic)
Topics
Questions
Brief Exercises
Exercises
Problems
Critical Thinking 1, 2, 3, 5
1.
Inventory accounts; 4, 5, 6, 7, 8 determining quantities, costs, and items to be included in inventory; the inventory equation; balance sheet disclosure.
1, 3
1, 2, 3, 4, 5, 6
1, 2, 3
2.
Perpetual vs. periodic.
1, 2, 3
1, 2
9, 10, 14, 17
4, 5, 6
3.
Recording of discounts.
9, 10
7, 8
3
4
4.
Flow assumptions.
11, 12, 17, 20
9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19
1, 4, 5, 6, 7
5, 6, 7, 8, 11
15
7
6, 7, 10 8, 9
4, 5, 6 7
5.
Inventory accounting changes.
6.
Dollar-value LIFO methods.
13, 14, 15, 16, 18, 19
8, 9
19, 20, 21, 22, 23
1, 8, 9, 10, 11
7.
Inventory errors.
20
10
24, 25, 26
2
Assignment Classification Table (By Learning Objective)
Learning Objectives
Questions
Brief Exercises
1.
Identify inventory classifications and different inventory systems.
1, 2, 3
1, 2
2.
Determine the goods and costs included in inventory.
4, 5, 6, 7, 8, 9, 10
3
1, 2, 3, 4, 5, 6, 7, 8
3.
Describe and compare the cost flow assumptions used to account for inventories.
6, 11, 12
4, 5, 6
1, 2, 4, 5, 9, 10, 11, 12, 13,14, 6, 7 15, 16, 17, 19
6, 7, 10, 11
4.
Identify special issues related to LIFO.
13, 14, 15, 16, 17, 18, 19
7, 8, 9
18, 19, 20, 8, 9, 10, 21, 22, 23 11
6, 8, 9, 10, 11
5.
Determine the effects of inventory errors on the financial statements.
20
10
24, 25, 26
Exercises
Problems
Critical Thinking
4,5,6
1, 2, 3
1, 2, 3, 4, 5
Assignment Characteristics Table
Item
Description
Level of Difficulty
E7.1 E7.2 E7.3 E7.4 E7.5 E7.6 E7.7 E7.8 E7.9 E7.10 E7.11 E7.12 E7.13 E7.14 E7.15 E7.16 E7.17 E7.18 E7.19 E7.20 E7.21 E7.22 E7.23 E7.24 E7.25 E7.26
Inventoriable goods and costs. Inventoriable goods and costs. Inventoriable goods and costs. Inventoriable goods and costs—perpetual. Inventoriable goods and costs—error adjustments. Determining merchandise amounts—periodic. Purchases recorded net. Purchases recorded, gross method. Periodic versus perpetual entries. FIFO and LIFO—periodic and perpetual. FIFO, LIFO and average-cost determination. FIFO, LIFO, average-cost inventory. Compute FIFO, LIFO, average-cost—periodic. FIFO and LIFO—periodic and perpetual. FIFO and LIFO; income statement presentation. FIFO and LIFO effects. FIFO and LIFO—periodic. LIFO effect. Alternate inventory methods—comprehensive. Dollar-value LIFO. Dollar-value LIFO. Dollar-value LIFO. Dollar-value LIFO. Inventory errors—periodic. Inventory errors. Inventory errors.
Moderate Moderate Moderate Moderate Complex Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate
15–20 10–15 10–15 10–15 15–20 10–20 10–15 20–25 15–25 15–20 20–25 15–20 15–20 10–15 15–20 20–25 10–15 10–15 25–30 5–10 15–20 20–25 15–20 10–15 10–15 15–20
P7.1 P7.2 P7.3 P7.4 P7.5 P7.6
Various inventory issues. Inventory adjustments. Purchases recorded gross and net. Compute FIFO, LIFO, and average-cost. Compute FIFO, LIFO, and average-cost. Compute FIFO, LIFO, and average-cost—periodic and perpetual. Financial statement effects of FIFO and LIFO. Dollar-value LIFO. Internal indexes—dollar-value LIFO. Internal indexes—dollar-value LIFO. Dollar-value LIFO.
Moderate Moderate Moderate Complex Complex Moderate
30–40 25–35 20–25 40–55 40–55 25–35
Moderate Moderate Moderate Complex Moderate
30–40 30–40 25–35 30–35 40–50
P7.7 P7.8 P7.9 P7.10 P7.11
Time (minutes)
Assignment Characteristics Table (Continued)
Item
Description
Level of Difficulty
Time (minutes)
CT7.1 CT7.2 CT7.3 CT7.4 CT7.5 CT7.6 CT7.7 CT7.8 CT7.9 CT7.10 CT7.11
Inventoriable goods and costs. Inventoriable goods and costs. Inventoriable goods and costs. Accounting treatment of purchase discounts. General inventory issues. LIFO inventory advantages. Average-cost, FIFO, and LIFO. LIFO application and advantages. Dollar-value LIFO issues. FIFO and LIFO. LIFO choices.
Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate
15–20 15–25 25–35 15–25 20–25 15–20 15–20 25–30 25–30 30–35 20–25
Answers to Questions 1. In a retailing concern, inventory normally consists of only one category that is the product awaiting resale. In a manufacturing company, inventories consist of raw materials, work in process, and finished goods. Sometimes a manufacturing or factory supplies inventory account is also included. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
2. (a)
Inventories are unexpired costs and represent future benefits to the owner. A statement of financial position includes a listing of all unexpired costs (assets) at a specific point in time. Because inventories are assets owned at the specific point in time for which a statement of financial position is prepared, they must be included in order that the owners’ financial position will be presented fairly.
(b) Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues recognized during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
3. In a perpetual inventory system, data are available at any time on the quantity and dollar amount of each item of material or type of merchandise on hand. A physical inventory is a physical count of inventory on hand at a point in time. In a periodic system, the inventory is periodically counted (at least once a year) but up-to-date records are not necessarily maintained. Discrepancies often occur between the physical count and the perpetual records because of clerical errors, theft, waste, misplacement of goods, etc. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
4. No, Mishima, Inc. should not report this amount on its balance sheet. As consignee, it does not own this merchandise and therefore it is inappropriate for it to recognize this merchandise as part of its inventory. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analysis, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
5. Sales with returns raise the possibility that legal title may have passed to the purchaser, but the seller of the goods retains control of the inventory, if the goods are returned. Sales with high rates of return illustrates the types of problems companies encounter in practice. In industries such as publishing, music, toys, and sporting goods, formal or informal agreements often exist that permit purchasers to return inventory for a full or partial refund In these situations, the seller: 1. Record sales revenue at the amount it expects to receive from the transaction. As discussed in Chapter 6, this transaction involves variable consideration. Therefore, the transaction price is adjusted to recognize that a portion of these textbooks will be returned. 2. Establish an estimated inventory return account to recognize that some of the goods will be returned. The reason for recording estimated inventory return is that control over a significant number of the textbooks has not passed to Campus Bookstore. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
6. (a) (b) (c) (d) (e) (f)
Inventory. Not shown, possibly in a note to the financial statements if material. Inventory. Inventory, separately disclosed as raw materials. Not shown, possibly a note to the financial statements. Inventory or manufacturing supplies.
LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: AICPA BB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC:, AICPA BB: None
7. Cost, which has been defined generally as the price paid or consideration given to acquire an asset, is the primary basis for accounting for inventories. As applied to inventories, cost means the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. These applicable expenditures and charges include all acquisition and production costs but exclude all selling expenses and that portion of general and administrative expenses not clearly related to production. Freight charges applicable to the product are considered a cost of the goods. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
8. By their nature, product costs “attach” to the inventory and are recorded in the inventory account. These costs are directly connected with the bringing of goods to the place of business of the buyer and converting such goods to a salable condition. Such charges would include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs are not considered to be directly related to the acquisition or production of goods and therefore are not considered to be a part of inventories. Conceptually, period costs are as much a cost of the product as the initial purchase price and related freight charges attached to the product. While selling expenses are generally considered as more directly related to the cost of goods sold than to the unsold inventory, in most cases, though, the costs, especially administrative expenses, are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary. Interest costs are considered a cost of financing and are generally expensed as incurred, when related to getting inventories ready for sale. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
9.
Ford Motor Co. should not account for cash discounts (purchase discounts) as financial income when payments are made. Income should be recognized when the performance obligation is satisfied (when the company sells the inventory). Furthermore, a company does not recognize revenue from purchasing goods. Cash discounts should be considered as a reduction in the cost of the items purchased.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
10. $60.00, $63.00, $61.80*. (Freight-In not included for discount.) * $63.00 − ($60 .02) = $61.80 LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: AICPA BB: None, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC:, AICPA BB: None
11. Arguments for the specific identification method are as follows: (1) It provides an accurate and ideal matching of costs and revenues because the cost is specifically identified with the sales price. (2) The method is realistic and objective since it adheres to the actual physical flow of goods rather than an artificial flow of costs. (3) Inventory is valued at actual cost instead of an assumed cost. Arguments against the specific identification method include the following: (1) The cost of using it restricts its use to goods of high unit value. (2) The method is impractical for manufacturing processes or cases in which units are commingled and identity lost. (3) It allows an artificial determination of income by permitting arbitrary selection of the items to be sold from a homogeneous group. (4) It may not be a meaningful method of assigning costs in periods of changing price levels. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: AICPA BB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC:, AICPA BB: None
12. The first-in, first-out method approximates the specific identification method when the physical flow of goods is on a FIFO basis. When the goods are subject to spoilage or deterioration, FIFO is particularly appropriate. In comparison to the specific identification method, an attractive aspect of FIFO is the elimination of the danger of artificial determination of income by the selection of advantageously priced items to be sold. The basic assumption is that costs should be charged in the order in which they are incurred. As a result, the inventories are stated at the latest costs. Where the inventory is consumed and valued in the FIFO manner, there is no accounting recognition of unrealized gain or loss. A criticism of the FIFO method is that it maximizes the effects of price fluctuations upon reported income because current revenue is matched with the oldest costs which are probably least similar to current replacement costs. On the other hand, this method produces a balance sheet value for the asset close to current replacement costs. It is claimed that FIFO is deceptive when used in a period of rising prices because the reported income is not fully available since a part of it must be used to replace inventory at higher cost. The results achieved by the average-cost method resemble those of the specific identification method where items are chosen at random or there is a rapid inventory turnover. Compared with the specific identification method, the average-cost method has the advantage that the goods need not be individually identified; therefore, accounting is not so costly and the method can be applied to fungible goods. The average-cost method is also appropriate when there is no marked trend in price changes. In opposition, it is argued that the method is illogical. Since it assumes that all sales are made proportionally from all purchases and that inventories will always include units from the first purchases, it is argued that the method is illogical because it is contrary to the chronological flow of goods. In addition, in periods of price changes there is a lag between current costs and costs assigned to income or to the valuation of inventories. If it is assumed that actual cost is the appropriate method of valuing inventories, last-in, first-out is not theoretically correct. In general, LIFO is directly averse to the specific identification method because the goods are not valued in accordance with their usual physical flow. An exception is the application of LIFO to piled coal or ores which are more or less consumed in a LIFO manner. Proponents argue that LIFO provides a better matching of current costs and revenues. During periods of sharp price movements, LIFO has a stabilizing effect upon reported income figures because it eliminates paper income and losses on inventory and smoothes the impact of income taxes. LIFO opponents object to the method principally because the inventory valuation reported in the balance sheet could be seriously misleading. The profit figures can be artificially influenced by management through contracting or expanding inventory quantities. Temporary involuntary depletion of LIFO inventories would distort current income by the previously unrecognized price gains or losses applicable to the inventory reduction. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
13. A company may obtain a price index from an outside source (external index)—the government, a trade association, an exchange—or by computing its own index (internal index) using the double extension method. Under the double extension method, the ending inventory is priced at both baseyear costs and at current-year costs, with the total current cost divided by the total base cost to obtain the current year index. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
14. Under the double extension method, LIFO inventory is priced at both base-year costs and currentyear costs. The total current-year cost of the inventory is divided by the total base-year cost to obtain the current-year index. The index for the LIFO pool consisting of product A and product B is computed as follows: Base-Year Cost Product Units Unit Total A 25,500 $10.20 $260,100 B 10,350 $37.00 382,950 December 31, 2025 inventory $643,050 Current-Year Cost Base-Year Cost
=
$1,007,460 $643,050
Current-Year Cost Unit Total $21.00 $ 535,500 $45.60 471,960 $1,007,460
= 156.67, index at 12/31/25.
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analysis, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
15. The LIFO method results in a smaller net income than FIFO because later costs, which are higher than earlier costs, are matched against revenue. Conversely, in a period of falling prices, the LIFO method would result in a higher net income because later costs in this case would be lower than earlier costs, and these later costs would be matched against revenue. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
16. The dollar-value method uses dollars instead of units to measure increments, or reductions in a LIFO inventory. After converting the closing inventory to the same price level as the opening inventory, the increases in inventories, priced at base-year costs, is converted to the current price level, and added to the opening inventory. Any decrease is subtracted at base-year costs to determine the ending inventory. The principal advantage is that it requires less record-keeping. It is not necessary to keep records or make calculations of opening and closing quantities of individual items. Also, the use of a base inventory amount gives greater flexibility in the makeup of the base and eliminates many detailed calculations. The unit LIFO inventory costing method is applied to each type of item in an inventory. Any type of item removed from the inventory base (e.g., magnets) and replaced by another type (e.g., coils) will cause the old cost (magnets) to be removed from the base and to be replaced by the more current cost of the other item (coils). The dollar-value LIFO costing method treats the inventory base as being composed of a base of cost in dollars rather than of units. Therefore, a change in the composition of the inventory (less magnets and more coils) will not change the cost of inventory base so long as the amount of the inventory stated in base-year dollars does not change. LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
17. (a) LIFO layer—a LIFO layer (increment) is formed when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices. (b) LIFO reserve—the difference between the inventory method used for internal purposes and LIFO. (c)
LIFO effect—the change in the LIFO reserve (Allowance to Reduce Inventory to LIFO) from one period to the next.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
18.
December 31, 2025 inventory at December 31, 2024 prices, $1,053,000 ÷ 1.08 ........
$975,000
Less: Inventory, December 31, 2024 ......................................................................... Increment added during 2025 at base prices ..............................................................
800,000 $175,000
Increment added during 2025 at December 31, 2025 prices, $175,000 × 1.08 ........... Add: Inventory at December 31, 2024 ......................................................................... Inventory, December 31, 2025, under dollar-value LIFO method ................................
$189,000 800,000 $989,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
19. Phantom inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The cost of goods sold therefore is understated and profit is considered overstated. Phantom profits are said to occur when FIFO is used during periods of rising prices. High inventory profits through involuntary liquidation occur if a company is forced to reduce its LIFO base or layers. If the base or layers of old costs are eliminated, strange results can occur because old, irrelevant costs can be matched against current revenues. A distortion in reported income for a given period may result, as well as consequences that are detrimental from an income tax point of view. LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
20. This omission of titled goods in transit by Clarkson would have no effect upon the net income for the year since the purchases and the ending inventory are understated in the same amount. With respect to financial position, both the inventory and the accounts payable would be understated. Materiality would be a factor in determining whether an adjustment for this item should be made as omission of a large item would distort the amount of current assets and the amount of current liabilities. It, therefore, might influence the current ratio to a considerable extent. LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 7.1 RIVERA COMPANY Balance Sheet (Partial) December 31 Current assets Cash ................................................................ Receivables (net) ........................................... Inventories Finished goods ...................................... Work in process ..................................... Raw materials ......................................... Prepaid insurance .......................................... Total current assets ...............................
$ 190,000 400,000 $170,000 200,000 335,000
705,000 41,000 $1,336,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.2 Inventory (150 × $34)............................................... Accounts Payable ..........................................
5,100
Accounts Payable (6 × $34) .................................... Inventory.........................................................
204
Accounts Receivable (125 × $50) ........................... Sales Revenue................................................
6,250
Cost of Goods Sold (125 × $34) ............................. Inventory.........................................................
4,250
5,100 204 6,250 4,250
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.3 December 31 inventory per physical count .......... Goods-in-transit purchased FOB shipping point . Goods-in-transit sold FOB destination.................. December 31 inventory.................................. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.4
$ 200,000 25,000 22,000 $ 247,000
Ending inventory 400 × $11.85 =
$11,850 = $ 11.85 1,000 $ 4,740
Cost of goods available for sale Deduct ending inventory Cost of goods sold (600 × $11.85)
$11,850 4,740 $ 7,110
Weighted average cost per unit
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.5 April 23 April 15 Ending inventory
350 × $13 = $ 4,550 50 × $12 = 600 $ 5,150
Cost of goods available for sale Deduct ending inventory Cost of goods sold
$11,850 5,150 $ 6,700
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.6 April 1 April 15 Ending inventory Cost of goods available for sale Deduct ending inventory Cost of goods sold
250 × $10 = 150 × $12 =
$ 2,500 1,800 $ 4,300 $11,850 4,300 $ 7,550
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.7 FIFO inventory balance at December 31, 2025 .............. LIFO inventory balance at December 31, 2025 .............. LIFO reserve at December 31, 2025 ...............................
$2,900,000 (1,500,000) 1,400,000
LIFO reserve at December 31, 2025 ............................... $1,400,000 LIFO reserve at January 1, .............................................. (1,300,000) LIFO effect for 2025 ......................................................... 100,000 At December 31, 2025, the entry to record the LIFO effect is: Cost of Goods Sold .................................................. 100,000 Allowance to Reduce Inventory to LIFO .... 100,000 LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.8 2024 2025
$100,000 $119,900 ÷ 1.10 = $109,000 $100,000 × 1.00 ........................................................... $9,000* × 1.10 ..............................................................
$100,000 9,900 $109,900
*$109,000 – $100,000 2026
$134,560 ÷ 1.16 = $116,000 $100,000 × 1.00 ........................................................... $9,000 × 1.10 ............................................................... $7,000** × 1.16.............................................................
$100,000 9,900 8,120 $118,020
**$116,000 – $109,000 LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analysis, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.9 2025 inventory at base amount ($22,140 ÷ 1.08) 2024 inventory at base amount Increase in base inventory 2025 inventory under LIFO Layer one $19,750 × 1.00 Layer two $ 750 × 1.08
$ 20,500 (19,750) $ 750
2026 inventory at base amount ($25,935 ÷ 1.14) 2025 inventory at base amount Increase in base inventory 2026 inventory under LIFO Layer one $19,750 × 1.00 Layer two $ 750 × 1.08 Layer three $ 2,250 × 1.14
$ 22,750 20,500 $ 2,250
$ 19,750 810 $ 20,560
$ 19,750 810 2,565 $ 23,125
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: AICPA BB: None
Brief Exercise 7.10 Cost of goods sold as reported ............................................ Overstatement of 12/31/24 inventory .................................... Overstatement of 12/31/25 inventory .................................... Corrected cost of goods sold ......................................
$1,400,000 (110,000) 35,000 $1,325,000
12/31/25 retained earnings as reported ................................ Overstatement of 12/31/25 inventory .................................... Corrected 12/31/25 retained earnings .........................
$5,200,000 (35,000) $5,165,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Solutions to Exercises Exercise 7.1 (15–20 minutes) Items 1, 3, 5, 8, 11, 13, 14, 16, and 17 would be reported as inventory in the financial statements. The following items would not be reported as inventory: 2. Cost of goods sold in the income statement. 4. Not reported in the financial statements. 6. Cost of goods sold in the income statement. 7. Cost of goods sold in the income statement. 9. Interest expense in the income statement. 10. Advertising expense in the income statement. 12. Office supplies in the current assets section of the balance sheet. 15. Not reported in the financial statements. 18. Short-term investments in the current asset section of the balance sheet. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Exercise 7.2 (10–15 minutes) Inventory per physical count Goods in transit to customer, f.o.b. destination Goods in transit from vendor, f.o.b. seller Inventory to be reported on balance sheet
$441,000 + 38,000 + 51,000 $530,000
The consigned goods of $61,000 are not owned by Jose Oliva and were properly excluded. The goods in transit to a customer of $46,000, shipped f.o.b. shipping point, are properly excluded from the inventory because the title to the goods passed when they left the seller (Oliva) and therefore a sale and related cost of goods sold should be recorded in 2025. The goods in transit from a vendor of $83,000, shipped f.o.b. destination, are properly excluded from the inventory because the title to the goods does not pass to Oliva until the buyer (Oliva) receives them. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analysis, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 7.3 (10–15 minutes) 1.
Include. Ownership of the merchandise passes to customer only when it is shipped.
2.
Do not include. Title did not pass until January 3.
3.
Include in inventory. Product belonged to Harlowe Inc. at December 31, 2025.
4.
Include in inventory. Under invoice terms, title passed when goods were shipped.
5.
Do not include. Goods received on consignment remain the property of the consignor.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Exercise 7.4 (10–15 minutes) 1. 2.
Raw Materials Inventory .............................. Accounts Payable ...............................
8,100
Raw Materials Inventory .............................. Accounts Payable ...............................
28,000
8,100 28,000
3.
No adjustment necessary.
4.
Accounts Payable ........................................ Raw Materials Inventory .....................
7,500
Raw Materials Inventory .............................. Accounts Payable ...............................
19,800
5.
7,500
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
19,800
Exercise 7.5 (15–20 minutes) (a)
Inventory December 31, 2025 (unadjusted) Transaction 2 Transaction 3 Transaction 4 Transaction 5 Transaction 6 Transaction 7 Transaction 8 Inventory December 31, 2025 (adjusted)
(b)
Transaction 3 Sales Revenue ............................................ Accounts Receivable ......................... (To reverse sale entry in 2025) Transaction 4 Purchases (Inventory) ................................ Accounts Payable .............................. (To record purchase of merchandise in 2025) Transaction 8 Sales Returns and Allowances .................. Accounts Receivable ......................... Inventory……………………………………… Cost of Goods Sold…………………..
$234,890 13,420 -0-08,540 (10,438) (10,520) 1,500 $237,392
12,800 12,800
15,630 15,630
2,600 2,600 1,500 1,500
LO: 2, Bloom: AP, Difficulty: Hard, Time: 15-20, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Exercise 7.6 (10–20 minutes)
Sales Revenue Sales Returns and Allowances Net Sales Beginning Inventory Ending Inventory Purchases Purchase Returns and Allowances Freight-in Cost of Goods Sold Gross Profit
2024
2025
2026
$290,000 (11,000) 279,000 20,000 (32,000*) 242,000 (5,000) 8,000 (233,000) $ 46,000
$360,000 (13,000) 347,000 32,000 (37,000) 260,000 (8,000) 9,000 (256,000) $ 91,000
$410,000 (20,000) 390,000 37,000** (44,000) 298,000 (10,000) 12,000 (293,000) $ 97,000
*This was given as the beginning inventory for 2025. **This was calculated as the ending inventory for 2025. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 10-20, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Exercise 7.7 (10–15 minutes) (a)
May 10
May 11
May 19
May 24
Purchases ....................................... Accounts Payable.................. ($15,000 × .98)
14,700
Purchases ....................................... Accounts Payable.................. ($13,200 × .99)
13,068
Accounts Payable ........................... Cash .......................................
14,700
Purchases ....................................... Accounts Payable ($11,500 × .98) ......................
11,270
14,700
13,068
14,700
11,270
Exercise 7.7 (Continued) (b)
May 31
Purchase Discounts Lost ............................. Accounts Payable ($13,200 × .01) ................................... (Discount lost on purchase of May 11, $13,200, terms 1/15, n/30)
132 132
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analysis, AICPA BB: None, AICPA FC: Reporting, AICPA PC: AICPA BB: None
Exercise 7.8 (20–25 minutes) (a)
Feb. 1
Feb. 4
Feb. 13
(b)
Feb. 1
Feb. 4
Feb. 13
(c)
Inventory [$10,800 – ($10,800 × .10)] ...... Accounts Payable ...........................
9,720
Accounts Payable [$2,500 – ($2,500 × .10)] ........................................ Inventory .........................................
2,250
9,720
2,250
Accounts Payable ($9,720 – $2,250) ....... Inventory (.03 × $7,470) .................. Cash.................................................
7,470
Purchases [$10,800 – ($10,800 × .10)] .... Accounts Payable ...........................
9,720
Accounts Payable [$2,500 – ($2,500 × .10)] ........................................................ Purchase Returns and Allowances ..
2,250
Accounts Payable ($9,720 – $2,250) ....... Purchase Discounts (.03 × $7,470) ... Cash.................................................
Purchase price (list) Less: Trade discount (.10 × $10,800) Price on which cash discount based Less: Cash discount (.03 × $9,720) Net price
224.10 7,245.90
9,720
2,250 7,470 224.10 7,245.90
$10,800.00 1,080.00 9,720.00 291.60 $ 9,428.40
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.9 (15–25 minutes) (a)
Jan. 4 Jan. 11 Jan. 13 Jan. 20 Jan. 27 Jan. 31
Accounts Receivable......................... Sales Revenue (80 × $8) ...........
640
Purchases ($150 × $6) ....................... Accounts Payable.....................
900
Accounts Receivable......................... Sales Revenue (120 × $8.75) ....
1,050
Purchases (160 × $7) ......................... Accounts Payable.....................
1,120
Accounts Receivable......................... Sales Revenue (100 × $9) .........
900
Inventory ($7 × 110) ........................... Cost of Goods Sold ........................... Purchases ($900 + $1,120) ....... Inventory (100 × $5) ..................
770 1,750*
640 900 1,050 1,120 900
2,020 500
*($500 + $2,020 – $770) (b)
Sales revenue ($640 + $1,050 + $900) Cost of goods sold Gross profit
$2,590 1,750 $ 840
Exercise 7.9 (Continued) (c)
Jan. 4
Jan. 11 Jan. 13
Jan. 20 Jan. 27
(d)
Accounts Receivable ......................... Sales Revenue (80 × $8) ...........
640
Cost of Goods Sold ........................... Inventory (80 × $5) ....................
400
Inventory ............................................ Accounts Payable (150 × $6) .....
900
Accounts Receivable ......................... Sales Revenue (120 × $8.75) ....
1,050
Cost of Goods Sold ........................... Inventory ([(20 × $5) + (100 × $6)] ...............................
700
Inventory ............................................ Accounts Payable (160 × $7)....
1,120
Accounts Receivable ......................... Sales Revenue (100 × $9) .........
900
Cost of Goods Sold ........................... Inventory [(50 × $6) + (50 × $7)] .................................
650
Sales revenue Cost of goods sold ($400 + $700 + $650) Gross profit
640 400 900 1,050
700 1,120 900
650 $2,590 1,750 $ 840
Note: FIFO periodic and FIFO perpetual provide the same gross profit and inventory value. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.10 (15–20 minutes) (a)
Units in ending inventory Beginning balance Purchases Goods available Sales Ending balance
300 1,300 (800 + 500) 1,600 (1,000) (200 + 500 + 300) 600
(1)
Cost of Goods Sold LIFO 500 @ $13 = $ 6,500 500 @ $12 = 6,000 $12,500
Ending Inventory 300 @ $10 = $3,000 300 @ $12 = 3,600 $6,600
(2)
FIFO
300 @ $10 = 700 @ $12 =
$ 3,000 8,400 $11,400
500 @ $13 = 100 @ $12 =
(b)
LIFO
100 @ $10 = 300 @ $12 = 200 @ $13 =
$ 1,000 3,600 2,600 $ 7,200
(c)
Sales Revenue Cost of Goods Sold Gross Profit (FIFO)
$6,500 1,200 $7,700
$25,400 = ($24 @ 200) + ($25 @ 500) + ($27 @ 300) 11,400 = (200 @ $10) + (100 @ $10) $14,000 + (400 @ $12) + (300 @ $12)
Note: FIFO periodic and FIFO perpetual provide the same gross profit and inventory value. (d)
LIFO matches the most current costs with revenue. When prices are rising (as is generally the case), this results in a higher amount for cost of goods sold and a lower gross profit. As indicated in this exercise, prices were rising, and cost of goods sold under LIFO was higher.
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.11 (20–25 minutes) (a)
(1)
LIFO
600 @ $6.00 = $3,600 100 @ $6.08 = 608 $4,208
(2)
Average cost Total cost = Total units
$33,655* 5,300
= $6.35 average cost per unit
700 (5,300 − 4,600) @ $6.35 *Units 600 1,500 800 1,200 700 500 5,300 (b)
@ @ @ @ @ @
Price $6.00 $6.08 $6.40 $6.50 $6.60 $6.79
= = = = = =
(1)
FIFO
500 @ $6.79 = $3,395 200 @ $6.60 = 1,320 $4,715
(2)
LIFO
100 @ $6.00 = $ 600 100 @ $6.08 = 608 500 @ $6.79 = 3,395 $4,603
= $4,445
Total Cost $ 3,600 9,120 5,120 7,800 4,620 3,395 $33,655
(c)
Total merchandise available for sale Less: Inventory (FIFO) Cost of goods sold
(d)
FIFO.
$33,655 4,715 $28,940
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.12 (15–20 minutes) (a)
Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER FIFO INVENTORY METHOD March 31, 2025
March 26, 2025 February 16, 2025 January 25, 2025 (portion) March 31, 2025, inventory (b)
Unit Cost $12.00 11.00 10.00
Total Cost $ 7,200 8,800 2,000 $18,000
Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER LIFO INVENTORY METHOD March 31, 2025
Beginning inventory January 5, 2025 (portion) March 31, 2025, inventory (c)
Units 600 800 200 1,600
Units 600 1,000 1,600
Unit Cost $8.00 9.00
Total Cost $ 4,800 9,000 $13,800
Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER WEIGHTED-AVERAGE INVENTORY METHOD March 31, 2025
Beginning inventory January 5, 2025 January 25, 2025 February 16, 2025 March 26, 2025
Units 600 1,200 1,300 800 600 4,500
Weighted average cost ($44,600 ÷ 4,500) March 31, 2025, inventory *Rounded.
Unit Cost $ 8.00 9.00 10.00 11.00 12.00
Total Cost $ 4,800 10,800 13,000 8,800 7,200 $44,600
$ 9.91* 1,600
$ 9.91
$15,856
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.13 (15–20 minutes) (a)
(1) 2,100 units available for sale – 1,400 units sold = 700 units in the ending inventory. 500 @ $4.58 = $2,290 200 @ 4.60 = 920 700 $3,210 Ending inventory at FIFO cost. (2) 100 @ $4.10 = 600 @ 4.20 = 700
$ 410 2,520 $2,930 Ending inventory at LIFO cost.
(3) $9,240 cost of goods available for sale ÷ 2,100 units available for sale = $4.40 weighted-average unit cost. 700 units × $4.40 = $3,080 Ending inventory at weighted-average cost. (b)
(1) LIFO will yield the lowest gross profit because this method will yield the highest cost of goods sold figure in the situation presented. The company has experienced rising purchase prices for its inventory acquisitions. In a period of rising prices, LIFO will yield the highest cost of goods sold because the most recent purchase prices (which are the higher prices in this case) are used to price cost of goods sold while the older (and lower) purchase prices are used to cost the ending inventory. (2) LIFO will yield the lowest ending inventory because LIFO uses the oldest costs to price the ending inventory units. The company has experienced rising purchase prices. The oldest costs in this case are the lower costs.
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, Communication, AICPA BB: None Measurement, Reporting, AICPA PC: Communication
Exercise 7.14 (10–15 minutes) (a)
(1)
400 @ $30 = 160 @ $25 =
(2)
400 @ $20 = 160 @ $25 =
$12,000 4,000 $16,000
$ 8,000 4,000 $12,000 Exercise 7.14 (Continued)
(b)
(1)
FIFO
$16,000 [same as (a)]
(2)
LIFO
100 @ $20 = 60 @ $25 = 400 @ $30 =
$ 2,000 1,500 12,000 $15,500
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.15 (15–20 minutes) First-in, first-out Sales revenue (21,000 $50) Cost of goods sold: Inventory, Jan. 1 Purchases Cost of goods available Inventory, Dec. 31 Cost of goods sold Gross profit Operating expenses Net income
Last-in, first-out
$1,050,000 $120,000 592,000* 712,000 (235,000**)
$1,050,000 $120,000 592,000 712,000 (164,000***)
477,000 573,000 200,000 $ 373,000
548,000 502,000 200,000 $ 302,000
*Purchases 6,000 @ $22 =
$132,000
10,000 @ $25 =
250,000
7,000 @ $30 =
210,000 $592,000
**Computation of inventory, Dec. 31: First-in, first-out: 7,000 units @ $30 =
$210,000
1,000 units @ $25 =
25,000 $235,000
***Last-in, first-out: 6,000 units @ $20 =
$120,000
2,000 units @ $22 =
44,000 $164,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.16 (20–25 minutes)
Sandy Alomar Corporation SCHEDULES OF COST OF GOODS SOLD For the First Quarter Ended March 31, 2025
Beginning inventory Plus purchases Cost of goods available for sale Less: Ending inventory Cost of goods sold
Schedule 1 First-in, First-out $ 40,000 146,200* 186,200 61,300 $124,900
Schedule 2 Last-in, First-out $ 40,000 146,200 186,200 56,800 $129,400
*($33,600 + $25,500 + $38,700 + $48,400) Schedules Computing Ending Inventory Units 10,000 34,000 44,000 30,000 14,000
Beginning inventory Plus purchases Units available for sale Less sales ($150,000 ÷ 5) Ending inventory
The unit computation is the same for both assumptions, but the cost assigned to the units of ending inventory are different. First-in, First-out (Schedule 1) 11,000 at $4.40 = $48,400 3,000 at $4.30 = 12,900 14,000 $61,300
Last-in, First-out (Schedule 2) 10,000 at $4.00 = $40,000 4,000 at $4.20 = 16,800 14,000 $56,800
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.17 (10–15 minutes) (a)
FIFO Ending Inventory 12/31/2025 76 @ $10.89* = $ 827.64 24 @ $11.88** = 285.12 $1,112.76 *[$11.00 – .01 ($11.00)] **[$12.00 – .01 ($12.00)]
(b)
LIFO Cost of Goods Sold—2025 76 @ $10.89 = $ 827.64 84 @ $11.88 = 997.92 90 @ $14.85* = 1,336.50 15 @ $15.84** = 237.60 $3,399.66 *[$15.00 – .01 ($15.00)] **[$16.00 – .01 ($16.00)]
(c)
FIFO matches older costs with revenue. When prices are declining, as in this case, this results in a higher amount for cost of goods sold. Therefore, it is recommended that FIFO be used by Brady Sports to minimize taxable income.
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analysis, Communication, AICPA BB: None Measurement, Reporting, AICPA PC: Communication
Exercise 7.18 (10–15 minutes) (a)
The difference between the inventory used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO reserve. The change in the allowance balance from one period to the next is called the LIFO effect (or as shown in this example, the LIFO adjustment).
(b)
LIFO subtracts inflation from inventory costs by charging the items purchased recently to cost of goods sold. As a result, ending inventory (assuming increasing prices) will be lower than FIFO or average cost.
Exercise 7.18 (Continued) (c)
Cash flow was computed as follows: Revenue $3,200,000 Cost of goods sold (2,800,000) Operating expenses (150,000) Income taxes (75,600) Cash flow $ 174,400 If the company has any sales on account or payables, then the cash flow number is incorrect. It is assumed here that the cash basis of accounting is used.
(d)
The company has extra cash because its taxes are less. The reason taxes are lower is because cost of goods sold (in a period of inflation) is higher under LIFO than FIFO. As a result, taxable income is lower which leads to lower income taxes. If prices are decreasing, the opposite effect results.
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
Exercise 7.19 (25–30 minutes) (a)
(1)
Ending inventory—Specific Identification Date No. Units Unit Cost December 2 July 20
(2)
Ending inventory—FIFO Date No. Units December 2 September 4
(3)
100 50 150
100 50 150
Ending inventory—LIFO Date No. Units January 1 March 15
100 50 150
Total Cost
$30 25
$3,000 1,250 $4,250
Unit Cost
Total Cost
$30 28
$3,000 1,400 $4,400
Unit Cost
Total Cost
$20 24
$2,000 1,200 $3,200
Exercise 7.19 (Continued) (4) Ending inventory—Average-Cost Date
Explanation
January 1 March 15 July 20 September 4 December 2
Beginning inventory Purchase Purchase Purchase Purchase
No. Units
Unit Cost
Total Cost
100 300 300 200 100 1,000
$20 24 25 28 30
$ 2,000 7,200 7,500 5,600 3,000 $25,300
$25,300 ÷ 1,000 = $25.30 Ending Inventory—Average-Cost No. Units Unit Cost Total Cost 150 $25.30 $3,795 (b)
Double Extension Method Base-Year Costs
Units 150
Base-Year Cost Per Unit $20
Current Costs Total $3,000
Units 100 50
Current-Year Cost Per Unit $30 $28
Ending Inventory for the Period at Current Cost Ending Inventory for the Period at Base-Year Cost
=
Total $3,000 1,400 $4,400
$4,400 = 1.4667 $3,000
Ending inventory at base-year prices ($4,400 ÷ 1.4667) Base layer (100 units at $20) Increment in base-year dollars Current index Increment in current dollars Base layer (100 units at $20) Ending inventory at dollar-value LIFO
$3,000 (2,000) 1,000 X 1.4667 1,467 2,000 $3,467
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Exercise 7.20 (5–10 minutes) $97,000 – $92,000 = $5,000 increase at base prices. $98,350 – $92,600 = $5,750 increase in dollar-value LIFO value. $5,000 × Index = $5,750. Index = $5,750 ÷ $5,000. Index = 115 LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Exercise 7.21 (15–20 minutes) (a)
(b)
12/31/25 inventory at 1/1/25 prices, $140,000 ÷ 1.12 Inventory 1/1/25 Inventory decrease at base prices
$125,000 160,000 $ 35,000
Inventory at 1/1/25 prices Less decrease at 1/1/25 prices Inventory 12/31/25 under dollar-value LIFO method
$160,000 35,000 $125,000
12/31/26 inventory at base prices, $172,500 ÷ 1.15 12/31/25 inventory at base prices Inventory increment at base prices
$150,000 125,000 $ 25,000
Inventory at 12/31/25 Increment added during 2026 at 12/31/26 prices, $25,000 × 1.15 Inventory 12/31/26
$125,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
28,750 $153,750
Exercise 7.22 (20–25 minutes)
2022 2023 2024 2025 2026 2027
Current $ $ 80,000 115,500 108,000 122,200 154,000 176,900
Price Index 1.00 1.05 1.20 1.30 1.40 1.45
Base Year $ $ 80,000 110,000 90,000 94,000 110,000 122,000
Change from Prior Year — $ +30,000 (20,000) + 4,000 +16,000 +12,000
Ending Inventory—Dollar-value LIFO: 2022
$80,000
2023
$80,000 @ 1.00 = 30,000 @ 1.05 =
$ 80,000 31,500 $111,500
2024
$80,000 @ 1.00 = 10,000 @ 1.05 =
$ 80,000 10,500 $ 90,500
2025
$80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 =
$ 80,000 10,500 5,200 $ 95,700
2026 $80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 = 16,000 @ 1.40 = 2027
$ 80,000 10,500 5,200 22,400 $118,100
$80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 = 16,000 @ 1.40 = 12,000 @ 1.45 =
$ 80,000 10,500 5,200 22,400 17,400 $135,500
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Exercise 7.23 (15–20 minutes) Date Dec. 31, 2021 Dec. 31, 2022 Dec. 31, 2023 Dec. 31, 2024 Dec. 31, 2025
Current $ $ 70,000 90,300 95,120 105,600 100,000
Price Index 1.00 1.05 1.16 1.20 1.25
Base-Year $ $70,000 86,000 82,000 88,000 80,000
Change from Prior Year — $+16,000 (4,000) + 6,000 (8,000)
Ending Inventory—Dollar-value LIFO: Dec. 31, 2021 $70,000 Dec. 31, 2022 $70,000 @ 1.00 = 16,000 @ 1.05 =
$70,000 16,800 $86,800
Dec. 31, 2023 $70,000 @ 1.00 = 12,000 @ 1.05 =
$70,000 12,600 $82,600
Dec. 31, 2024 $70,000 @ 1.00 = 12,000 @ 1.05 = 6,000 @ 1.20 =
$70,000 12,600 7,200 $89,800
Dec. 31, 2025 $70,000 @ 1.00 = 10,000 @ 1.05 =
$70,000 10,500 $80,500
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Exercise 7.24 (10–15 minutes)
1.
Working capital Current ratio Retained earnings Net income
Current Year Overstated Overstated Overstated Overstated
Subsequent Year No effect No effect No effect Understated
2.
Working capital Current ratio Retained earnings Net income
No effect Overstated* No effect No effect
No effect No effect No effect No effect
3.
Working capital Current ratio Retained earnings Net income
Overstated Overstated Overstated Overstated
No effect No effect No effect Understated
*Assume that the correct current ratio is greater than one. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Exercise 7.25 (10–15 minutes) (a)
$370,000 = 1.85 to 1 $200,000 $370,000 + $22,000 – $13,000 $200,000 – $15,000
(b)
=
$379,000 = 2.05 to 1 $185,000
(c) 1. 2. 3.
Event Understatement of ending inventory Overstatement of purchases Overstatement of ending inventory
Effect of Error Decreases net income
Adjust Income Increase (Decrease) $22,000
Decreases net income Increases net income
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Exercise 7.26 (15–20 minutes)
15,000 (13,000) $24,000
Errors in Inventories
Year 2020 2021 2022 2023 2024 2025
Net Income Per Books $ 50,000 52,000 54,000 56,000 58,000 60,000 $330,000
Add Overstatement Jan. 1
Deduct Understatement Jan. 1
Deduct Add OverstateUnderstatement Dec. 31 ment Dec. 31 $3,000* 9,000
$3,000 9,000
$11,000 $11,000 2,000 2,000
8,000
*The error will reverse in 2021. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Corrected Net Income $ 47,000 46,000 74,000 45,000 60,000 50,000 $322,000
Time and Purpose of Problems Problem 7.1 (Time 30–40 minutes) Purpose—to provide a multipurpose problem with trade discounts, goods in transit, computing internal price indexes, dollar-value LIFO, comparative FIFO, LIFO, and average-cost computations, and inventoriable cost identification. Problem 7.2 (Time 25–35 minutes) Purpose—to provide the student with eight different situations that require analysis to determine their impact on inventory, accounts payable, and net sales. Problem 7.3 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to prepare general journal entries to record purchases on a gross and net basis. Problem 7.4 (Time 40–55 minutes) Purpose—to provide a problem where the student must compute the inventory using a FIFO, LIFO, and average-cost assumption. These inventory value determinations must be made under two differing assumptions: (1) perpetual inventory records are kept in units only and (2) perpetual records are kept in dollars. Many detailed computations must be made in this problem. Problem 7.5 (Time 40–55 minutes) Purpose—to provide a problem where the student must compute the inventory using a FIFO, LIFO, and average-cost assumption. These inventory value determinations must be made under two differing assumptions: (1) perpetual inventory records are kept in units only and (2) perpetual records are kept in dollars. This problem is very similar to Problem 7.4, except that the differences in inventory values must be explained. Problem 7.6 (Time 25–35 minutes) Purpose—to provide a problem where the student must compute cost of goods sold using FIFO, LIFO, and weighted average, under both a periodic and perpetual system. Problem 7.7 (Time 30–40 minutes) Purpose—to provide a problem where the student must identify the accounts that would be affected if LIFO had been used rather than FIFO for purposes of computing inventories. Problem 7.8 (Time 30–40 minutes) Purpose—to provide a problem which covers the use of inventory pools for dollar-value LIFO. The student is required to compute ending inventory, cost of goods sold, and gross profit using dollar-value LIFO, first with one inventory pool and then with three pools. Problem 7.9 (Time 25–35 minutes) Purpose—the student computes the internal conversion price indexes for a LIFO inventory pool and then computes the inventory amounts using the dollar-value LIFO method. Problem 7.10 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to compute inventories using the dollar-value approach. An index must be developed in this problem to price the new layers. This problem will prove difficult for the student because the indexes are hidden. Problem 7.11 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to write a memo on how a dollar-value LIFO pool works. In addition, the student must explain the step-by-step procedure used to compute dollar value LIFO.
Solutions to Problems Problem 7.1
1.
$175,000 – ($175,000 × .20) = $140,000; $140,000 – ($140,000 × .10) = $126,000, cost of goods purchased
2.
$1,100,000 + $69,000 = $1,169,000. The $69,000 of goods in transit on which title had passed on December 24 (f.o.b. shipping point) should be added to 12/31/25 inventory. The $29,000 of goods shipped (f.o.b. shipping point) on January 3, 2026, should remain part of the 12/31/25 inventory.
3.
Because no date was associated with the units issued or sold, the periodic (rather than perpetual) inventory method must be assumed. FIFO inventory cost:
1,000 units at $24 1,000 units at 23 Total
$ 24,000 23,000 $ 47,000
LIFO inventory cost:
1,500 units at $21 500 units at 22 Total
$ 31,500 11,000 $ 42,500
Average-cost:
1,500 at $21 2,000 at 22 3,500 at 23 1,000 at 24 8,000
$ 31,500 44,000 80,500 24,000 $180,000
Totals
$180,000 ÷ 8,000 = $22.50 Ending inventory (2,000 × $22.50) is $45,000.
Problem 7.1 (Continued) 4.
Computation of price indexes: 12/31/25
$264,000 = 1.10 (110) $240,000
12/31/26
$286,720 = 1.12 (112) $256,000
Dollar-value LIFO inventory 12/31/25: Increase $240,000 – $200,000 = 12/31/25 price index Increase in terms of 110 Base inventory Dollar-value LIFO inventory
$ 40,000 × 1.10 44,000 2025 Layer 200,000 $244,000
Dollar-value LIFO inventory 12/31/26: Increase $256,000 – $240,000 = 12/31/26 price index Increase in terms of 112 2025 layer Base inventory Dollar-value LIFO inventory 5.
$ 16,000 × 1.12 17,920 2026 Layer 44,000 200,000 $261,920
The inventoriable costs for 2026 are: Merchandise purchased ................................ Add: Freight-in .............................................. Deduct: Purchase returns ............................ Purchase discounts ....................... Inventoriable cost ..........................................
$909,400 22,000 931,400 $16,500 6,800
23,300 $908,100
LO: 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC:, AICPA BB: None
Problem 7.2 DIMITRI COMPANY Schedule of Adjustments December 31, 2025
Initial amounts Adjustments: 1. 2. 3. 4. 5. 6. 7. 8. Total adjustments Adjusted amounts
Inventory $1,520,000
Accounts Payable $1,200,000
Net Sales $8,150,000
NONE 76,000 30,000 32,000 26,000 27,000 NONE 4,000 195,000 $1,715,000
NONE 76,000 NONE NONE NONE NONE 56,000 8,000 140,000 $1,340,000
(40,000) NONE NONE (47,000) NONE NONE NONE NONE (87,000) $8,063,000
1.
The $31,000 of tools on the loading dock were properly included in the physical count. The sale should not be recorded until the goods are picked up by the common carrier. Therefore, no adjustment is made to inventory, but sales must be reduced by the $40,000 billing price.
2.
The $76,000 of goods in transit from a vendor to Dimitri were shipped f.o.b. shipping point on 12/29/25. Title passes to the buyer as soon as goods are delivered to the common carrier when sold f.o.b. shipping point. Therefore, these goods are properly includable in Dimitri’s inventory and accounts payable at 12/31/25. Both inventory and accounts payable must be increased by $76,000.
3.
The work-in-process inventory sent to an outside processor is Dimitri’s property and should be included in ending inventory. Since this inventory was not in the plant at the time of the physical count, the inventory column must be increased by $30,000.
Problem 7.2 (Continued) 4.
The tools costing $32,000 were recorded as sales ($47,000) in 2025. However, these items were returned by customers on December 31, so 2025 net sales should be reduced by the $47,000 return. Also, $32,000 has to be added to the inventory column since these goods were not included in the physical count.
5.
The $26,000 of Dimitri’s tools shipped to a customer f.o.b. destination are still owned by Dimitri while in transit because title does not pass on these goods until they are received by the buyer. Therefore, $26,000 must be added to the inventory column. No adjustment is necessary in the sales column because the sale was properly recorded in 2026 when the customer received the goods.
6.
The goods received from a vendor at 5:00 p.m. on 12/31/25 should be included in the ending inventory but were not included in the physical count. Therefore, $27,000 must be added to the inventory column. No adjustment is made to accounts payable, since the invoice was included in 12/31/25 accounts payable.
7.
The $56,000 of goods received on 12/26/25 were properly included in the physical count of inventory; $56,000 must be added to accounts payable since the invoice was not included in the 12/31/25 accounts payable balance.
8.
Since one-half of the freight-in cost ($8,000) pertains to merchandise properly included in inventory as of 12/31/25, $4,000 should be added to the inventory column. The remaining $4,000 debit should be reflected in cost of goods sold. The full $8,000 must be added to accounts payable since the liability was not recorded.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
Problem 7.3 (a)
1.
2.
8/10 Purchases......................................................... Accounts Payable ...................................
12,000
8/13 Accounts Payable ............................................ Purchase Returns and Allowances ........
1,200
8/15 Purchases......................................................... Accounts Payable ...................................
16,000
8/25 Purchases......................................................... Accounts Payable ...................................
20,000
8/28 Accounts Payable ............................................ Cash .........................................................
16,000
12,000
1,200
16,000
20,000
16,000
Purchases—addition to beginning inventory in cost of goods sold section of income statement. Purchase returns and allowances—deduction from purchases in cost of goods sold section of the income statement. Accounts payable—current liability in the current liabilities section of the balance sheet.
(b)
1.
8/10 Purchases......................................................... Accounts Payable ($12,000 × .98) .......... 8/13 Accounts Payable ............................................ Purchase Returns and Allowances ($1,200 × .98).........................................
11,760 11,760 1,176 1,176
Problem 7.3 (Continued)
2.
3.
(c)
8/15 Purchases.......................................................... Accounts Payable ($16,000 × .99) ...........
15,840
8/25 Purchases.......................................................... Accounts Payable ($20,000 × .98) ...........
19,600
8/28 Accounts Payable ............................................. Purchase Discounts Lost ................................. Cash ..........................................................
15,840 160
8/31 Purchase Discounts Lost ................................. Accounts Payable (.02 × [$12,000 – $1,200]) ......................
15,840
19,600
16,000 216 216
Same as part (a) (2) except: Purchase Discounts Lost—treat as financial expense in income statement.
The second method is better theoretically because it results in the inventory being carried net of purchase discounts, and purchase discounts not taken are shown as an expense. The first method is normally used, however, for practical reasons.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
Problem 7.4 (a)
Purchases Total Units April 1 (balance on hand) April 4 April 11 April 18 April 26 April 30 Total units Total units sold Total units (ending inventory)
Sales Total Units 100 400 300 200 600 200 1,800 1,450 350
April 5 April 12 April 27 April 28 Total units
300 200 800 150 1,450
Assuming costs are not computed for each withdrawal: 1.
2.
First-in, first-out. Date of Invoice April 30 April 26
No. Units 200 150
Unit Cost $5.80 5.60
Total Cost $1,160 840 $2,000
Last-in, first-out. Date of Invoice April 1 April 4
No. Units 100 250
Unit Cost $5.00 5.10
Total Cost $ 500 1,275 $1,775
Problem 7.4 (Continued) 3.
Average-cost. Cost of Part X available. Date of Invoice No. Units April 1 100 April 4 400 April 11 300 April 18 200 April 26 600 April 30 200 Total Available 1,800
Unit Cost $5.00 5.10 5.30 5.35 5.60 5.80
Total Cost $ 500 2,040 1,590 1,070 3,360 1,160 $9,720
Average-cost per unit = $9,720 ÷ 1,800 = $5.40. Inventory, April 30 = 350 × $5.40 = $1,890. (b) Assuming costs are computed for each withdrawal: 1.
First-in, first-out. The inventory would be the same in amount as in part (a), $2,000.
Problem 7.4 (Continued) 2.
Last-in, first-out. Purchased Date
No. of units
Unit cost
April 1
100
April 4
400
Unit cost
Amount
$5.00
100
$5.00
$
5.10
100
5.00
400
5.10
April 26
100
5.00
100
5.10
300
100
5.00
100
5.10
300
5.30
100
5.00
100
5.10
100
5.30
100
5.00
100
5.10
100
5.30
200
5.35
100
5.00
100
5.10
100
5.30
200
5.35
600
5.60
100
5.00
100
5.10
100
5.30
$5.10
5.30
200
200
600
5.60
800
April 28 150 200
5.30
5.35
April 27
April 30
Unit cost
300
April 12
April 18
No. of units
Balance* No. of units
April 5 April 11
Sold
5.80
600 @
5.60
200 @
5.35
100 @
5.30
100
5.00
50 @
5.10
50
5.10
100
5.00
50
5.10
200
5.80
500 2,540 1,010
2,600
1,540
2,610
5,970
1,540
755
1,915
Inventory, April 30 is $1,915. *The balance on hand is listed in detail after each transaction.
Problem 7.4 (Continued) 3.
Average-cost. Purchased Date
No. of units
Unit cost
April 1
100
April 4
400
No. of units
Unit cost*
Amount
$5.00
100
$5.0000
$ 500.00
5.10
500
5.0800
2,540.00
200
5.0800
1,016.00
500
5.2120
2,606.00
300
5.2120
1,563.60
300 300
Unit cost
Balance No. of units
April 5 April 11
Sold
$5.0800
5.30
April 12
200
5.2120
April 18
200
5.35
500
5.2672
2,633.60
April 26
600
5.60
1,100
5.4487
5,993.57
April 27
800
5.4487
300
5.4487
1,634.61
April 28
150
5.4487
150
5.4487
817.30
350
5.6494
1,977.30
April 30
200
5.80
Inventory, April 30 is $1,977.30 *Four decimal places are used to minimize rounding errors. LO: 3, Bloom: AP Complex, Time: 40-55, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC:, AICPA BB: None
Problem 7.5 (a) Assuming costs are not computed for each withdrawal (units received, 5,700, minus units issued, 4,700, equals ending inventory of 1,000 units): 1.
2.
3.
First-in, first-out. Date of Invoice Jan. 28
No. Units 1,000
Unit Cost $3.50
Total Cost $3,500
Last-in, first-out. Date of Invoice Jan. 2
No. Units 1,000
Unit Cost $3.00
Total Cost $3,000
Unit Cost $3.00 3.20 3.30 3.40 3.50
Total Cost $ 3,600 1,920 3,300 4,420 5,600 $18,840
Average-cost. Cost of goods available: Date of Invoice No. Units Jan. 2 1,200 Jan. 10 600 Jan. 18 1,000 Jan. 23 1,300 Jan. 28 1,600 Total Available 5,700
Average-cost per unit = $18,840 ÷ 5,700 = $3.31 Cost of inventory Jan. 31 = 1,000 × $3.31 = $3,310 (b) Assuming costs are computed at the time of each withdrawal: Under FIFO—Yes. The amount shown as ending inventory would be the same as in (a) above. In each case the units on hand would be assumed to be part of those purchased on Jan. 28. Under LIFO—No. During the month the available balance dropped below the ending inventory quantity so that the layers of oldest costs were partially liquidated during the month.
Problem 7.5 (Continued) Under Average-Cost — No. A new average cost would be computed each time a purchase was made instead of only once for all items purchased during the year. The calculations to determine the inventory on this basis are given below. 1.
First-in, first-out. The inventory would be the same in amount as in part (a), $3,500.
2.
Last-in, first-out. Received Date
No. of units
Unit cost
Jan. 2
1,200
$3.00
Jan. 7 Jan. 10
600
500 1,000
1,300
3.30
Jan. 31
300
3.20 3.30
700
3.30
100
3.20
300
3.00
800 1,600
$3.00
3.40
Jan. 26 Jan. 28
Unit cost
3.20
Jan. 20
Jan. 23
No. of units 700
Jan. 13 Jan. 18
Issued
3.40
3.50
1,300
Inventory, January 31 is $3,350.
3.50
Balance No. of units
Unit cost*
Amount
1,200
$3.00
$3,600
500
3.00
1,500
500
3.00
600
3.20
500
3.00
100
3.20
500
3.00
100
3.20
700
3.30
200
3.00
200
3.00
1,300
3.40
200
3.00
500
3.40
200
3.00
500
3.40
1,600
3.50
200
3.00
500
3.40
300
3.50
3,420 1,820
4,130
600 5,020 2,300
7,900
3,350
Problem 7.5 (Continued) 3.
Average-cost. Received Date
No. of units
Unit cost
Jan. 2
1,200
$3.00
Jan. 7 Jan. 10
600 1,000 1,300
3.30
Jan. 31
$3.0000
No. of units
Unit cost*
Amount
1,200
$3.0000
$3,600
500
3.0000
1,500
1,100
3.1091
3,420
3.1091
600
3.1091
1,865
300
3.2281
1,300
3.2281
4,197
1,100
3.2281
200
3.2281
646
1,500
3.3773
5,066
700
3.3773
2,364
2,300
3.4626
7,964
1,000
3.4626
3,463
800 1,600
Balance
500
3.40
Jan. 26 Jan. 28
Unit cost
3.20
Jan. 20 Jan. 23
No. of units 700
Jan. 13 Jan. 18
Issued
3.3773
3.50 1,300
3.4626
Inventory, January 31 is $3,463. *Four decimal places are used to minimize rounding errors. LO: 3, Bloom: AP Complex, Time: 40-55, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC:, AICPA BB: None
Problem 7.6
(a)
(b)
(c)
(d) Date
Beginning inventory .................... Purchases (2,000 + 3,000) ........... Units available for sale ................ Sales (2,500 + 2,200) .................... Goods on hand ............................ Periodic FIFO 1,000 × $12 = 2,000 × $18 = 1,700 × $23 = 4,700
$12,000 36,000 39,100 $87,100
Perpetual FIFO Same as periodic:
$87,100
Periodic LIFO 3,000 × $23 = 1,700 × $18 = 4,700
$69,000 30,600 $99,600
1,000 5,000 6,000 (4,700) 1,300
Perpetual LIFO Purchased
Sold
Balance
1/1 2/4
1,000 × $12 2,000 × $18 = $36,000
1,000 × $12 2,000 × $18
2/20
2,000 × $18 500 × $12
4/2
} $42,000
3,000 × $23 = $69,000
500 × $12 2,200 × $23
= $50,600
500 × $12 800 × $23
$92,600
}
500 × $12 3,000 × $23
11/4
=
$12,000 $48,000
=
$ 6,000
}
$75,000
}
$24,400
Problem 7.6 (Continued) (e)
(f)
Periodic weighted-average 1,000 × $12 = $ 12,000 2,000 × $18 = 36,000 3,000 × $23 = 69,000 $117,000 ÷ 6,000 = $19.50
4,700 × $19.50 $91,650
Perpetual moving average Date
Purchased
Sold
Balance
1/1
1,000 × $12 = $12,000
2/4
2,000 × $18 = $36,000
2/20
2,500 × $16 =
4/2
$40,000
48,000
500 × $16 =
8,000
a
3,000 × $23 = $69,000
11/4
3,000 × $16 =
2,200 × $22 =
48,400
3,500 × $22 =
77,000
1,300 × $22 =
28,600
$88,400 a
500 × $16 = $ 8,000 3,000 × $23 = 69,000 3,500
$77,000
($77,000 ÷ 3,500 = $22) LO: 3, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analysis, AICPA BB: None Measurement, Reporting, AICPA PC: AICPA BB: None
Problem 7.7 The accounts in the 2026 financial statements which would be affected by a change to LIFO and the new amount for each of the accounts are as follows: New amount Account for 2026 (1) Cash $176,400 (2) Inventory 120,000 (3) Retained earnings 226,400 (4) Cost of goods sold 792,000 (5) Income taxes 101,600 The calculations for both 2025 and 2026 to support the conversion to LIFO are presented below. Income for the Years Ended
12/31/25
12/31/26
Sales revenue Less: Cost of goods sold Other expenses Income before taxes Income taxes (40%) Net income
$900,000 525,000 205,000 730,000 170,000 68,000 $102,000
$1,350,000 792,000 304,000 1,096,000 254,000 101,600 $ 152,400
Cost of Goods Sold and Ending Inventory for the Years Ended
12/31/25
12/31/26
Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold
$120,000 525,000 645,000 (120,000) $525,000
( 40,000 × $3.00) (150,000 × $3.50) ( 40,000 × $3.00)
( 40,000 × $3.00) (180,000 × $4.40) ( 40,000 × $3.00)
$120,000 792,000 912,000 (120,000) $792,000
Determination of Cash at
12/31/25
12/31/26
Income taxes under FIFO Income taxes as calculated under LIFO Increase in cash Adjust cash at 12/31/26 for 2025 tax difference Total increase in cash Cash balance under FIFO Cash balance under LIFO
$ 76,000 68,000 8,000
$116,000 101,600 14,400
— 8,000 130,000 $138,000
8,000 22,400 154,000 $176,400
Problem 7.7 (Continued) Determination of Retained Earnings at
12/31/25
12/31/26
Net income under FIFO Net income under LIFO Reduction in retained earnings Adjust retained earnings at 12/31/26 for 2025 reduction Total reduction in retained earnings Retained earnings under FIFO Retained earnings under LIFO
$114,000 (102,000) 12,000
$174,000 (152,400) 21,600
— 12,000 200,000 $188,000
12,000 33,600 260,000 $226,400
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Problem 7.8
(a)
1.
2.
3.
Ending inventory in units Portable 6,000 + 15,000 – 14,000 = Midsize 8,000 + 20,000 – 24,000 = Flat-screen 3,000 + 10,000 – 6,000 =
Ending inventory at current cost Portable 7,000 × $110 = Midsize 4,000 × $300 = Flat-screen 7,000 × $500 =
Ending inventory at base-year cost Portable 7,000 × $100 = Midsize 4,000 × $250 = Flat-screen 7,000 × $400 =
4.
Price index $5,470,000 ÷ $4,500,000 = 1.2156
5.
Ending inventory $3,800,000 × 1.0000 = 700,000* × 1.2156 =
7,000 4,000 7,000 18,000
$ 770,000 1,200,000 3,500,000 $5,470,000
$ 700,000 1,000,000 2,800,000 $4,500,000
$3,800,000 850,920 $4,650,920
*($4,500,000 – $3,800,000 = $700,000) 6.
Cost of goods sold Beginning inventory ............................................... Purchases [(15,000 × $110) + (20,000 × $300) + (10,000 × $500)] .................................................... Cost of goods available .......................................... Ending inventory..................................................... Cost of goods sold............................................
$ 3,800,000
12,650,000 16,450,000 (4,650,920) $11,799,080
Problem 7.8 (Continued) 7.
(b)
1.
Gross profit Sales revenue [(14,000 × $150) + (24,000 × $405) + (6,000 × $600)] ......................................................... Cost of goods sold..................................................... Gross profit ................................................................
$15,420,000 11,799,080 $ 3,620,920
Ending inventory at current cost restated to base cost Portable $ 770,000 ÷ 1.10a = $ 700,000 Midsize 1,200,000 ÷ 1.20b = $ 1,000,000 Flat-screen 3,500,000 ÷ 1.25c = $ 2,800,000 a. $110 ÷ $100 b. $300 ÷ $250 c. $500 ÷ $400
2.
3.
4.
Ending inventory Portable $ 600,000 × 1.00 = 100,000 × 1.10 = Midsize 1,000,000 × 1.00 = Flat-screen 1,200,000 × 1.00 = 1,600,000 × 1.25 =
$
600,000 110,000 1,000,000 1,200,000 2,000,000 $ 4,910,000
Cost of goods sold Cost of goods available ............................................. Ending inventory ........................................................ Cost of goods sold ...............................................
$16,450,000 (4,910,000) $11,540,000
Gross profit Sales revenue ............................................................. Cost of goods sold..................................................... Gross profit ................................................................
$15,420,000 11,540,000 $ 3,880,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC:, AICPA BB: None
Problem 7.9 (a)
BONANZA WHOLESALERS INC. Computation of Internal Conversion Price Index for Inventory Pool No. 1 Double Extension Method
Current inventory at current-year cost Product A Product B
17,000 × $36 = 9,000 × $26 =
Current inventory at base cost Product A Product B
17,000 × $30 = 9,000 × $25 =
2025 $612,000 234,000 $846,000
$510,000 225,000 $735,000
Conversion price index $846,000 ÷ $735,000 = 1.15
(b)
13,000 × $30 = 10,000 × $25 =
$390,000 250,000 $640,000
$840,000 ÷ $640,000 = 1.31
BONANZA WHOLESALERS INC. Computation of Inventory Amounts Under Dollar-Value LIFO Method for Inventory Pool No. 1 at December 31, 2025 and 2026 Current Inventory at base cost
December 31, 2025 Base inventory 2025 layer ($735,000 – $525,000) Total
$525,000 210,000 $735,000
December 31, 2026 Base inventory 2025 layer (remaining) Total
$525,000 115,000 $640,000
(a) (b)
13,000 × $40 = 10,000 × $32 =
2026 $520,000 320,000 $840,000
Conversion price index 1.00 1.15
(a)
$525,000 241,500 $766,500
(a)
$525,000 132,250 $657,250
(a)
(b) (a)
1.00 1.15
Inventory at LIFO cost
Per schedule for instruction (a). After liquidation of $95,000 base cost ($735,000 – $640,000).
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Problem 7.10 Base-Year Cost December 31, 2024 January 1, 2024, base December 31, 2024, layer
December 31, 2025 January 1, 2024, base December 31, 2024, layer December 31, 2025, layer
December 31, 2026 January 1, 2024, base December 31, 2024, layer December 31, 2025, layer December 31, 2026, layer
Index %
Dollar-Value LIFO
$45,000 11,000 $56,000
100 112*
$45,000 12,320 $57,320
$45,000 11,000 12,400 $68,400
100 112 128**
$45,000 12,320 15,872 $73,192
$45,000 11,000 12,400 1,600 $70,000
100 112 128 130***
$45,000 12,320 15,872 2,080 $75,272
*$62,700 ÷ $56,000 **$87,300 ÷ $68,400 ***$90,800 ÷ $70,000 LO: 4, Bloom: AP Complex, Time: 30-35, AACSB: Analysis, AICPA BB: None Reporting, AICPA PC: AICPA BB: None
Problem 7.11 (a) Schedule A
2021 2022 2023 2024 2025 2026
A
B
C
Current $ $ 80,000 111,300 108,000 128,700 147,000 174,000
Price Index 1.00 1.05 1.20 1.30 1.40 1.45
Base-Year $ $ 80,000 106,000 90,000 99,000 105,000 120,000
D Change from Prior Year — + $26,000 (16,000) + 9,000 + 6,000 + 15,000
Schedule B Ending Inventory-Dollar-Value LIFO: 2021 2022
2023
2024
$80,000 @ $1.00 = 26,000 @ 1.05 = $80,000 @ 1.00 = 10,000 @ 1.05 = $80,000 @ 1.00 = 10,000 @ 1.05 = 9,000 @ 1.30 =
$ 80,000 $ 80,000 27,300 $107,300 $ 80,000 10,500 $ 90,500 $ 80,000 10,500 11,700 $102,200
2025 $80,000 @ $1.00 = 10,000 @ 1.05 = 9,000 @ 1.30 = 6,000 @ 1.40 = 2026 $80,000 @ 10,000 @ 9,000 @ 6,000 @ 15,000 @
1.00 = 1.05 = 1.30 = 1.40 = 1.45 =
$ 80,000 10,500 11,700 8,400 $110,600 $ 80,000 10,500 11,700 8,400 21,750 $132,350
Problem 7.11 (Continued) (b) To:
Richardson Company
From:
Accounting Student
Subject:
Dollar-Value LIFO Pool Accounting
Dollar-value LIFO is an inventory method which values groups or “pools” of inventory in layers of costs. It assumes that any goods sold during a given period were taken from the most recently acquired group of goods in stock and, consequently, any goods remaining in inventory are assumed to be the oldest goods, valued at the oldest prices. Because dollar-value LIFO combines various related costs in groups or “pools,” no attempt is made to keep track of each individual inventory item. Instead, each group of annual purchases forms a new cost layer of inventory. Further, the most recent layer will be the first one carried to cost of goods sold during this period. However, inflation distorts any cost of purchases made in subsequent years. To counteract the effect of inflation, this method measures the incremental change in each year’s ending inventory in terms of the first year’s (base year’s) costs. This is done by adjusting subsequent cost layers, through the use of a price index, to the base year’s inventory costs. Only after this adjustment can the new layer be valued at current-year prices. To do this valuation, you need to know both the ending inventory at yearend prices and the price index used to adjust the current year’s new layer. The idea is to convert the current ending inventory into base-year costs. The difference between the current year’s and the previous year’s ending inventory expressed in base-year costs usually represents any inventory which has been purchased but not sold during the year, that is, the newest LIFO layer. This difference is then readjusted to express this most recent layer in current-year costs.
Problem 7.11 (Continued) 1.
Refer to Schedule A. To express each year’s ending inventory (Column A) in terms of base-year costs, simply divide the ending inventory by the price index (Column B). For 2021, this adjustment would be $80,000/ 100% or $80,000; for 2022, it would be $111,300/105%, etc. The quotient (Column C) is thus expressed in base-year costs.
2.
Next, compute the difference between the previous and the current years’ ending inventory in base-year costs. Simply subtract the current year’s base-year inventory from the previous year’s. In 2022, the change is +$26,000 (Column D).
3.
Finally, express this increment in current-year terms. For the second year, this computation is straightforward: the base-year ending inventory value is added to the difference in #2 above multiplied by the price index. For 2022, the ending inventory for dollar-value LIFO would equal $80,000 of base-year inventory plus the increment ($26,000) times the price index (1.05) or $107,300. The product is the most recent layer expressed in current-year prices. See Schedule B.
Be careful with this last step in subsequent years. Notice that, in 2023, the change from the previous year is –$16,000, which causes the 2022 layer to be eroded during the period. Thus, the 2023 ending inventory is valued at the original base-year cost $80,000 plus the remainder valued at the 2022 price index, $10,000 times 1.05. See 2023 computation on Schedule B. When valuing ending inventory, remember to include each yearly layer adjusted by that year’s price index. Refer to Schedule B for 2024. Notice that the +$9,000 change from the 2024 ending inventory indicates that the 2022 layer was not further eroded. Thus, ending inventory for 2024 would value the first $80,000 worth of inventory at the base-year price index (1.00), the next $10,000 (the remainder of the 2022 layer) at the 2022 price index (1.05), and the last $9,000 at the 2024 price index (1.30). These instructions should help you implement dollar-value LIFO in your inventory valuation. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 40-50, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
UYJ7.1 Financial Statement Analysis Case (a)
Sales ....................................................................... Cost of goods sold* ............................................... Gross profit ............................................................ Selling and administrative expense ..................... Income from operations ........................................ Other expense ........................................................ Income before income tax .....................................
$618,876,000 474,206,000 144,670,000 102,112,000 42,558,000 24,712,000 $ 17,846,000
*Cost of goods sold (per annual report) ................ LIFO effect ($5,263,000 – $3,993,000) ................... Cost of goods sold (per FIFO) ..............................
$475,476,000 (1,270,000) $474,206,000
(b)
$17,846,000 income before taxes × 46.6% tax = $8,316,236 tax; $17,846,000 – $8,316,236 tax = $9,529,764 net income as compared to $8,848,000 net income under LIFO. This is $681,764 or about 8% different. The question as to materiality is to allow the students an opportunity to judge the significance of the difference between the two costing methods. Since it is less than 10% different, some students may feel that it is not material. An 8% change in net income, however, is probably material, but this would depend on the industry and perhaps on the company’s own past averages.
(c)
No, the use of different costing methods does not necessarily mean that there is a difference in the physical flow of goods. As explained in the text, the actual physical flow need have no relationship to the cost flow assumption. The management of T J International has determined that LIFO is appropriate only for a subset of its products, and these reasons have to do with economic characteristics, rather than the physical flow of the goods.
LO: 3, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None Reporting, Research, AICPA PC: Communication
UYJ7.2 Financial Statement Analysis Case (a)
The most likely physical flow of goods for a pharmaceutical manufacturer would be FIFO; that is, the first goods manufactured would be the first goods sold. This is because pharmaceutical goods have an expiration date. The manufacturer would be careful to ship the goods made earliest first and thereby reduce the risk that outdated goods will remain in the warehouse.
(b)
Noven should consider first whether the inventory costing method will make a difference. If the prices in the economy, especially if the raw materials prices, are stable, then the inventory cost will be nearly the same under any of the measurement methods. If inventory levels are very small, then the method used will make little difference. Noven should also consider the cost of keeping records. A small company might not want to invest in complicated record keeping. The tax effects of any differences should be considered, as well as any international rules that might dictate Noven’s measurement of part of its inventory.
(c)
This amount is likely not shown in a separate inventory account because it is immaterial; that is, it is not large enough to make a difference with investors. Another possible reason is that no goods have yet been offered for sale. This amount might be in the Inventory of supplies account, but it is more likely to be included with Prepaid and other current assets since it clearly is not just an item of supplies. This will definitely be shown separately as soon as Noven begins to sell its products to outside customers.
LO: 3, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None Reporting, Research, AICPA PC: Communication
UYJ7.3 Financial Statement Analysis Case
Net Sales .........................................
February 1, 2020 $122,286
February 2, 2019 $121,852
February 3, 2018 $122,662
Cost of sales (using LIFO) ............. Year-end inventories using FIFO .. Year-end inventories using LIFO .. Difference ............................... FIFO adjusted cost of sales............
95,294 8,464 7,084 (1,380) $ 93,914
95,103 8,123 6,846 (1,277) $ 93,826
95,662 7,781 6,533 (1,248) $ 94,414
(a)
2020 2021 (1) Inventory turnover @ LIFO* 13.68 14.22 (2) Inventory turnover @ FIFO* 11.32 11.80 Recall that the formula for computing inventory turnover is Cost of Sales/Average Inventory
(b)
2020 2019 (1) Inventory turnover using sales and LIFO* 17.56 18.21 Recall that the formula for computing inventory turnover in part (b) is Sales/Average Inventory (2) Inventory turnover using sales and FIFO* 14.74 15.32
(c)
Using sales instead of cost of goods sold accounts for the mark-up in the inventory. By using cost of goods sold, there is a better matching of the costs associated to inventory and should result in more useful information.
*Computations for Inventory Turnover a) Inventory turnover LIFO– 2020 - $95,294/{($7,084 + $6,846)/2} = 13.68 2019 - $95,103/{($6,846 + $6,533)/2} = 14.22 Inventory turnover FIFO– 2020 - $93,914/{($8,464 + $8,123)/2} = 11.32 2019 - $93,826/{($8,123 + $7,781)/2} = 11.80
UYJ7.3 Financial Statement Analysis Case (Continued) b) Inventory turnover LIFO– 2020 - $122,286/{($7,084 + $6,846)/2} = 17.56 2019 - $121,852/{($6,846 + $6,533)/2} = 18.21 Inventory turnover FIFO– 2020 - $122,286/{($8,464 + $8,123)/2} = 14.74 2019 - $121,852/{($8,123 + $7,781)/2} = 15.32 LO: 3, Bloom: AN, Difficulty: Complex, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None Reporting, Research, AICPA PC: Communication
UYJ7.4 Accounting, Analysis, and Principles Accounting (a)
FIFO
Residential pumps: Ending inventory cost = (300 × $500) + (200 × $475) = Beginning inventory cost = (200 × $400) = Purchases = $225,000 + $190,000 + $150,000 = Cost of goods sold = $80,000 + $565,000 – $245,000 =
$ 245,000 $ 80,000 $ 565,000 $ 400,000
Commercial pumps: Ending inventory at cost = (500 × $1,000) = Beginning inventory at cost = (600 × $800) = Purchases = $540,000 + $285,000 + $500,000 = Cost of goods sold = $480,000 + $1,325,000 – $500,000 =
$ 500,000 $ 480,000 $1,325,000 $1,305,000
Total ending inventory at cost = $245,000 + $500,000 =
$ 745,000
Total cost of goods sold = $1,305,000 + $400,000 =
$1,705,000
(b)
Dollar-value LIFO (one pool) Ending inventory at current cost = Ending inventory at base-year cost = (500 × $800) + (500 × $400) = Price index = $745,000 / $600,000 = 1.242 Current Inventory at base cost
Ending inventory Base inventory ($80,000 + $480,000) Layer ($600,000 – $560,000) Total
$560,000 40,000 $600,000
$ 745,000 $ 600,000
Conversion price index 1.000 1.242
Cost of goods sold = $560,000 + ($565,000 + $1,325,000) – $609,680 =
Inventory at LIFO cost $560,000 49,680 $609,680
$1,840,320
UYJ7.4 Accounting, Analysis, and Principles (Continued) Analysis (a)
The purpose of a current ratio is to provide some indication of the resources the company has available to meet short term obligations if those obligations come due. FIFO, which generally approximates the current cost of inventory, usually better suits this objective. LIFO inventory numbers on a balance sheet can sometimes be stated at lower values.
(b)
The U.S. Securities and Exchange Commission requires companies using LIFO to disclose the current cost of their inventories. Many companies disclose the FIFO cost of their inventories since that generally approximates current cost. This difference between LIFO cost and current cost is called the “LIFO reserve.” A financial statement reader can use the LIFO reserve to convert a LIFO company’s inventory and cost of goods sold to what they would have been if the company had used FIFO. This makes it possible to directly compare LIFO and FIFO companies, although the comparison must be done on a FIFO basis, not LIFO.
Principles Companies can change from one inventory accounting method to another, but not back and forth. Changes in accounting method (when not mandated by a regulatory body such as the FASB) should be to improve the financial statement reader’s ability to understand the companies’ financial results and position. The tradeoff is usually comparability for consistency. That is, if a company changes to a method that is used by most of its competitors, the change increases comparability. But, because the company now uses different methods across different years, consistency is sacrificed. Companies sometimes change accounting methods because they believe it improves the matching of expenses to revenues. Again, consistency across reporting periods is sacrificed, however. LO: 3, 4, Bloom: SYN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 7.1 (Time 15–20 minutes) Purpose—a short case designed to test the skills of the student in determining whether an item should be reported in inventory. In addition, the student is required to speculate as to why the company may wish to postpone recording this transaction. CT 7.2 (Time 15–25 minutes) Purpose—to provide the student with four questions about the carrying value of inventory. These questions must be answered and defended with rationale. The topics are shipping terms, freight–in, weighted-average cost vs. FIFO, and consigned goods. CT 7.3 (Time 25–35 minutes) Purpose—to provide a number of difficult financial reporting transactions involving inventories. This case is vague, and much judgment is required in its analysis. Right or wrong answers should be discouraged; rather emphasis should be placed on the underlying rationale to defend a given position. Includes a product versus period cost transaction, proper classification of a possible inventory item, and a product financing arrangement. CT 7.4 (Time 15–25 minutes) Purpose—the student discusses the acceptability of alternative methods of reporting cash discounts. Also, the student identifies the effects on financial statements of using LIFO instead of FIFO when prices are rising. CT 7.5 (Time 20–25 minutes) Purpose—to provide a broad overview to students as to why inventories must be included in the balance sheet and income statement. In addition, students are asked to determine why taxable income and accounting income may be different. Finally, the conditions under which FIFO and LIFO may give different answers must be developed. CT 7.6 (Time 15–20 minutes) Purpose—to provide the student with the opportunity to discuss the rationale for the use of the LIFO method of inventory valuation. The conditions that must exist before the tax benefits of LIFO will accrue also must be developed. CT 7.7 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss the cost flow assumptions of average cost, FIFO, and LIFO. Student is also required to distinguish between weighted-average and movingaverage and discuss the effect of LIFO on the B/S and I/S in a period of rising prices. CT 7.8 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to discuss the differences between traditional LIFO and dollar-value LIFO. In this discussion, the specific procedures employed in traditional LIFO and dollarvalue LIFO must be examined. This case provides a good basis for discussing LIFO conceptual issues. CT 7.9 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the concept of a LIFO pool and its use in various LIFO methods. The student is also asked to define LIFO liquidation, to explain the use of price indexes in dollar-value LIFO, and to discuss the advantages of using dollar-value LIFO.
Time and Purposes of Concepts for Analysis (Continued) CT 7.10 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to analyze the effect of changing from the FIFO method to the LIFO method on items such as ending inventory, net income, earnings per share, and year-end cash balance. The student is also asked to make recommendations considering the results from computation and other relevant factors. CT 7.11 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to analyze the ethical implications of purchasing decisions under LIFO.
Solutions to Critical Thinking CT 7.1 (a) Purchased merchandise in transit at the end of an accounting period to which legal title has passed should be recorded as purchases within the accounting period. If goods are shipped f.o.b. shipping point, title passes to the buyer when the seller delivers the goods to the common carrier. Generally, when the terms are f.o.b. shipping point, transportation costs must be paid by the buyer. This liability arises when the common carrier completes the delivery. Thus, the client has a liability for the merchandise and the freight. (b) Inventory............................................................................................... Accounts Payable (Supplier) .............................................................
35,300
Inventory............................................................................................... Accounts Payable (Transportation Co.) ............................................
1,500
35,300
1,500
(c) Possible reasons to postpone the recording of the transaction might include: 1. Desire to maintain a current ratio at a given level which would be affected by the additional inventory and accounts payable. 2. Desire to minimize the impact of the additional inventory on other ratios such as inventory turnover. 3. Possible tax ramifications. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, Communication, Reflective Thinking, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.2 (a) If the terms of the purchase are f.o.b. shipping point (manufacturer’s plant), Strider Enterprises should include in its inventory goods purchased from its suppliers when the goods are shipped. For accounting purposes, title is presumed to pass at that time. (b) Freight-in expenditures should be considered an inventoriable cost because they are part of the price paid or the consideration given to acquire the asset. (c) Theoretically the net approach is the more appropriate because the net amount (1) provides a correct reporting of the cost of the asset and related liability and (2) presents the opportunity to measure the inefficiency of financial management if the discount is not taken. Many believe, however, that the difficulty involved in using the somewhat more complicated net method is not justified by the resulting benefits. (d) Products on consignment represent inventories owned by Strider Enterprises, which are physically transferred to another enterprise. However, Strider Enterprises retains title to the goods until their sale by the other company (Chavez Inc.). The goods consigned are still included by Strider Enterprises in the inventory section of its balance sheet. Often the inventory is reclassified from regular inventory to consigned inventory (Note to instructor: Additional coverage of consignments is presented in chapter 17.) LO: 2, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.3 (a) According to FASB ASC 330-10-30-1: “As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.” The discussion includes the following: “Selling expenses constitute no part of the inventory costs.” To the extent that warehousing is a necessary function of importing merchandise before it can be sold, certain elements of warehousing costs might be considered an appropriate cost of inventory in the warehouse. For example, if goods must be brought into the warehouse before they can be made ready for sale, the cost of bringing such goods into the warehouse would be considered a cost of inventory. Similarly, if goods must be handled in the warehouse for assembly or for removal of foreign packaging, etc., it would be appropriate to include such costs in inventory. However, costs involved in storing the goods for any additional period would appear to be period costs. Costs of delivering the goods from the warehouse would appear to be selling expenses related to the goods sold and should not under any circumstances be allocated to goods that are still in the warehouse. In theory, warehousing costs are considered a product cost because these costs are incurred to maintain the product in a salable condition. However, in practice, warehousing costs are most frequently treated as a period cost. Under the Tax Reform Act of 1986, warehousing and off-site storage of inventory, including finished goods, are specifically included in the “production and resale activities” that are to be capitalized for tax purposes. (b) It is correct to conclude that obsolete items are excludable from inventory. Cost attributable to such items is “nonuseful” and “nonrecoverable” cost (except for possible scrap value) and should be written off. If the cost of obsolete items was simply excluded from ending inventory, the resultant cost of goods sold would be overstated by the amount of these costs. The cost of obsolete items, if immaterial, should be commingled with cost of goods sold. If material, these costs should be separately disclosed. (c) The primary use of the airplanes should determine their treatment on the balance sheet. Since the airplanes are held primarily for sale, and chartering is only a temporary use, the airplanes should be classified as current assets. Depreciation would not be appropriate if the planes are considered inventory. FASB ASC Glossary entry for “Inventory” states in part that the term Inventory “excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified.” (d) The transaction is a product financing arrangement and should be reported by the company as inventory with a related liability. The substance of the transaction is that inventory has been purchased and the fact that a trust is established to purchase the goods has no economic significance. Given that the company agrees to buy the coal over a certain period of time at specific prices, it appears clear that the company has the liability and not the trust. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analysis, Communication, Reflective Thinking, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.4 (a) Cash discounts should not be accounted for as financial income when payments are made. Income should be recognized when the company sells the inventory. Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded.
CT 7.4 (Continued) (b) Cash discounts should not be accounted for as a reduction of cost of goods sold for the period when payments are made. Cost of goods sold should be reduced when the company sells the inventory which has been reduced by the cash discounts. Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded. (c) Cash discounts should be accounted for as a direct reduction of purchase cost because they reduce the cost of acquiring the inventories. Purchases should be recorded net of cash discounts to reflect the net cash to be paid. The primary basis of accounting for inventories is cost, which represents the price paid or consideration given to acquire an asset. LO: 2, Bloom: AN, Difficulty: Simple, Time: 15-25, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.5 (a)
1. Inventories are unexpired costs and represent future benefits to the owner. A balance sheet includes a listing of unexpired costs and future benefits of the owner’s assets at a specific point in time. Because inventories are assets owned at the specific point in time for which a balance sheet is prepared, they must be included in order that the owner’s financial position will be presented fairly. 2. Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues recognized during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed.
(b) Financial accounting has as its goal the proper reporting of financial transactions and events in accordance with generally accepted accounting principles. Income tax accounting has as its goal the reporting of taxable transactions and events in conformity with income tax laws and regulations. While the primary purpose of an income tax is the production of tax revenues to finance the operations of government, income tax laws and regulations are often produced by various forces. The income tax may be used as a tool of fiscal policy to stimulate all of the segments of the economy or to decelerate the economy. Some income tax laws may be passed because of political pressures brought to bear by individuals or industries. When the purposes of financial accounting and income tax accounting differ, it is often desirable to report transactions or events differently and to report the deferred tax consequences of any existing temporary differences as assets or liabilities. (c) FIFO and LIFO are inventory costing methods employed to measure the flow of costs. FIFO matches the first cost incurred with the first revenue produced while LIFO matches the last cost incurred with the first revenue produced after the cost is incurred. (This, of course, assumes a perpetual inventory system is in use and may not be precisely true if a periodic inventory system is employed.) If prices are changing, different costs would be matched with revenue for the same quantity sold depending upon whether the LIFO or FIFO system is in use. (In a period of rising or falling prices FIFO tends to value inventories at approximate market value in the balance sheet and LIFO tends to match approximately the current replacement cost of an item with the revenue produced.) LO: 2,3, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.6 (a) Inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The cost of goods sold therefore is understated and net income is considered overstated. By using LIFO (rather than some method such as FIFO), more recent costs are matched against revenues and inventory profits are thereby reduced.
CT 7.6 (Continued) (b) As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs under LIFO because the items most recently purchased at the higher price level are matched against revenues. It should be noted that where unit costs tend to decrease as production increases, the tax benefits that LIFO might provide are nullified. Also, where the inventory turnover is high, the difference between inventory methods is negligible. LO: 3, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, Communication, Reflective Thinking, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.7 (a) The average-cost method assumes that inventories are sold or issued evenly from the stock on hand; the FIFO method assumes that goods are sold or used in the order in which they are purchased (i.e., the first goods purchased are the first sold or used); and the LIFO method matches the cost of the last goods purchased against revenue. (b) The weighted-average-cost method combines the cost of all the purchases in the period with the cost of beginning inventory and divides the total costs by the total number of units to determine the average cost per unit. The moving-average-cost method, on the other hand, calculates a new average unit cost when a purchase is made. The moving-average-cost method is used with perpetual inventory records. (c) When the purchase prices of inventoriable items are rising for a significant period of time, the use of the LIFO method (instead of FIFO) will result in a lower net income figure. The reason is that the LIFO method matches most recent purchases against revenue. Since the prices of goods are rising, the LIFO method will result in higher cost of goods sold, thus lower net income. On the balance sheet, the ending inventory tends to be understated (i.e., lower than the most recent replacement cost) because the oldest goods have lower costs during a period of rising prices. In addition, retained earnings under the LIFO method will be lower than that of the FIFO method when inflation exists. LO: 3, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.8 (a) 1. The LIFO method (periodic) allocates costs on the assumption that the last goods purchased are used first. If the amount of the inventory is computed at the end of the month under a periodic system, then it would be assumed that the total quantity sold or issued during the month would have come from the most recent purchases, and ordinarily no attempt would be made to compare the dates of purchases and sales. 2. The dollar-value method of LIFO inventory valuation is a procedure using dollars instead of units to measure increments or reductions in inventory. The method presumes that goods in the inventory can be classified into pools or homogenous groups. After the grouping into pools the ending inventory is priced at the end-of-year prices and a price index number is applied to convert the total pool to the base-year price level. Such a price index might be obtained from government sources, if available, or computed from the company’s records. The pools or groupings of inventory are required where a single index number is inappropriate for all elements of the inventory. After the closing inventory and the opening inventory have been placed on the same base-year price level, any difference between the two inventories is attributable to an increase or decrease in inventory quantity at the base-year price. An increase in quantity so determined is converted to the current-year price level and added to the amount of the opening inventory as a separate inventory layer. A decrease in quantity is deducted from the appropriate layer of opening inventory at the price level in existence when the layer was added.
CT 7.8 (Continued)
(b) The advantages of the dollar-value method over the traditional LIFO method are as follows: 1. The application of the LIFO method is simplified because, under the pooling procedure, it is not necessary to assign costs to opening and closing quantities of individual items. As a result, companies with inventories comprised of thousands of items may adopt the dollar-value method and minimize their bookkeeping costs. 2. Base inventories are more easily maintained. The dollar-value method permits greater flexibility because each pool is made up of dollars rather than quantities. Thus, the problem of LIFO liquidation is less possible. The disadvantages of the dollar-value method as compared to the traditional LIFO method are as follows: 1. Due to technological innovations and improvements over time, material changes in the composition of inventory may occur. Items found in the ending inventory may not have existed during the base year. Thus, conversion of the ending inventory to base-year prices may be difficult to calculate or to justify conceptually. This may necessitate a periodic change in the choice of base year used. 2. Application of a year-end index, although widely used, implies use of the FIFO method. Other indexes used include beginning-of-year index and average indexes. 3. Determination of the degree of similarity between items for the purpose of grouping them into pools may be difficult and may be based upon arbitrary management decisions. (c) The basic advantages of LIFO are: 1. Matching—In LIFO, the more recent costs are matched against current revenues to provide a better measure of current earnings. 2. Tax benefits—As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs. 3. Improved cash flow—By receiving tax benefits from use of LIFO, the company may reduce its borrowings and related interest costs. 4. Future earnings hedge—With LIFO, a company’s future reported earnings will not be affected substantially by future price declines. LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases because the inventory value ordinarily will be much lower than net realizable value, unlike FIFO. The major disadvantages of LIFO are: 1. Reduced earnings—Because current costs are matched against current revenues, net income is lower than it is under other inventory methods when price levels are increasing. 2. Inventory understated—The inventory valuation on the balance sheet is ordinarily outdated because the oldest costs remain in inventory. 3. Physical flow—LIFO does not approximate physical flow of the items except in peculiar situations. 4. Real income not measured—LIFO falls short of measuring real income because it is often not an adequate substitute for replacement cost. 5. Involuntary liquidation—If the base or layers of old costs are partially liquidated, irrelevant costs can be matched against current revenues. 6. Poor buying habits—LIFO may cause poor buying habits because a company may simply purchase more goods and match the cost of these goods against revenue to ensure that old costs are not charged to expense. LO: 4, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.9 (a) A LIFO pool is a group of similar items which are combined and accounted for together under the LIFO inventory method. (b) It is possible to use a LIFO pool concept without using dollar-value LIFO. For example, the specific goods pooled approach utilizes the concept of a LIFO pool with quantities as its measurement basis. (c) A LIFO liquidation occurs when a significant drop in inventory level leads to the erosion of an earlier or base inventory layer. In a period of inflation (as usually is the case) LIFO liquidation will distort net income (make it higher) and incur substantial tax payments. (d) Price indexes are used in the dollar-value LIFO method to: (1) convert the ending inventory at current year-end cost to base-year cost, and (2) determine the current-year cost for each inventory layer other than the base-year layer. (e) The dollar-value LIFO method measures the increases and decreases in a pool in terms of total dollar value, not by the physical quantity of the goods in the inventory pool. As a result, the dollarvalue LIFO approach has the following advantages over specific goods LIFO pool. First, the pooled approach reduces record keeping and clerical costs. Second, replacement is permitted if it is a similar material, or similar in use, or interchangeable. Thus, it is more difficult to erode LIFO layers when using dollar-value LIFO techniques. LO: 4, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.10 (a) FIFO (Amounts in thousands, except earnings per share) 2025 $11,000
Sales revenue Cost of goods sold Beginning inventory 8,000 Purchases 8,000 Cost of goods available for sale 16,000 1. Ending inventory* (7,200) Cost of goods sold 8,800 Gross profit 2,200 Operating expenses (.15 X sales) 1,650 Depreciation expense 300 Income before taxes 250 Income tax expense (20%) 50 2. Net income $ 200
2026 $12,000
2027 $15,600
7,200 9,900 17,100 (9,000) 8,100 3,900 1,800 300 1,800 360 $ 1,440
9,000 12,000 21,000 (9,000) 12,000 3,600 2,340 300 960 192 $ 768
CT 7.10 (Continued) 2025 $ 0.20
2026 $ 1.44
2027 $ 0.77
4. Cash balance Beginning balance $ 400 Sales proceeds 11,000 Purchases (8,000) Operating expenses (1,650) Property, plant, and equipment (350) Income taxes (50) Dividends (150) Ending balance $ 1,200
$ 1,200 12,000 (9,900) (1,800) (350) (360) (150) $ 640
$
3. Earnings per share
640 15,600 (12,000) (2,340) (350) (192) (150) $ 1,208
*2025 = $ 8 × (1,000 + 1,000 – 1,100) = $7,200. 2026 = $ 9 × ( 900 + 1,100 – 1,000) = $9,000. 2027 = $10 × (1,000 + 1,200 – 1,300) = $9,000. LIFO (Amounts in thousands, except earnings per share)
Sales revenue Cost of goods sold Beginning inventory Purchases Cost of goods available for sale 1. Ending inventory** Cost of goods sold Gross profit Operating expenses Depreciation expense Income before taxes Income tax expense (20%)
2025 $11,000
2026 $12,000
2027 $15,600
8,000 8,000 16,000 (7,200) 8,800 2,200 1,650 300 250 50
7,200 9,900 17,100 (8,100) 9,000 3,000 1,800 300 900 180
8,100 12,000 20,100 (7,200) 12,900 2,700 2,340 300 60 12
2. Net income
$
200
$
720
$
48
3. Earnings per share
$
0.20
$
0.72
$
0.05
CT 7.10 (Continued) 2025 4. Cash balance Beginning balance $ 400 Sales proceeds 11,000 Purchases (8,000) Operating expenses (1,650) Property, plant, and equipment (350) Income taxes (50) Dividends (150) Ending balance $ 1,200
2026 $ 1,200 12,000 (9,900) (1,800) (350) (180) (150) $ 820
2027 $
820 15,600 (12,000) (2,340) (350) (12) (150) $ 1,568
**2025 = $8 × (1,000 + 1,000 – 1,100) = $7,200. 2026 = ($8 × 900) + ($9 × 100) = $8,100. 2027 = $8 × 900 = $7,200. (b)
According to the computation in (a), Harrisburg Company can achieve the goal of income tax savings by switching to the LIFO method. As shown in the schedules, under the LIFO method, Harrisburg will have lower net income and thus lower income taxes for 2026 and 2027 (tax savings in each year). As a result, Harrisburg will have a better cash position at the end of 2026 and especially 2027 (year-end cash balance will be higher by $180,000 for 2026 and $360,000 for 2027). However, since Harrisburg Company is in a period of rising purchase prices, the LIFO method will result in significantly lower net income and earnings per share for 2026 and 2027. The management may need to evaluate the potential impact that lower net income and earnings per share might have on the company before deciding on the change to the LIFO method.
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analysis, Communication, AICPA BB: None Reporting, AICPA PC: Communication
CT 7.11 (a)
Major stakeholders are investors, creditors, Wilkens’ management (including the president and plant accountant), and other employees of Wilkens Company. The inventory purchase in this instance reduces net income substantially and lowers Wilkens Company’s tax liability. Current stockholders and company management benefit during the current year by this decision. However, the purchasing department may be concerned about inventory management and complications such as storage costs and possible inventory obsolescence. Assuming awareness of these benefits and possible complications, the plant accountant may follow the president’s recommendation without violating GAAP. The plant accountant also must consider whether this action is in the long-term best interests of the company and whether inventory amounts would provide a meaningful picture of Wilkens Company’s financial condition.
(b)
No, the president would not recommend a year-end inventory purchase because under FIFO there would be no effect on net income.
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Communication, Reflective Thinking Professional Demeanor Reporting, AICPA PC: Communication, Professional Demeanor
Codification Exercises CE7-1 (a)
Inventory is the aggregate of those items of tangible personal property that have any of the following characteristics: a. Held for sale in the ordinary of business. b. To process of production for such sale. c. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.
(b)
A customer is a reseller or a consumer, either an individual or a business that purchases a vendor’s products or services for end use rather than for resale. This definition is consistent with paragraph 280-10-50-42, which states that a group of entities known to a reporting entity to be under common control shall be considered as a single customer, and the federal government, a state government, a local government (for example, a country or municipality), or a foreign government each shall be considered as a single customer.
(c)
Customer includes any purchaser of the vendor’s products at any point along the distribution chain, regardless of whether the purchaser acquires the vendor’s products directly or indirectly (for example, from a distributor) from the vendor. For example, a vendor may sell its products to a distributor who in turn resells the products to a retailer. In that example, the retailer—not the distributor—is a customer of the vendor.
(d)
A product financing arrangement is a transaction in which an entity sells and agrees to repurchase inventory with the repurchase price equal to the original sale price plus carrying and financing costs, or other similar transactions.
LO: 1, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, Technology Reporting, Research, Technology, AICPA PC: Communication
CE7-2 According 606-10-25-18A An entity that promises a good to a customer also might perform shipping and handling activities related to that good. If the shipping and handling activities are performed before the customer obtains control of the good (see paragraphs 606-10-25-23 through 25-30 for guidance on satisfying performance obligations), then the shipping and handling activities are not a promised service to the customer. Rather, shipping and handling are activities to fulfill the entity’s promise to transfer the good. 606-10-25-18A If shipping and handling activities are performed after a customer obtains control of the good, then the entity may elect to account for shipping and handling as activities to fulfill the promise to transfer the good. The entity shall apply this accounting policy election consistently to similar types of transactions.
CE7-2 (Continued)
An entity that makes this election would not evaluate whether shipping and handling activities are promised services to its customers. If revenue is recognized for the related good before the shipping and handling activities occur, the related costs of those shipping and handling activities shall be accrued. An entity that applies this accounting policy election shall comply with the accounting policy disclosure requirements in paragraphs 235-10-50-1 through 50-6. LO: 2, Bloom: K, Difficulty: Simple, Time: 7-10, AACSB: Communication, Technology Reporting, Research, Technology, AICPA PC: Communication
CE7-3 FASB ASC 330-10-35-1 and 15 with respect to adjustments to Lower of Cost or Market: 35-1
A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.
With respect to Stating Inventories Above Cost: 35-15 Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability. LO: 2, Bloom: K, Difficulty: Simple, Time: 7-10, AACSB: Communication, Technology Reporting, Research, Technology, AICPA PC: Communication
CE7-4 FASB ASC 330-10-S99-3 (SAB Topic 11.F, LIFO Liquidations) The following is the text of SAB Topic 11.F, LIFO Liquidations. Facts: Registrant on LIFO basis of accounting liquidates a substantial portion of its LIFO inventory and as a result includes a material amount of income in its income statement which would not have been recorded had the inventory liquidation not taken place. Question: Is disclosure required of the amount of income realized as a result of the inventory liquidation? Interpretive Response: Yes. Such disclosure would be required in order to make the financial statements not misleading. Disclosure may be made either in a footnote or parenthetically on the face of the income statement. LO: 5, Bloom: K, Difficulty: Simple, Time: 7-10, AACSB: Communication, Technology Reporting, Research, Technology, AICPA PC: Communication
Codification Research Case (a) (b)
A search using “right of return” and revenue indicates that FASB ASC 606 Revenue from Contracts with Customers is the relevant literature. At ASC 606-10-55-201, the codification indicates that the examples following: … illustrates the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration. In addition, the following guidance is illustrated in these Examples. a. Paragraph 606-10-32-10 on refund liabilities (Example 22) b. Paragraphs 606-10-55-22 through 55-29 on sales with a right of return (Example 22) Thus, the accounting for right-of-return pertains to determining the transaction price – Step 3 in the 5-Step Model. Note to Instructor: Students may be referred to discussion of revenue recognition in Chapters 2 and 18.
(c)
Example 22 at FASB ASC 606-10-55-202 through 207 provides an example of Right of Return as it relates to Constraining Estimates of Variable Consideration (as of March 21, 2018, these are marked as pending content): 55-202 An entity enters into 100 contracts with customers. Each contract includes the sale of 1 product for $100 (100 total products $100 = $10,000 total consideration). Cash is received when control of a product transfers. The entity’s customary business practice is to allow a customer to return any unused product within 30 days and receive a full refund. The entity’s cost of each product is $60. 55-203 The entity applies the guidance in this Topic to the portfolio of 100 contracts because it reasonably expects that, in accordance with paragraph 606-10-10-4, the effects on the financial statements from applying this guidance to the portfolio would not differ materially from applying the guidance to the individual contracts within the portfolio.
Codification Research Case (Continued) 55-204 Because the contract allows a customer to return the products, the consideration received from the customer is variable. To estimate the variable consideration to which the entity will be entitled, the entity decides to use the expected value method (see paragraph 606-10-328(a)) because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled. Using the expected value method, the entity estimates that 97 products will not be returned. 55-205 The entity also considers the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration to determine whether the estimated amount of variable consideration of $9,700 ($100 97 products not expected to be returned) can be included in the transaction price. The entity considers the factors in paragraph 606-10-32-12 and determines that although the returns are outside the entity’s influence, it has significant experience in estimating returns for this product and customer class. In addition, the uncertainty will be resolved within a short time frame (that is, the 30day return period). Thus, the entity concludes that it is probable that a significant reversal in the cumulative amount of revenue recognized (that is, $9,700) will not occur as the uncertainty is resolved (that is, over the return period). 55-206 The entity estimates that the costs of recovering the products will be immaterial and expects that the returned products can be resold at a profit. 55-207 Upon transfer of control of the 100 products, the entity does not recognize revenue for the 3 products that it expects to be returned. Consequently, in accordance with paragraphs 606-10-32-10 and 60610-55-23, the entity recognizes the following: Cash Revenue Refund liability
$10,000 ($100 100 products transferred) $9,700 ($100 97 products not expected to be returned) $300 ($100 refund 3 products expected to be returned)
Codification Research Case (Continued) Cost of sales Asset Inventory
$5,820 ($60 97 products not expected to be returned) $180 ($60 3 products for its right to recover products from customers on setting the refund liability) $6,000 ($60 100 products)
In essence, when right of return exists, the seller uses prior experience to estimate the items that will be returned and adjust the transaction price so that it reflects the total amount expected to be received. (d)
The general guidelines for “Constraining Estimates of Variable Consideration” are found at FASB ASC 606-10-32-11 to 12. 32-11 An entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 60610-32-8 only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. 32-12 In assessing whether it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur once the uncertainty related to the variable consideration is subsequently resolved, an entity shall consider both the likelihood and the magnitude of the revenue reversal. Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following. a.
b. c.
The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service. The uncertainty about the amount of consideration is not expected to be resolved for a long period of time. The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.
Codification Research Case (Continued) d. e.
The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances. The contract has a large number and broad range of possible consideration amounts.
LO: NA, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, Technology Reporting, Research, Technology, AICPA PC: Communication
CHAPTER 8 Inventories: Additional Valuation Issues Assignment Classification Table (By Topic) Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1. Lower-of-cost-or-net realizable value
1, 2, 3, 4, 5
1, 2, 3
1, 2, 3, 4, 5, 6
1, 2, 3, 11
1, 2, 3, 4, 6
2. Lower-of-cost-or-market.
6, 7
4, 5
7, 8
4, 5
6
3. Inventory accounting changes; relative sales value method; net realizable value.
8, 9
6
9, 10
4. Purchase commitments.
10
7, 8
11, 12
11
7
5. Gross profit method.
11, 12, 13, 14
9
13, 14, 15, 6, 7 16, 17, 18, 19
6. Retail inventory method.
15, 16, 17
10
20, 21, 22, 8, 9, 10
7. Presentation and analysis.
18, 19
11
23
11
*8. LIFO retail.
20
12
24, 25
13, 14
13
26, 27, 28, 12 29
Topics
*9. Dollar-value LIFO retail. *10. Special LIFO problems.
*This material is discussed in an Appendix to the chapter.
30
15
5, 6
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Describe and apply the lower-of-cost-or net realizable value rule.
1, 2, 3, 4, 5
1, 2, 3
1, 2, 3, 4, 5, 6
1, 2, 3, 11
1, 2, 3, 4, 6
2.
Describe and apply the lower-of-cost-or-market rule.
6, 7
4, 5
7, 8
4, 5
6
3.
Identify other inventory valuation issues
8, 9, 10
6, 7, 8
9, 10, 11, 12
11
7
4.
Determine ending inventory by applying the gross profit method.
11, 12, 13, 14
9
13, 14, 15, 16, 17, 18, 19
6, 7
5.
Determine ending inventory by applying the retail inventory method.
15, 16, 17
10
20, 21, 22
8, 9, 10
6.
Explain how to report and analyze inventory.
18, 19
11
23
11
*7.
Determine ending inventory by applying the LIFO retail methods.
20
12, 13
24, 25, 26, 27, 28, 29 30
12, 13, 14, 15
*This material is discussed in an Appendix to the chapter.
5, 6
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E8.1 E8.2 E8.3 E8.4 E8.5 E8.6 E8.7 E8.8 E8.9 E8.10 E8.11 E8.12 E8.13 E8.14 E8.15 E8.16 E8.17 E8.18 E8.19 E8.20 E8.21 E8.22 E8.23 *E8.24 *E8.25 *E8.26 *E8.27 *E8.28 *E8.29 *E8.30
LCNRV. LCNRV. LCNRV. LCNRV—journal entries. LCNRV. LCNRV—error effect. Lower-of-cost-or-market Lower-of-cost-or-market--journal entries. Relative sales value method. Relative sales value method. Purchase commitments. Purchase commitments. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Retail inventory method. Retail inventory method. Retail inventory method. Analysis of inventories. Retail inventory method—conventional and LIFO. Retail inventory method—conventional and LIFO. Dollar-value LIFO retail. Dollar-value LIFO retail. Conventional retail and dollar-value LIFO retail. Dollar-value LIFO retail. Change to LIFO retail.
Simple Simple Simple Simple Moderate Simple Simple Simple Simple Simple Simple Simple Simple Simple Simple Moderate Simple Simple Moderate Moderate Simple Simple Simple Moderate Moderate Simple Simple Moderate Moderate Simple
15–20 10–15 15–20 10–15 20–25 10–15 15-20 10-15 15–20 12–17 5–10 15–20 8–13 10–15 15–20 15–20 10–15 15–20 20–25 20–25 12–17 20–25 10–15 25–35 15–20 10–15 5–10 20–25 20–25 5-10
P8.1 P8.2 P8.3 P8.4 P8.5 P8.6 P8.7 P8.8 P8.9
LCNRV. LCNRV. LCNRV—cost-of-good-sold and loss. Lower-of-cost-or-market Lower-of-cost-or-market. Gross profit method. Gross profit method. Retail inventory method. Retail inventory method.
Simple Moderate Moderate Moderate Moderate Moderate Complex Moderate Moderate
10–15 25–30 30–35 25-30 30-40 20–30 40–45 20–30 20–30
Assignment Characteristics Table (Continued) Level of Difficulty
Time (minutes)
Item
Description
P8.10 P8.11
Moderate Moderate
20–30 30–40
*P8.12 *P8.13 *P8.14 *P8.15
Retail inventory method. Statement and note disclosure, LCNRV, and purchase commitment. Conventional and dollar-value LIFO retail. Retail, LIFO retail, and inventory shortage. Change to LIFO retail. Change to LIFO retail; dollar-value LIFO retail.
Moderate Moderate Moderate Complex
30–35 30–40 30–40 40–50
CT8.1 CT8.2 CT8.3 CT8.4 CT8.5 CT8.6 CT8.7
LCNRV. LCNRV. LCNRV. LCNRV. Retail inventory method. Cost determination, LCM, retail method. Purchase commitments.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate
15–25 20–30 15–20 15-20 25–30 15–25 10–15
Answers to Questions 1. Where there is evidence that the utility of goods to be disposed of in the ordinary course of business will be less than cost, the difference should be recognized as a loss in the current period, and the inventory should be stated at net realizable value in the financial statements. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
2. The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required when the utility of the goods included in the inventory is less than their cost, this loss in utility should be recognized as a loss in the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower-of-cost-or-net realizable value rule arose from the accounting convention of providing for all losses and anticipating no profits.) In accordance with the foregoing reasoning, the rule of “cost or net realizable value, whichever is lower” may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly reflects operations. The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product, alternative procedures are suitable. The arguments against the use of the lower-of-cost-or-net realizable value method of valuing inventories include the following: Mismatch in valuation A company recognizes decreases in the value of the asset and the charge to expense in the period in which the loss in utility occurs—not in the period of sale. On the other hand, it recognizes increases in the value of the asset only at the point of sale. In other words, a company may value the inventory at cost in one year and at market or NRV in the next year. Mismatch in income Net income for the year in which a company takes the loss is lower. Net income of the subsequent period may be higher than normal if the expected reductions in sales price do not materialize. Use of estimates Application of these rules uses “normal profit” or “ordinary” costs to sell or dispose in determining inventory values. Since companies develop these estimates based on past experience (which they may not attain in the future), this subjective measure presents an opportunity for income manipulation. LO: 1, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 8 (Continued) 3. The lower-of-cost-or-net realizable value rule may be applied directly to each item, to each category, or to the total of the inventory (or in some cases, to the total of the components of each major category). The method should be the one that most clearly reflects income. The most common practice is to value the inventory on an item-by-item basis. Companies favor the individual item approach because tax requirements in some countries require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation on the statement of financial position. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
4. (1) (2) (3) (4) (5)
$12.80 ($14.80 - $1.50 - $0.50) NRV. $16.10 Cost. $13.00 ($15.20 - $1.65 - $0.55) NRV. $9.20 ($10.40 - $0.80 - $0.40) NRV. $15.90 Cost.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
5. One approach is to reduce inventory from cost to net realizable value by debiting a loss account and crediting Inventory. This method reports a loss in the period in which the decline in value takes place (often referred to as the loss method). The loss would then be shown as a separate item in the income statement and the cost of goods sold for the year would not be distorted by its inclusion. An objection to this method of valuation is that an inconsistency is created between the income statement and the statement of financial position. Another approach is to increase Cost of Goods Sold by the amount of the loss and decrease the Inventory account. Because this method fails to reflect this loss separately, objections can be raised against this procedure because the loss is buried in Cost of Goods Sold and is not easy to separately identify LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
6. The upper (ceiling) and lower (floor) limits for the value of the inventory are intended to prevent the inventory from being reported at an amount in excess of the net realizable value or at an amount less than the net realizable value less a normal profit margin. The maximum limitation, not to exceed the net realizable value (ceiling) covers obsolete, damaged, or shopworn material and prevents overstatement of inventories and understatement of the loss in the current period. The minimum limitation deters understatement of inventory and overstatement of the loss in the current period. LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
7. (1) (2) (3) (4) (5)
$14.50 NRV. $16.10 Cost. $13.75 NRV – Normal profit margin. $9.70 Replacement cost. $15.90 Cost.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
8. An exception to the normal recognition rule occurs where (1) there is a controlled market with a quoted price applicable to specific commodities and (2) no significant costs of disposal are involved. Certain agricultural products and precious metals which are immediately marketable at quoted prices are often valued at net realizable value (market price). LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
Questions Chapter 8 (Continued) 9. Relative sales value is an appropriate basis for pricing inventory when a group of varying units is purchased at a single lump-sum price (basket purchase). The purchase price must be allocated in some manner or on some basis among the various units. When the units vary in size, character, and attractiveness, the basis for allocation must reflect both quantitative and qualitative aspects. A suitable basis then is the relative sales value of the units that comprise the inventory. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
10. The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made [($6.20 – $5.90) × 150,000] = $45,000: Loss on Purchase Commitments ............................................................... Estimated Liability on Purchase Commitments ...............................
45,000 45,000
The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet with an appropriate note indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
11. The major uses of the gross profit method are: (1) it provides an approximation of the ending inventory which the auditor might use for testing validity of physical inventory count; (2) it means that a physical count need not be taken every month or quarter; and (3) it helps in determining damages caused by casualty when inventory cannot be counted. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
12. Gross profit as a percentage of sales indicates that the markup is based on selling price rather than cost; for this reason the gross profit as a percentage of selling price will always be lower than if based on cost. Conversions are as follows: 25% on cost = .25 ÷ ( 1 + .25) = 20% on selling price 33 1/3% on cost = .333 ÷ (1 + .333) = 25% on selling price 33 1/3% on selling price = .333 ÷ (1 - .333) = 50% on cost 60% on selling price = .60 ÷ (1 - .60) = 150% on cost LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
13. A markup of 25% on cost equals a 20% markup on selling price; therefore, gross profit equals $1,000,000 ($5 million × .20) and net income equals $250,000 [$1,000,000 – (.15. × $5 million)]. The following formula was used to compute the 20% markup on selling price: Gross profit on selling price =
Percentage markup on cost .25 = = 20% 100% + Percentage markup on cost 1 + .25
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 8 (Continued) 14. Inventory, January 1, 2025 .................................................................... Purchases to February 10, 2025 ............................................................ Freight-in to February 10, 2025.............................................................. Merchandise available.................................................................... Sales revenue to February 10, 2025 ...................................................... Less gross profit at 40% ($1,950,000 × .40) ................................... Estimated cost of goods sold ..................................................... Inventory (approximately) at February 10, 2025 .........................
$ 400,000 $1,140,000 60,000
1,200,000 1,600,000
1,950,000 780,000 1,170,000 $ 430,000
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
15. The validity of the retail inventory method is dependent upon (1) the composition of the inventory remaining approximately the same at the end of the period as it was during the period, and (2) there being approximately the same rate of markup at the end of the year as was used throughout the period. The retail method, though ordinarily applied on a departmental basis, may be appropriate for the business as a unit if the above conditions are met. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
16. The conventional retail method is based on lower-of-average-cost-or-market whereby inventory figures at retail are reduced to an inventory valuation figure by multiplying the retail figures by a percentage which is the complement of the markup percent. To determine the markup percent, original markups and additional net markups are related to the original cost. The complement of the markup percent so determined is then applied to the inventory at retail after the latter has been reduced by net markdowns, thus in effect achieving a lower-of-costor-market valuation. An example of reduction to market follows: Assume purchase of 100 items at $1 each, marked to sell at $1.50 each, at which price 80 were sold. The remaining 20 are marked down to $1.15 each. The inventory at $15.33 is $4.67 below original cost and is valued at an amount which will produce the “normal” 33 1/3% gross profit if sold at the present retail price of $23.00. Computation of Inventory Purchases Sales revenue Markdowns (20 × $.35) Inventory at retail Inventory at lower-of-cost-or-market $23 × 66 2/3% = $15.33
Cost $100
Retail $150 (120) (7) $ 23
Ratio 66 2/3%
LO: 5, Bloom: C, Difficulty: Moderate, Time: 5-7, AACSB: Aalytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 8 (Continued) 17. (a)
Ending inventory: Cost Beginning inventory........................................................... Purchases ......................................................................... Freight-in........................................................................... Totals ........................................................................ Add net markups ...............................................................
$ 149,000 1,400,000 70,000 1,619,000 _________ $1,619,000
Deduct net markdowns ..................................................... Deduct sales revenue ....................................................... Ending inventory, at retail .................................................. Ratio of cost to selling price
$1,619,000 $2,535,500
Retail $
283,500 2,160,000
2,443,500 92,000 2,535,500 48,000 2,487,500 2,175,000 $ 312,500
= 63.85%.
Ending inventory estimated at cost = 63.85% × $312,500 = $199,531. (b)
The retail method, above, showed an ending inventory at retail of $312,500; therefore, merchandise not accounted for amounts to $17,500 ($312,500 – $295,000) at retail and $11,174 ($17,500 × 63.85%) at cost.
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
18. Information relative to the composition of the inventory (i.e., raw material, work-in-process, and finished goods); the inventory financing where significant or unusual (transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidations of LIFO inventories, pledging inventories as collateral); and the inventory costing methods employed (lower-of-cost-or-market, FIFO, LIFO, average cost) should be disclosed. If Deere and Company uses LIFO, it should also report the LIFO reserve. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
19. Inventory turnover measures how quickly inventory is sold. Generally, the higher the inventory turnover, the better the enterprise is performing. The more times the inventory turns over, the smaller the net margin can be to earn an appropriate total profit and return on assets. For example, a company can price its goods lower if it has a high inventory turnover. A company with a low profit margin, such as 2%, can earn as much as a company with a high net profit margin, such as 40% if its inventory turnover is often enough. To illustrate, a grocery store with a 2% profit margin can earn as much as a jewelry store with a 40% profit margin and an inventory turnover of 1 if its turnover is more than 20 times. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*20. Two major modifications are necessary. First, the beginning inventory should be excluded from the numerator and denominator of the cost-to-retail percentage and second, markdowns should be included in the denominator of the cost-to-retail percentage. LO: 7, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 8.1 Item
Cost
NRV
LCNRV
Skis Boots Parkas
$190.00 106.00 53.00
$161.00 108.00 50.00
$161.00 106.00 50.00
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.2 (a)
Item
Cost
NRV
LCNRV
$ 2,000 5,000 4,400 3,200 $14,600
$ 2,100 4,950 4,625 3,830 $15,505
$ 2,000 4,950 4,400 3,200 $14,550
Item-by-item Jokers Penguins Riddlers Scarecrows Total (b)
1. Penguins only: $50 2. No adjustment is needed when the evaluation is made for the total inventory: $15,505 > $14,600.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.3 (a)
(b)
Cost-of-goods-sold-method Cost of Goods Sold............................................ Inventory ($572,000 - $530,000)................
42,000
Loss method Inventory Loss .................................................. Inventory ($572,000 - $530,000)................
42,000
42,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
42,000
Brief Exercise 8.4 (a)
Ceiling Floor
(b)
$106
(c)
$51
$193 ($212 – $19) $161 ($212 – $19 – $32)
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.5 (a)
Cost-of-goods-sold method Cost of Goods Sold ............................................... Inventory .......................................................
21,000 21,000*
*($286,000 – $265,000) (b)
Loss method Inventory Loss ...................................................... Inventory .......................................................
21,000 21,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.6
Group
Number of CDs
Sales Price per CD
1 2 3
100 800 100
$ 5 $10 $15
*$500/$10,000 = 5/100
Total Sales Price
Relative Sales Price
$
5/100* X $8,000 = 80/100 X $8,000 = 15/100 X $8,000 =
500 8,000 1,500 $10,000
Total Cost
Cost Allocated to CDs $ 400 6,400 1,200 $8,000
Cost per CD $ 4** $ 8 $12
**$400/100 = $4
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.7 Loss on Purchase Commitments ........................................................................... Estimated Liability on Purchase Commitments ($1,000,000 – $950,000) .........
50,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
50,000
Brief Exercise 8.8 Purchases (Inventory) ........................................................................... Estimated Liability on Purchase Commitments ...... Cash ..................................................................
950,000 50,000 1,000,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.9 Beginning inventory ................................................. Purchases .................................................................. Cost of goods available ............................................ Sales revenue ............................................................ Less gross profit (35% × $700,000) .......................... Estimated cost of goods sold .................................. Estimated ending inventory destroyed in fire .........
$150,000 500,000 650,000 $700,000 245,000 455,000 $195,000
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.10
Beginning inventory ............................................ Net purchases ...................................................... Net markups ......................................................... Totals .................................................................... Deduct: Net markdowns .................................................... Sales revenue ....................................................... Ending inventory at retail ....................................
Cost $ 12,000 120,000 $132,000
Retail $ 20,000 170,000 10,000 200,000 7,000 147,000 $ 46,000
Cost-to-retail ratio: $132,000 ÷ $200,000 = 66% Ending inventory at lower-of cost-or-market (66% × $46,000) = $30,360 LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 8.11 Inventory turnover: $9,789 $1,997 + $1,830 2
= 5.12 times
Average days to sell inventory: 365 ÷ 5.12 = 71.3 days LO: 6, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Brief Exercise 8.12
Beginning inventory ............................................. Net purchases ....................................................... Net markups .......................................................... Net markdowns ..................................................... Total (excluding beginning inventory) ................ Total (including beginning inventory) ................. Deduct: Sales revenue......................................... Ending inventory at retail .....................................
Cost $ 12,000
Retail $ 20,000
120,000
170,000 10,000 (7,000) 173,000 193,000 147,000 $ 46,000
120,000 $132,000
Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at cost $20,000 × .60 ($12,000/$20,000) 26,000 × .694 $46,000
= $12,000 = 18,044 $30,044
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Brief Exercise 8.13
Beginning inventory ............................................ Net purchases ...................................................... Net markups ......................................................... Net markdowns .................................................... Total (excluding beginning inventory)................ Total (including beginning inventory) ................ Deduct: Sales revenue ........................................ Ending inventory at retail ....................................
Cost $ 12,000
Retail $ 20,000
120,000
170,000 10,000 (7,000) 173,000 193,000 147,000 $ 46,000
120,000 $132,000
Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at retail deflated to base year prices $46,000 ÷ 1.15 = $40,000 Ending inventory at cost $20,000 × 100% × 60% = $12,000 20,000 × 115% × 69.4% = 15,962 $27,962 LO: 7, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Solutions to Exercises Exercise 8.1 (15–20 minutes) Per Unit Part No. 110 111 112 113 120 121 122 Totals (a)
Quantity 600 1,000 500 200 400 1,600 300
Cost $ 95 60 80 170 205 16 240
NRV $100 52 76 180 208 1 235
Total Cost $ 57,000 60,000 40,000 34,000 82,000 25,600 72,000 $370,600
Total NRV $ 60,000 52,000 38,000 36,000 83,200 1,600 70,500 $341,300
Lower-ofCost-orNRV $ 57,000 52,000 38,000 34,000 82,000 1,600 70,500 $335,100
$335,100.
(b) $341,300. LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.2 (10–15 minutes)
Item D E F G H I
Net Realizable Value $80* 62 60 35 70 40
Cost $75 80 80 80 50 36
LCNRV $75 62 60 35 50 36
*Estimated selling price – Estimated selling costs and cost to complete = $120 – $30 – $10 = $80. LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.3 (15–20 minutes)
Item No.
Cost per Unit
Net Realizable Value
LCNRV
Quantity
1320 1333 1426 1437 1510 1522 1573 1626
$3.20 2.70 4.50 3.60 2.25 3.00 1.80 4.70
$2.90* 2.40 3.60 1.85 1.85 3.10 1.30 4.50
$2.90 2.40 3.60 1.85 1.85 3.00 1.30 4.50
1,200 900 800 1,000 700 500 3,000 1,000
Final Inventory Value $ 3,480 2,160 2,880 1,850 1,295 1,500 3,900 4,500 $21,565
*$4.50 – $1.60 = $2.90. LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.4 (10–15 minutes)
(a)
(b)
December 31, 2025 Cost of Goods Sold ($346,000 – $322,000) .......... Inventory.......................................................
24,000
December 31, 2026 Cost of Goods Sold............................................... Inventory.......................................................
20,000
December 31, 2025 Inventory Loss ..................................................... Inventory.......................................................
24,000
December 31, 2026 Inventory Loss ..................................................... Inventory.......................................................
20,000
24,000*
20,000*
24,000*
20,000*
Exercise 8.4 (Continued) *Cost of inventory at 12/31/25 ................................... LCNRV at 12/31/25 ................................................... Amount needed to reduce inventory to NRV (a) ..............................................................
(c)
$346,000 (322,000) $ 24,000
Cost of inventory at 12/31/26 .................................. $410,000 LCNRV at 12/31/26 ................................................... (390,000) Amount needed to reduce inventory to NRV (b) .............................................................. $ 20,000 Both methods of recording lower-of-cost-or-NRV adjustments have the same effect on net income.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.5 (20–25 minutes) (a) Sales revenue Cost of goods sold Inventory, beginning Purchases Cost of goods available Less: Inventory, ending Cost of goods sold Gross profit Inventory loss
February
March
April
$29,000
$35,000
$40,000
15,000 17,000 32,000 15,100 16,900 12,100 (2,500) $ 9,600
15,100 24,000 39,100 17,000 22,100 12,900 (1,400) $11,500
17,000 26,500 43,500 14,000 29,500 10,500 __ 0 $10,500
Jan. 31
Feb. 28
Mar. 31
Apr. 30
Inventory at cost
$15,000
$15,100
$17,000
$14,000
Inventory at LCNRV
(14,500)
(12,600)
(15,600)
(14,500)
Inventory loss
$
$ 2,500
$ 1,400
500
$
(500)
Exercise 8.5 (Continued)
(b)
January 31 Inventory Loss ........................................................ Inventory..........................................................
500
February 28 Inventory Loss ........................................................ Inventory..........................................................
2,500
March 31 Inventory Loss ........................................................ Inventory..........................................................
1,400
500
2,500
1,400
April 30 No Entry – Inventory is not written back up after a writedown. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.6 (10–15 minutes) $50 – $14 = $36 $40 $36
Net realizable value Cost Lower-of-cost-or-NRV
$38 figure used – $36 correct value per unit = $2 per unit. $2 × 1,000 units = $2,000. If ending inventory is overstated, net income will be overstated. If beginning inventory is overstated, net income will be understated. Therefore, net income for 2025 was overstated by $2,000 and net income for 2026 was understated by $2,000. LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.7 (15–20 minutes)
Item No.
Cost per Unit
Replacement Cost
Net Realizable Value (Ceiling)
1320 1333 1426 1437 1510 1522 1573 1626
$3.20 2.70 4.50 3.60 2.25 3.00 1.80 4.70
$3.00 2.30 3.70 3.10 2.00 2.70 1.60 5.20
$4.15* 3.00 4.60 2.95 2.45 3.40 1.75 5.50
NRV Less Normal Profit (Floor)
Designated Market Value
Quantity
$2.90** 2.50 3.60 2.05 1.85 2.90 1.25 4.50
$3.00 2.50 3.70 2.95 2.00 2.90 1.60 5.20
1,200 900 800 1,000 700 500 3,000 1,000
Final Inventory Value $ 3,600 2,250 2,960 2,950 1,400 1,450 4,800 4,700*** $24,110
*$4.50 – $.35 = $4.15. **$4.15 – $1.25 = $2.90. ***Cost is used because it is lower than designated market value. LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.8 (10–15 minutes) (a)
12/31/24 12/31/25
(b)
12/31/24 12/31/25
(c)
Cost of Goods Sold ............................ Inventory ...................................
29,000*
Cost of Goods Sold ................................................. Cost of Goods Sold ...................
25,000**
Inventory Loss ................................... Inventory ....................................
29,000*
Inventory Loss ................................... Inventory ..........................................
25,000**
29,000*
25,000** 29,000* 25,000**
*Cost of inventory at 12/31/24 Lower of cost or market at 12/31/24 Amount needed to reduce inventory to market
$356,000 (327,000)
**Cost of inventory at 12/31/25 Lower of cost or market at 12/31/25 Amount needed to reduce inventory to market
$420,000 (395,000)
$ 29,000
$ 25,000
Both methods of recording lower-of-cost-or-market adjustments have the same effect on net income.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
15
17
Group 2
Group 3 2,400
4,000
$3,000
Sales Price Per Lot
$ 5,800
Net income
$ 3,600 9,600 10,800 $24,000
$12,000 32,000 36,000 $80,000
89,460
89,460
LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
17 – 2 = 15
15 – 7 = 8
* 9–5=4
$
18,200
Operating expenses
Gross Profit
24,000
$80,000
$40,800/$127,800 X
$60,000/$127,800 X
Gross profit
Number Cost of Lots Cost of Sold* Per Lots Group 1 4 $2,100 Lot 8,400 Sold Group 2 8 2,800 22,400 Group 3 15 1,680 25,200 Total 27 $56,000
Total Cost
$27,000/$127,800 X $89,460
56,000
Sales
$127,800
40,800
60,000
$ 27,000
Relative Sales Price
Cost of goods sold (see schedule)
Sales revenue (see schedule)
9
Group 1
No. of Lots
Total Sales Price
$89,460
28,560
42,000
$18,900
Cost Allocated to Lots
1,680
2,800
$2,100
Cost Per Lot (Cost Allocated/ No. of Lots)
Exercise 8.9 (15–20 minutes)
120
Straight chairs
(700 – 120) × $31.50 = $18,270
Inventory of straight chairs
(b)
100
Armchairs 31.50
50.40
$56.70
Chairs 200
Cost per Chair
Number of Chairs Sold
Lounge chairs
50
700
Straight chairs
Sales Price per Chair $90 80
400 300
Chairs
No. of Chairs
Lounge chairs Armchairs
(a)
6,000 $32,000
$20,160
8,000
$18,000
Sales
$35,000/$95,000
$36,000/$95,000 $24,000/$95,000
Relative Sales Price
3,780
5,040
$11,340
Cost of Chairs Sold
$95,000
35,000
$36,000 24,000
Total Sales Price
X
$11,840
2,220
2,960
$ 6,660
Gross Profit
59,850
X $59,850 X 59,850
Total Cost
$59,850
22,050
$22,680 15,120
Cost Allocated to Chairs
31.50
$56.70 50.40
Cost per Chair
Exercise 8.10 (12–17 minutes)
LO: 3, Bloom: AP, Difficulty: Simple, Time: 12-17, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.11 (5–10 minutes) Loss on Purchase Commitments ....................... Estimated Liability on Purchase Commitments ($400,000 – $365,000) ......
35,000 35,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.12 (15–20 minutes) (a)
If the commitment is material in amount, there should be a footnote in the balance sheet stating the nature and extent of the commitment. The footnote may also disclose the market price of the materials. The excess of market price over contracted price is a gain contingency which per GAAP cannot be recognized in the accounts until it is realized.
(b)
The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made: Loss on Purchase Commitments .......................... Estimated Liability on Purchase Commitments [36,000 × ($3.00 – $2.70)] ...
10,800 10,800
The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet, with an appropriate footnote indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract. (c)
Assuming the $10,800 market decline entry was made on December 31, 2025, as indicated in (b), the entry when the materials are received in January 2025 would be: Inventory (Raw Materials) ...................................... Estimated Liability on Purchase Commitments ... Accounts Payable..........................................
97,200 10,800 108,000
Exercise 8.12 (Continued) This entry records the raw materials at the actual cost, eliminates the $10,800 liability set up at December 31, 2025, and records the contractual liability for the purchase. This permits operations to be charged this year with the $97,200, the other $10,800 of the cost having been charged to operations in 2025. LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.13 (8–13 minutes) 1.
20% 100% + 20%
= 16.67% OR 16 2/3%.
2.
25% 100% + 25%
= 20%.
3.
33 1/3% = 25%. 100% + 33 1/3%
4.
50% 100% + 50%
= 33.33% OR 33 1/3%.
LO: 4, Bloom: AP, Difficulty: Simple, Time: 8-13, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.14 (10–15 minutes) (a)
Inventory, May 1 (at cost) Purchases (at cost) Purchase discounts Freight-in Goods available (at cost) Sales revenue (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less: Gross profit (.30 × $930,000) 279,000 Net sales (at cost) Approximate inventory, May 31 (at cost)
$160,000 640,000 (12,000) 30,000 818,000
651,000 $167,000
Exercise 8.14 (Continued) (b)
Gross profit as a percent of sales must be computed: 30% 100% + 30%
= 23.08% of sales.
Inventory, May 1 (at cost) Purchases (at cost) Purchase discounts Freight-in Goods available (at cost) Sales revenue (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less: Gross profit (.2308 × $930,000) 214,644 Net sales (at cost) Approximate inventory, May 31 (at cost)
$160,000 640,000 (12,000) 30,000 818,000
715,356 $102,644
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Commmunication
Exercise 8.15 (15–20 minutes) (a)
Merchandise on hand, January 1 Purchases Less: Purchase returns and allowances Freight-in Total merchandise available (at cost) Cost of goods sold* Ending inventory Less: Undamaged goods Estimated fire loss *Gross profit =
33 1/3% = 25% of sales. 100% + 33 1/3%
Cost of goods sold = 75% of sales of $100,000 = $75,000.
$ 38,000 72,000 (2,400) 3,400 111,000 75,000 36,000 10,900 $ 25,100
Exercise 8.15 (Continued) (b)
Cost of goods sold = 66 2/3% of sales of $100,000 = $66,667 Total merchandise available (at cost) (as computed above) Cost of goods sold Ending inventory Less: Undamaged goods Estimated fire loss
$111,000 66,667 44,333 10,900 $33,433
LO: 4, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.16 (15 – 20 minutes) Beginning inventory Purchases Purchase returns Goods available (at cost) Sales revenue Sales returns Net sales Less: Gross profit (40% × $626,000) Estimated ending inventory (unadjusted for damage) Less: Goods on hand—undamaged (at cost) $21,000 × (1 – 40%) Less: Goods on hand—damaged (at net realizable value) Fire loss on inventory
$170,000 390,000 560,000 (30,000) 530,000 $650,000 (24,000) 626,000 (250,400)
375,600 154,400 (12,600) (5,300) $136,500
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.17 (10–15 minutes) Beginning inventory (at cost) Purchases (at cost) Goods available (at cost) Sales revenue (at selling price) Less sales returns Net sales Less: Gross profit* (2/7 of $112,000) Net sales (at cost) Estimated inventory (at cost) Less: Goods on hand ($30,500 – $6,000)
$ 38,000 85,000 123,000 $116,000 4,000 112,000 32,000 80,000 43,000 24,500
Claim against insurance company
*Computation of gross profit:
$ 18,500
40% = 2/7 of selling price 100% + 40%
Note: Depending on details of the consignment agreement and Duncan’s insurance policy, the consigned goods might be considered owned for insurance purposes. LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.18 (15–20 minutes)
Inventory 1/1/25 (cost) Purchases to 8/18/25 (cost) Cost of goods available Deduct cost of goods sold* Inventory 8/18/25
Lumber
Millwork
Hardware
$ 250,000 1,500,000 1,750,000 1,664,000 $ 86,000
$ 90,000 375,000 465,000 410,000 $ 55,000
$ 45,000 160,000 205,000 150,000 $ 55,000
*(See computations on next page)
Exercise 8.18 (Continued) Computation for cost of goods sold:* Lumber:
$2,080,000 = $1,664,000 1.25
Millwork:
$533,000 1.30
= $410,000
Hardware:
$210,000 1.40
= $150,000
*Alternative computation for cost of goods sold: Markup on selling price:
Cost of goods sold:
Lumber:
25% = 20% or 1/5 100% + 25%
$2,080,000 × 80% = $1,664,000
Millwork:
30% = 3/13 100% + 30%
$533,000 × 10/13 = $410,000
Hardware:
40% = 2/7 100% + 40%
$210,000 × 5/7 = $150,000
LO: 4, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.19 (20–25 minutes) Ending inventory: (a)
Gross profit is 45% of sales Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (45% of sales) Estimated cost of goods sold Ending inventory (at cost)
(b)
$2,500,000 1,125,000 1,375,000 $ 725,000
Gross profit is 60% of cost 60% 100% + 60%
= 37.5% markup on selling price
Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (37.5% of sales) Estimated cost of goods sold Ending inventory (at cost)
(c)
$2,100,000
$2,100,000 $2,500,000 937,500 1,562,500 $ 537,500
Gross profit is 35% of sales Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (35% of sales) Estimated cost of goods sold Ending inventory (at cost)
$2,100,000 $2,500,000 875,000 1,625,000 $ 475,000
Exercise 8.19 (Continued) (d)
Gross profit is 25% of cost 25% 100% + 25%
= 20% markup on selling price
Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (20% of sales) Estimated cost of goods sold Ending inventory (at cost)
$2,100,000 $2,500,000 500,000 2,000,000 $ 100,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.20 (20–25 minutes) (a) Beginning inventory Purchases Net markups Totals Net markdowns Sales price of goods available Deduct: Sales revenue Ending inventory at retail
(b)
1. 2. 3. 4.
$180,000 ÷ $300,000 = 60% $180,000 ÷ $273,865 = 65.73% $180,000 ÷ $310,345 = 58% $180,000 ÷ $284,210 = 63.33%
Cost $ 58,000 122,000 _______ $180,000
Retail $100,000 200,000 10,345 310,345 (26,135) 284,210 186,000 $ 98,210
Exercise 8.20 (Continued) (c)
1. 2. 3.
Method 3 Method 3 Method 3
(d)
58% × $98,210 = $56,962
(e)
$180,000 – $56,962 = $123,038
(f)
$186,000 – $123,038 = $62,962
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.21 (12–17 minutes)
Beginning inventory Purchases Totals Add: Net markups Markups Markup cancellations Totals
Cost $ 200,000 1,375,000 1,575,000 _________ $1,575,000
Retail $ 280,000 2,140,000 2,420,000 $95,000 (15,000)
Deduct: Net markdowns Markdowns Markdowns cancellations Sales price of goods available Deduct: Sales revenue Ending inventory at retail Cost-to-retail ratio =
$1,575,000 $2,500,000
35,000 (5,000)
80,000 2,500,000
30,000 2,470,000 2,200,000 $ 270,000
= 63%
Ending inventory at cost = 63% × $270,000 = $170,100 LO: 5, Bloom: AP, Difficulty: Simple, Time: 12-17, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.22 (20–25 minutes) Cost $30,000 48,000 (2,000) 2,400 78,400
Beginning inventory Purchases Purchase returns Freight on purchases Totals Add: Net markups Markups Markup cancellations Net markups Totals
$10,000 (1,500) _______ $78,400
Deduct: Net markdowns Markdowns Markdowns cancellations Net markdowns Sales price of goods available Deduct: Net sales ($99,000 – $2,000) Ending inventory, at retail Cost-to-retail ratio =
$78,400 $140,000
Retail $ 46,500 88,000 (3,000) _______ 131,500
8,500 140,000
9,300 (2,800) 6,500 133,500 97,000 $ 36,500
= 56%
Ending inventory at cost = .56 × $36,500 = $20,440 LO: 5, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 8.23 (10–15 minutes) (a)
Inventory turnover: Current year $5,484.8 $934.2 + $1,044.1 2
(b)
= 5.5 times
Prior year $6,234.9 $1,044.1 + $1,642.6 2
= 4.6 times
Average days to sell inventory: Current year
Prior year
365 ÷ 5.5 = 66 days
365 ÷ 4.6 = 79 days
LO: 6, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 8.24 (25–35 minutes) (a)
Conventional Retail Method Cost $ 38,100 130,900 169,000 ________ $169,000
Inventory, January 1, 2025 Purchases (net) Add: Net markups Totals Deduct: Net markdowns Sales price of goods available Deduct: Sales (net) Ending inventory at retail Cost-to-retail ratio =
$169,000 $260,000
Retail $ 60,000 178,000 238,000 22,000 260,000 13,000 247,000 167,000 $ 80,000
= 65%
Ending inventory at cost = .65 × $80,000 = $52,000 (b)
LIFO Retail Method Inventory, January 1, 2025 Net purchases Net markups Net markdowns Total (excluding beginning inventory) Total (including beginning inventory) Deduct sales (net) Ending inventory at retail Cost-to-retail ratio =
$130,900 $187,000
= 70%
Cost $ 38,100 130,900 130,900 $169,000
Retail $ 60,000 178,000 22,000 (13,000) 187,000 247,000 167,000 $ 80,000
*Exercise 8.24 (Continued) Computation of ending inventory at LIFO cost, 2025: Ending Inventory at Retail Prices
Layers at Retail Prices
$80,000
2024 $60,000 2025 20,000
*$38,100 $60,000
Cost to Retail (Percentage)
Ending Inventory at LIFO Cost
63.5%* 70.0%
$38,100 14,000 $52,100
X X
(prior years cost to retail)
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 8.25 (15–20 minutes) (a)
Cost $14,000 58,800 7,500
Inventory, January 1, 2025 Net purchases Freight-in Net markups Totals Sales revenue Net markdowns Estimated theft Ending inventory at retail Cost-to-retail ratio:
$80,300 $110,000
$80,300
Retail $ 20,000 81,000 9,000 110,000 (80,000) (1,600) (2,000) $ 26,400
= 73%
Ending inventory at lower-of-average-cost-or-market = $26,400 × 73% = $19,272
*Exercise 8.25 (Continued) (b)
Cost $58,800 7,500
Purchases Freight-in Net markups Net markdowns Totals Cost-to-retail ratio:
$66,300 $66,300 $88,400
Retail $81,000 9,000 (1,600) $88,400
= 75%
The increment at retail is $26,400 – $20,000 = $6,400. The increment is costed at .75 × $6,400 = $4,800. Ending inventory at LIFO retail: Beginning inventory, 2025 Increment Ending inventory, 2025
Cost $14,000 4,800 $18,800
Retail $20,000 6,400 $26,400
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 8.26 (10–15 minutes) (a)
Cost-to-retail ratio—beginning inventory:
$216,000 = 72% $300,000
*($294,300 ÷ 1.09) × .72 = $194,400 *Since the above computation reveals that the inventory quantity has declined below the beginning level, it is necessary to convert the ending inventory to beginning-of-the-year prices (by dividing by 1.09) and then multiply it by the beginning cost-to-retail ratio (72%).
*Exercise 8.26 (Continued) (b)
Ending inventory at retail prices deflated $365,150 ÷ 1.09 Beginning inventory at beginning-of-year prices Inventory increase in terms of beginning-of-year dollars
$335,000 300,000 $ 35,000
Beginning inventory (at cost) Additional layer, $35,000 × 1.09 × .76*
$216,000 28,994 $244,994
*($364,800 ÷ $480,000) LO: 7, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 8.27 (5–10 minutes) Ending inventory at retail (deflated) $100,100 ÷ 1.10 Beginning inventory at retail Increment at retail Ending inventory on LIFO basis First layer Second layer ($16,500 × 1.10 × .60)
$91,000 74,500 $16,500 Cost $36,000 10,890 $46,890
LO: 7, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 8.28 (20–25 minutes) (a) Beginning inventory Net purchases Net markups Totals Net markdowns Sales revenue Ending inventory at retail
Cost $ 30,100 108,500 ________ $138,600
Cost-retail ratio = 66% ($138,600/$210,000) Ending inventory at cost ($78,100 × .66) (b)
Cost $ 30,100 108,500
Beginning inventory Net purchases Net markups Net markdowns Total (excluding beginning inventory) 108,500 Total (including beginning inventory) $138,600 Sales revenue Ending inventory at retail (current) Ending inventory at retail (base year) ($78,100 ÷ 1.10) Cost-to-retail ratio for new layer: $108,500/$155,000 = 70% Layers: Base layer $50,000 × 1.00 × .602* = New layer ($71,000 – $50,000) × 1.10 × .70 =
Retail $ 50,000 150,000 10,000 210,000 (5,000) (126,900) $ 78,100
$ 51,546 Retail $ 50,000 150,000 10,000 (5,000) 155,000 205,000 (126,900) 78,100 $ 71,000
$ 30,100 16,170 $ 46,270
*($30,100/$50,000) (c)
Cost of goods available for sale Ending inventory at cost, from (b) Cost of goods sold
$138,600 46,270 $ 92,330
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 8.29 (20–25 minutes) 2024
Restate to base-year retail ($118,720 ÷ 1.06)
$112,000
Layers: 1. $100,000 × 1.00 × .54* = 2. $ 12,000 × 1.06 × .57 = Ending inventory
$ 54,000 7,250 $ 61,250
*$54,000 ÷ $100,000 2025
2026
2027
Restate to base-year retail ($138,750 ÷ 1.11)
$125,000
Layers: 1. $100,000 × 1.00 × .54 = 2. $ 12,000 × 1.06 × .57 = 3. $ 13,000 × 1.11 × .60 = Ending inventory
$ 54,000 7,250 8,658 $ 69,908
Restate to base-year retail ($125,350 ÷ 1.15)
$109,000
Layers: 1. $100,000 × 1.00 × .54 = 2. $ 9,000 × 1.06 × .57 = Ending inventory
$ 54,000 5,438 $ 59,438
Restate to base-year retail ($162,500 ÷ 1.25)
$130,000
Layers: 1. $100,000 × 1.00 × .54 = 2. $ 9,000 × 1.06 × .57 = 3. $ 21,000 × 1.25 × .58 = Ending inventory
$ 54,000 5,438 15,225 $ 74,663
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 8.30 (5–10 minutes) Inventory (beginning) ............................................. Adjustment to Record Inventory at Cost (Cost of Goods Sold)* ................................ ($212,600 – $205,000)
7,600 7,600
*Note: This account is an income statement account (Cost of Goods Sold could be used) showing the effect of changing from a lower-of-cost-ormarket approach to a straight cost basis. LO: 7, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Time and Purpose of Problems Problem 8.1 (Time 10–15 minutes) Purpose—to provide the student with an understanding of the lower-of-cost-or NRV approach to inventory valuation, similar to Problem 8.2. The major difference between these problems is that Problem 8.1 provides some ambiguity to the situation by changing the catalog prices near the end of the year. Problem 8.2 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the lower-of-cost-or NRV approach to inventory valuation. The student is required to examine a number of individual items and apply the lower-of-costor NRV rule and to also explain the use and value of the lower-of-cost- and NRV rule. Problem 8.3 (Time 30–35 minutes) Purpose—to provide a problem that requires entries for reducing inventory to lower-of-cost-or NRV under the perpetual inventory system using both the cost-of-goods-sold and the loss methods. Problem 8.4 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the lower-of-cost-or-market approach to inventory valuation. The student is required to examine a number of individual items and apply the lowerof-cost-or-market rule and to also explain the use and value of the lower-of-cost-or-market rule. Problem 8.5 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to write a memo explaining designated market value and how it is computed. As part of this memo, the student is required to compute inventory on the lowerof-cost-or-market basis using the individual item approach. Problem 8.6 (Time 20–30 minutes) Purpose—to provide another problem where a fire loss must be computed using the gross profit method. Certain goods remained undamaged and therefore an adjustment is necessary. In addition, the inventory was subject to an obsolescence factor which must be considered. Problem 8.7 (Time 40–45 minutes) Purpose—to provide the student with a complex problem involving a fire loss where the gross profit method must be employed. The problem is complicated because a number of adjustments must be made to the purchases account related to merchandise returned, unrecorded purchases, and shipments in transit. In addition, some cash to accrual computations are necessary. Problem 8.8 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. The problem is relatively straightforward although transfers-in from other departments as well as the proper treatment for normal spoilage complicate the problem. A good problem that summarizes the essentials of the retail inventory method. Problem 8.9 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problem 9-8, except that a few different items must be evaluated in finding ending inventory at retail and cost. Unusual items in this problem are employee discounts and loss from breakage. A good problem that summarizes the essentials of the retail inventory method. Problem 8.10 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problems 8.8 and 8.9, except that the student is asked to list the factors that may have caused the difference between the computed inventory and the physical count. Time and Purpose of Problems (Continued)
Problem 8.11 (Time 30–40 minutes) Purpose—to provide the student with a problem requiring financial statement and note disclosure of inventories, the income statement disclosure of an inventory market decline, and the treatment of purchase commitments. *Problem 8.12 (Time 30–35 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. An excellent problem for highlighting the difference between these two approaches to inventory valuation. It should be noted that the cost-to-retail percentage is given for LIFO so less computation is necessary. *Problem 8.13 (Time 30–40 minutes) Purpose—to provide the student with a comprehensive problem covering the retail and LIFO retail inventory methods, the computation of an inventory shortage, and the treatment of four special items relative to the retail inventory method. *Problem 8.14 (Time 30–40 minutes) Purpose—to provide the student with a basic problem illustrating the comparison between conventional retail and LIFO retail. This problem emphasizes many of the same issues as Problem 8.11, except that a dollar-value LIFO computation is not needed. A good problem for providing the essential issues related to a change to LIFO retail. *Problem 8.15 (Time 40–50 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. The problem is similar to Problem 8.12, except that the problem involves a three-year period which adds complexity to the problem. This problem provides an excellent summary of the essential elements related to the change of the retail inventory method from conventional retail to LIFO retail and dollar-value LIFO retail.
Solutions to Problems Problem 8.1
Item A B C D
Cost $47 45 83 96
Net Realizable Value* $ 45 43 64 100
Lower-of-Cost-or-NRV $45 43 64 96
*Net Realizable Value = 2026 catalog selling price less estimated costs to complete and sell. (2026 catalog prices are in effect as of 12/01/25.) LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.2
(a)
(b)
The write-down to reduce inventory to the lower-of-cost-or NRV at May 31, 2025, should be $15,200, as calculated as follows. Cost
NRV
LCNRV
Aluminum siding
$ 70,000
$ 56,000
$ 56,000
Cedar shake siding
86,000
84,800
84,800
Louvered glass doors
112,000
168,300
112,000
Thermal windows
140,000
140,000
140,000
Totals
$408,000
$449,100
$392,800
Inventory cost
$408,000
Less: LCNRV valuation
392,800
Inventory writedown
$ 15,200
For the fiscal year ended May 31, 2025, Garcia Home Improvement prepares the following entry. Inventory Loss .................................................... Inventory..................................................
(c)
15,200 15,200
The use of the lower-of-cost-or-net realizable value (LCNRV) rule is based on both the expense recognition principle and the concept of conservatism. The expense recognition principle applies because the application of the LCNRV rule allows for the recognition of a decline in the utility (value) of inventory as a loss in the period in which the decline takes place. The general rule is that the historical cost principle is abandoned when the future utility of an asset is no longer as great as its original cost (conservatism).
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.3
(a)
Cost-of-Goods-Sold Method December 31, 2026 Cost of Goods Sold ............................................... Inventory ($780,000 – $712,000)................................ December 31, 2027 Cost of Goods Sold ............................................... Inventory ($905,000 – $830,000) ................................
(b)
Loss Method December 31, 2026 Inventory Loss ...................................................... Inventory ($780,000 – $712,000)................................. December 31, 2027 Inventory Loss ...................................................... Inventory ($905,000 – $830,000).................................
68,000 68,000
75,000 75,000
68,000 68,000
75,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
75,000
Problem 8.4 (a)
(1)
The amount of the adjustment to Reduce Inventory to Market at May 31, 2025, should be $34,600, as calculated in Exhibit 1 below. Exhibit 1
(2)
Cost
Replacement Cost
NRV (Ceiling)
NRV less normal profit (Floor)
Aluminum siding
$ 70,000
$ 62,500
$ 56,000
$ 50,900
$ 56,000
Cedar shake siding
86,000
79,400
84,800
77,400
79,400
Louvered glass doors
112,000
124,000
168,300
149,800
112,000
Thermal windows
140,000
126,000
140,000
124,600
126,000
Totals
$408,000
$391,900
$449,100
$402,700
$373,400
Inventory cost
$408,000
Less: LCM valuation
373,400
Write-down May 31, 2025
$ 34,600
For the fiscal year ended May 31, 2025, entry to record the loss to reduce inventory to market is as follows. Inventory Loss .................................................... 34,600 Inventory ......................................................
(b)
LCM
34,600
The use of the lower-of-cost-or-market (LCM) rule is based on both the expense recognition principle and the concept of conservatism. The expense recognition principle applies because the application of the LCM rule allows for the recognition of a decline in the utility (value) of inventory as a loss in the period in which the decline takes place. The general rule is that the historical cost principle is abandoned when the future utility of an asset is no longer as great as its original cost (conservatism).
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.5
(a)
Schedule A
Item
On Hand Quantity
Replacement Cost/Unit
NRV (Ceiling)
NRV— Normal Profit (Floor)
A B C D E
1,100 800 1,000 1,000 1,400
$8.40 7.90 5.40 4.20 6.30
$9.00* 8.50 6.05 5.50 6.00
$7.20 7.30 5.45 4.00 5.00
Designated Market
Cost
Lower-ofCost-orMarket
$8.40 7.90 5.45 4.20 6.00
$7.50 8.20 5.60 3.80 6.40
$7.50 7.90 5.45 3.80 6.00
*$10.50-$1.50 Schedule B Item A B C D E
(b)
Cost 1,100 × $7.50 = $8,250 800 × $8.20 = $6,560 1,000 × $5.60 = $5,600 1,000 × $3.80 = $3,800 1,400 × $6.40 = $8,960
Lower-of-Cost-or-Market 1,100 × $7.50 = $8,250 800 × $7.90 = $6,320 1,000 × $5.45 = $5,450 1,000 × $3.80 = $3,800 1,400 × $6.00 = $8,400
Cost of Goods Sold ................................................ Inventory .........................................................
Difference $-0240 150 -0560 $950 950 950
Or Inventory Loss ........................................................ Inventory .........................................................
950 950
Problem 8.5 (Continued) (c) To:
Greg Forda, Clerk
From:
Accounting Manager
Date:
January 14, 2026
Subject:
Instructions on determining lower-of-cost-or-market for inventory valuation
This memo responds to your questions regarding our use of lower-of-costor-market for inventory valuation. Simply put, inventory should be valued at whichever is the lower: the actual cost or the market value of the inventory at the time of valuation. The term cost is relatively simple. It refers to the amount our company paid for our inventory including costs associated with preparing the inventory for sale. The term market, on the other hand, is more complicated. As you have already noticed, this value could be the inventory’s replacement cost, its net realizable value (selling price minus any estimated costs to complete and sell), or its net realizable value less a normal profit margin. The profession requires that the middle value of the three above costs be chosen as the “designated market value.” This designated market value is then compared to the actual cost in determining the lower-of-cost-or-market. Refer to Item A on the attached schedule. The values for the replacement cost, net realizable value, and net realizable value less a normal profit margin are $8.40, $9.00 ($10.50 – $1.50), and $7.20 ($9.00 – $1.80) respectively. The middle value is the replacement cost, $8.40, which becomes the designated market value for Item A. Compare it with the actual cost, $7.50, choosing the lower to value Item A in inventory. In this case, $7.50 is the value chosen to value inventory. Thus, inventory for Item A amounts to $8,250. (See Schedule B, Item A.)
Problem 8.5 (Continued) Proceed in the same way, always choosing the middle value among replacement cost, net realizable value, and net realizable value less a normal profit, and compare that middle value to the actual cost. The lower of these will always be the amount at which you value the particular item. After you have aggregated the total lower-of-cost-or-market for all items, you will be likely to have a loss on inventory which must be accounted for. In our example, the loss is $950. You can journalize this loss in one of two ways: Cost of Goods Sold ............................................................. Inventory .....................................................................
950 950
Or Inventory Loss ..................................................................... Inventory .....................................................................
950 950
This memo should answer your questions about which value to choose when valuing inventory at lower-of-cost-or-market. Schedule A
Item
On Hand Quantity
Replacement Cost/Unit
NRV Ceiling
NRV— Normal Profit (Floor)
A B C D E
1,100 800 1,000 1,000 1,400
$8.40 7.90 5.40 4.20 6.30
$9.00 8.50 6.05 5.50 6.00
$7.20 7.30 5.45 4.00 5.00
Designated Market
Cost
Lower-ofCost-orMarket
$8.40 7.90 5.45 4.20 6.00
$7.50 8.20 5.60 3.80 6.40
$7.50 7.90 5.45 3.80 6.00
Schedule B Item A B C D E
Cost 1,100 × $7.50 = $8,250 800 × $8.20 = $6,560 1,000 × $5.60 = $5,600 1,000 × $3.80 = $3,800 1,400 × $6.40 = $8,960
Lower-of-Cost-or-Market 1,100 × $7.50 = $8,250 800 × $7.90 = $6,320 1,000 × $5.45 = $5,450 1,000 × $3.80 = $3,800 1,400 × $6.00 = $8,400
Difference $-0240 150 -0560 $950
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.6
Beginning inventory ................................................... Purchases .................................................................... Purchase returns......................................................... Total goods available .................................................. Sales revenue .............................................................. Sales returns ............................................................... Net sales ...................................................................... Less: Gross profit (35% × $394,000) ......................... Ending inventory (unadjusted for damage) .............. Less: Goods on hand—undamaged ($30,000 × [1 – 35%]) ........................................ Inventory damaged ..................................................... Less: Net realizable value of damaged inventory .... Fire loss on inventory .................................................
$ 80,000 290,000 370,000 (28,000) 342,000 $415,000 (21,000) 394,000 137,900
(256,100) 85,900 19,500 66,400 8,150 $ 58,250
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.7 STANISLAW CORPORATION Computation of Inventory Fire Loss April 15, 2026 Inventory, 1/1/26 .......................................... Purchases, 1/1/26 – 3/31/26 ........................ April merchandise shipments paid ............ Unrecorded purchases on account ........... Total................................................... Less: Shipments in transit ........................ Merchandise returned ..................... Merchandise available for sale .................. Less estimated cost of sales: Sales revenue, 1/1/26 – 3/31/26 ........ Sales revenue, 4/1/26 – 4/15/26 Receivables acknowledged at 4/15/26 .................................. Estimated receivables not acknowledged .......................... Total ............................................. Add collections, 4/1/26 – 4/15/26 ($12,950 – $950) ............................. Total ............................................. Less receivables, 3/31/26 ................. Total sales 1/1/26 – 4/15/26 ........ Less gross profit (.45* × $161,000) ............ Estimated merchandise inventory ............. Less: Sale of salvaged inventory.............. Inventory fire loss .......................................
$ 75,000 52,000 3,400 15,600 146,000 $
2,300 950
3,250 142,750
135,000 $46,000 8,000 54,000 12,000 66,000 40,000
26,000 161,000 72,450
88,550 54,200 3,500 $ 50,700
Problem 8.7 (Continued) *Computation of Gross Profit Rate Net sales, 2024 .............................................. Net sales, 2025 .............................................. Total net sales..................................... Beginning inventory ..................................... Net purchases, 2024 ..................................... Net purchases, 2025 ..................................... Total ..................................................... Less: Ending inventory................................ Gross profit ........................................
$390,000 530,000 920,000 $ 66,000 235,000 280,000 581,000 75,000
506,000 $414,000
Gross profit rate ($414,000 ÷ $920,000) ....... LO: 4, Bloom: AP, Difficulty: Complex, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
45%
Problem 8.8 (a) Beginning inventory ........................... Purchases ........................................... Freight-in ............................................. Purchase returns ................................ Transfers in from suburban branch.............................. Totals .......................................... Net markups ........................................
Cost
Retail
$ 17,000 82,500 7,000 (2,300)
$ 25,000 137,000
9,200 $113,400
13,000 172,000 8,000 180,000 (4,000)
Net markdowns ................................... Sales revenue...................................... Sales returns ....................................... Inventory losses - normal breakage .. Ending inventory at retail ................... Cost-to-retail ratio = (b)
$113,400 $180,000
(3,000)
$(95,000) 2,400
(92,600) (400) $ 83,000
= 63%
Ending inventory at lower-of-average-cost-or-market (.63 × $83,000) ..................................
$ 52,290
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.9
Beginning inventory ......................... Purchases .......................................... Purchase returns............................... Purchase discounts .......................... Freight-in ........................................... Markups ............................................. Markup cancellations ........................ Totals ........................................ Markdowns ........................................ Markdown cancellations ................... Sales revenue .................................... Less: Sales returns ........................... Inventory losses - normal breakage Employee discounts ......................... Ending inventory at retail ................. Cost-to-retail ratio =
Cost
Retail
$ 250,000 914,500 (60,000) (18,000) 42,000
$ 390,000 1,460,000 (80,000) $
$1,128,500
120,000 (40,000)
80,000 1,850,000
(45,000) 20,000 (25,000) (1,410,000) 97,500 (1,312,500) (4,500) (8,000) $ 500,000
$1,128,500 = 61% $1,850,000
Ending inventory at cost (.61 × $500,000)...............................
$ 305,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.10
(a) Inventory (beginning) ..................... Purchases ....................................... Purchase returns ............................ Freight-in ......................................... Totals ...................................... Markups ........................................... Markup cancellations .....................
Cost
Retail
$ 52,000 272,000 (5,600) 16,600 $335,000
$ 78,000 423,000 (8,000)
$ 9,000 (2,000)
Net markdowns ............................... Normal spoilage and breakage ...... Sales revenue.................................. Ending inventory at retail ............... Cost-to-retail ratio =
$335,000 $500,000
7,000 500,000 (3,600) (10,000) (390,000) $ 96,400
= 67%
Ending inventory at lower-of-cost-or-market (.67 × $96,400) .............................. (b)
493,000
$ 64,588
The difference between the inventory estimate per retail method and the amount per physical count may be due to: 1. Theft losses (shoplifting or pilferage). 2. Spoilage or breakage above normal. 3. Differences in cost/retail ratio for purchases during the month, beginning inventory, and ending inventory. 4. Markups on goods available for sale inconsistent between cost of goods sold and ending inventory. 5. A wide variety of merchandise with varying cost/retail ratios. 6. Incorrect reporting of markdowns, additional markups, or cancellations.
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 8.11 (a)
The inventory section of Maddox’s balance sheet as of November 30, 2025, including required footnotes, is presented below. Also presented below are the inventory section supporting calculations. Current assets Inventory section (Note 1.) Finished goods (Note 2.) ........................ Work-in-process...................................... Raw materials.......................................... Factory supplies ..................................... Total inventories .....................................
$643,000 108,700 237,400 64,800 $1,053,900
Note 1.
Lower-of-cost (first-in, first-out) or-NRV is applied on a major category basis for finished goods, and on a total inventory basis for work-in-process, raw materials, and factory supplies.
Note 2.
Seventy-five percent of bar end shifters finished goods inventory in the amount of $136,500 ($182,000 × .75) is pledged as collateral for a bank loan, and one-half of the head tube shifters finished goods is held by catalog outlets on consignment.
Problem 8.11 (Continued) Supporting Calculations
Down tube shifters at NRV ............ Bar end shifters at cost.................. Head tube shifters at cost .............. Work-in-process at NRV ................ Derailleurs at market ...................... Remaining items at NRV ................ Supplies at cost .............................. Totals ....................................
Finished Goods $266,000 182,000 195,000
Work-inProcess
Raw Materials
Factory Supplies
$108,700 $110,0001 127,400 $643,000
$108,700
$237,400
$64,8002 $64,800
1$264,000 × 1/2 = $132,000; $132,000 ÷ 1.2 = $110,000. 2$69,000 – $4,200 = $64,800.
(b)
The decline in the NRV of inventory below cost may be reported using one or two alternate methods, the direct write-down of inventory (costof-goods-sold method) or the (loss method). The decline in the market value of inventory may be reflected in Maddox’s income statement as a separate loss item for the fiscal year ended November 30, 2025. The loss amount may also be written off directly, increasing the cost of goods sold on Maddox’s income statement. The loss must be reported in continuing operations. The loss must be included in the income statement since it is material to Maddox’s financial statements.
(c)
Purchase contracts for which a fixed price has been established should be disclosed on the financial statements of the buyer. If the contract price is greater than the current market price (a loss would occur if the purchase takes place). An unrealized holding loss amounting to the difference between the contracted price and the current market price should be recognized on the income statement in the period during which the price decline takes place. Also, an estimated liability on purchase commitments should be recognized on the balance sheet.
LO: 1, 3, 6, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Problem 8.12
(a) Inventory, January 1 ....................... Purchases........................................ Purchase returns ............................ Totals ...................................... Add: Net markups Markups ................................. Markup cancellations ........... Totals ...................................... Deduct: Net markdowns Markdowns ............................. Markdown cancellations........ Sales price of goods available ....... Sales revenue .................................. Sales returns and allowances ........ Ending inventory at retail ............... Cost-to-retail ratio =
$132,000 $200,000
Cost
Retail
$ 30,000 104,800 (2,800) 132,000
$ 43,000 155,000 (4,000) 194,000 $
9,200 (3,200)
$132,000 10,500 (6,500) 154,000 (8,000)
4,000 196,000 (146,000) $ 50,000
= 66%
Inventory at lower-of-cost-ormarket (.66 × $50,000) .................. (b)
6,000 200,000
Ending inventory at retail at January 1 price level ($59,400 ÷ 1.08).................................................................. Less beginning inventory at retail ...................................... Inventory increment at retail, January 1 price level .......... Inventory increment at retail, June 30 price level ($12,000 × 1.08).................................................................. Beginning inventory at cost ................................................ Inventory increment at cost at June 30 price level ($12,960 × .70*) .................................................................. Ending inventory at dollar-value LIFO cost .......................
$ 33,000
$ 55,000 43,000 $ 12,000 $ 12,960 $ 30,000 9,072 $ 39,072
*70% = $30,000/$43,000 LO: 7, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Problem 8.13
(a)
The retail method is appropriate in businesses that sell many different items at relatively low unit costs and that have a large volume of transactions such as Home Depot or Wal-Mart. The advantages of the retail method in these circumstances include the following: 1. Interim physical inventories can be estimated. 2. The retail method acts as a control as deviations from the physical count will have to be explained.
(b)
Becker Department Stores’ ending inventory value, at cost, is $83,000, calculated as follows:
Beginning inventory .................................... Purchases .................................................... Net markups ........................................ Net markdowns ................................... Net purchases ..................................... Goods available ........................................... Sales revenue .............................................. Estimated ending inventory at retail ..........
Cost $ 68,000 $255,000 $255,000
Retail $100,000 $400,000 50,000 (110,000) 340,000 440,000 (320,000) $120,000
Cost-to-retail percentage: $255,000 ÷ $340,000 = 75%. Beginning inventory layer ........................... Incremental increase At retail ($120,000 – $100,000) ........... At cost ($20,000 × .75) ........................ Estimated ending inventory at LIFO cost ..
$ 68,000
$100,000 20,000
15,000 $ 83,000
$120,000
*Problem 8.13 (Continued) (c)
The estimated shortage amount, at retail, for Becker Department Stores is $5,000 calculated as follows: Estimated ending inventory at retail ............................. Actual ending inventory at retail ................................... Estimated inventory shortage........................................
(d)
$120,000 (115,000) $ 5,000
When using the retail inventory method, the four expenses and allowances noted are treated in the following manner: 1. Freight costs are added to the cost of purchases. 2. Purchase returns are considered as reductions to both the cost price and the retail price. Purchase allowances are considered a reduction in cost price. 3. Sales returns and allowances are subtracted as an adjustment to sales. 4. Employee discounts are deducted from the retail column in a manner similar to sales. They are not considered in the cost-toretail percentage because they do not reflect an overall change in the selling price.
LO: 7, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Problem 8.14
(a) Inventory (beginning) ..................... Purchases ....................................... Markups ........................................... Totals ...................................... Markdowns ...................................... Sales revenue.................................. Ending inventory at retail ............... Cost-to-retail ratio =
$132,000 $220,000
Cost
Retail
$ 15,800 116,200
$ 24,000 184,000 12,000 220,000 (5,500) (175,000) $ 39,500
$132,000
= 60%
Ending inventory at cost (.60 × $39,500) (b)
$ 23,700
Ending inventory for 2025 under the LIFO method: The cost-to-retail ratio for 2025 can be computed as follows:
Net purchases at cost $116,200 = = 61% Net purchases plus markups less markdowns at retail $184,000 + $12,000 – $5,500
December 31, 2025 inventory at LIFO cost:
Beginning inventory ............. Increment in 2025.................. Ending inventory...................
Retail $24,000 15,500* $39,500
Ratio 61%
LIFO Cost $15,800 9,455 $25,255
*$39,500 – $24,000 = $15,500 LO: 7, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Problem 8.15 (a)
DAVENPORT DEPARTMENT STORE COMPUTATION OF COST OF DECEMBER 31, 2024 INVENTORY BASED ON THE CONVENTIONAL RETAIL METHOD
Beginning inventory, January 1, 2024 .............. Add (deduct) transactions affecting cost ratio: Purchases ................................................ Purchase returns ..................................... Purchase discounts................................. Freight-in .................................................. Net markups ............................................. Totals .................................................. Add (deduct) other retail transactions not considered in computation of cost ratio: Gross sales .............................................. Sales returns ............................................ Net markdowns ........................................ Employee discounts ................................ Totals .................................................. Inventory, December 31, 2024: At retail ..................................................... At cost ($63,000 × .56*) ............................ *Ratio of cost-to-retail = $347,200 ÷ $620,000 = 56%
At Cost
At Retail
$ 29,800
$ 56,000
311,000 (5,200) (6,000) 17,600
554,000 (10,000)
$347,200
20,000 620,000
(551,000) 9,000 (12,000) (3,000) (557,000) $ 63,000 $ 35,280
*Problem 8.15 (Continued) (b)
COMPUTATION OF COST OF DECEMBER 31, 2024 INVENTORY UNDER THE LIFO RETAIL METHOD
Totals used in computing cost ratio under conventional retail method (part a)................ Exclude beginning inventory ............................ Net purchases .................................................... Deduct net markdowns...................................... Totals used in computing cost ratio under LIFO retail method .......................................... Cost ratio under LIFO retail method ($317,400 ÷ $552,000)...................................... Inventory, December 31, 2024: At retail (Conventional) ........................... At cost under LIFO retail method ($60,000 × .575) .....................................
Cost
Retail
$347,200 29,800 317,400
$620,000 56,000 564,000 12,000
$317,400
$552,000
57.5% $ 60,000 $ 34,500
*Problem 8.15 (Continued) (c)
COMPUTATION OF 2025 AND 2026 YEAR-END INVENTORIES UNDER THE DOLLAR-VALUE LIFO METHOD
Computation of retail values on the basis of January 1, 2025, price levels Cost Retail 2025: Inventory at end of year (given) ................... Inventory at end of year stated in terms of January 1, 2025 prices ($75,600 ÷ 1.05) .......................................... January 1, 2025 inventory base (given) cost ratio of 55.5% ($33,300 ÷ $60,000) .... Increment in inventory: In terms of January 1, 2025 prices .............. In terms of 2025 prices—$12,000 × 1.05...... At LIFO cost— .61 (2025 cost ratio) × $12,600 ....................................................... December 31, 2025 inventory at LIFO cost ...........
$75,600
$72,000 $33,300
60,000 $12,000 $12,600
7,686 $40,986
2026: Inventory at end of year (given) ................... Inventory at end of year stated in terms of January 1, 2026 prices ($62,640 ÷ 1.08) .......................................... December 31, 2026 inventory at LIFO cost— .555* (January 1, 2025 cost ratio) × $58,000........................................... *Based on the beginning inventory for 2025 of
$62,640
$58,000
$32,190
$33,300 Cost = 55.5%. $60,000 Retail
(Note to instructor: Because the retail inventory stated in terms of January 1, 2025 prices at December 31, 2026, $58,000, has fallen below the January 1, 2026 inventory base at retail, $60,000, under the LIFO theory the 2024 layer has been depleted and only a portion of the original inventory base remains. Hence the LIFO cost at December 31, 2026 is determined by applying the January 1, 2025 cost ratio of 55.5 percent to the retail inventory value of $58,000). LO: 7, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 8.1 Financial Reporting Problem (a) Inventories are valued at the lower of cost or net realizable value. Productrelated inventories are primarily maintained on the first-in, first-out method. The cost of spare part inventories is maintained using the average cost method. (b) Inventories are reported on the balance sheet simply as “inventories” with sub-totals reported for (1) Materials and supplies, (2) Work in process, and (3) Finished goods. (c) In its note describing Cost of Products Sold, P&G indicates that cost of products sold is primarily comprised of direct materials and supplies consumed in the manufacture of product, as well as manufacturing labor, depreciation expense and direct overhead expense necessary to acquire and convert the purchased materials and supplies into finished product. Cost of products sold also includes the cost to distribute products to customers, inbound freight costs, internal transfer costs, warehousing costs and other shipping and handling activity. Cost of Goods Sold = $35,250 Average Inventory ($5,498 + $5,017) 2 = 6.7 or approximately 55 days to turn its inventory, which is lower than in 2019 (7.13 or 51 days).
(d) Inventory turnover =
Its gross profit percentages for 2020 and 2019 are as follows:
Net sales ............................ Cost of goods sold ........... Gross profit .......................
2020 $70,950 35,250 $35,700
2019 $67,684 34,768 $32,916
Gross profit percentage ...
50.32%
48.63%
P&G had an increase in its gross profit and gross profit percentage. Sales in 2020 showed 4.8% increase. It appears that P&G has been able to increase gross margin, by holding cost increases to just over 1%. LO: 1, 6, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 8.2 Comparative Analysis Case (a) Coca-Cola reported inventories of $3,266 million, which represents 3.7% of total assets. PepsiCo reported inventories of $4,172 million, which represents 4.49% of its total assets. (b) Coca-Cola determines the cost of its inventories on the basis of average cost or first-in, first-out (FIFO) methods; its inventories are valued at the lower of cost or net realizable value. PepsiCo’s inventories are valued at the lower of cost (computed on the average, FIFO or LIFO method) or net realizable value. PepsiCo also reported that the cost for 6% of its 2020 inventories was computed using the LIFO method. (c) Coca-Cola classifies and describes its inventories as primarily raw materials and packaging and finished goods. PepsiCo classifies and describes its inventories as (1) raw materials, (2) work-in-process and (3) finished goods. (d) Inventory turnovers and days to sell inventory for 2020: Coca-Cola $13,433 = 4.04 times ($3,266 + $3,379) 2 365 ÷ 4.04 = 90.3 days
PepsiCo $31,797 = 8.47 times ($4,172 + $3,338) 2 365 ÷ 8.47 = 43.1 days
A substantial difference between Coca-Cola and PepsiCo exists regarding the inventory turnover and related days to sell inventory. The primary reason is that PepsiCo’s cost of goods sold and related inventories involve food operations as well as beverage cost. This situation is not true for Coca-Cola. Food will have a much higher turnover because food must be turned over quickly or else spoilage will become a major problem. LO: 1, 6, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 8.3 Financial Statement Analysis Case 1 (a) It may provide this information (although it is not required to do so) because it believes that this information tells the reader that both its income and inventory would be higher if FIFO had been used. (b) The LIFO liquidation reduces operating costs because low price goods are matched against current revenue. As a result, operating costs are lower than normal because higher operating costs would have normally been deducted from revenues. (c) It would probably have reported more income if it had been on a FIFO basis. For example, its inventory as of December 31, 2025 was stated at $1,635,040. Its inventory under FIFO would have been $364,960 ($2,000,000–$1,635,040) higher in 2025 if FIFO had been used. On the other hand, the LIFO liquidation would not have occurred in 2025 or previous years because FIFO would have been used. Thus, the 2025 reduction in operating costs of $24,000 due to the LIFO liquidation would not have occurred. LO: 6, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 8.4 Financial Statement Analysis Case 2 (a)
There are probably no finished goods because gold is a highly liquid commodity, and so it can be sold as soon as processing is complete. Ore in stockpiles is probably a noncurrent asset because processing takes more than one year.
(b)
Sales are recorded as follows: Accounts Receivable or Cash .......................... Sales Revenue ............................................
XXX XXX
AND Cost of Goods Sold .......................................... Gold in Process Inventory ........................ (c)
Balance Sheet Inventory Overstated Retained earnings Overstated Accounts payable No effect Working capital Overstated Current ratio Overstated
XXX XXX
Income Statement Cost of goods sold Understated Net income Overstated
LO: 6, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 8.5 Accounting, Analysis, and Principles Accounting (a) Residential pumps: Ending inventory cost = (300 × $500) + (200 × $475) = Beginning inventory cost = (200 × $400) = Purchases = $225,000 + $190,000 + $150,000 = Cost of goods sold = $80,000 + $565,000 – $245,000 =
$ 245,000 $ 80,000 $ 565,000 $ 400,000
Commercial pumps: Ending inventory at cost = (500 × $1,000) = Beginning inventory at cost = (600 × $800) = Purchases = $540,000 + $285,000 + $500,000 = Cost of goods sold = $480,000 + $1,325,000 – $500,000 =
$ 500,000 $ 480,000 $1,325,000 $1,305,000
Total ending inventory at cost = $245,000 + $500,000 = Total cost of goods sold = $1,305,000 + $400,000 =
$ 745,000 $1,705,000
Lower-of-cost-or-NRV: NRV per unit Number of units on hand, Mar. 31 Designated market value of ending inventory Required write-down
*($580 × 500)
Residential pumps $580 500
Commercial pumps $900 500
$290,000*
$450,000**
None
Yes, $450,000 < $500,000
**($900 × 500)
Total amount of inventory reported on March 31 balance sheet = $695,000 ($245,000 + $450,000).
Accounting, Analysis, and Principles (Continued) (b)
Inventory at cost = $245,000 + $500,000 = $745,000 NRV = $275,000 + $450,000 = $725,000 $725,000 < $745,000, therefore write inventory down to $725,000 Total amount of inventory reported on March 31 balance sheet = $725,000
Analysis In this problem, one product’s market value is above cost and the other one is below. From a conservative perspective, the individual product approach results in a write-down for any product whose NRV is below cost. So, potentially the individual product approach informs the financial statement reader about any products with weak markets, while the category approach does not. One could argue that the company’s balance sheet inventory amount, if aggregated into one category, is closer to its market value than with the individual product approach. This approach allows unrealized inventory gains to offset inventory losses. It is difficult to say which approach provides better information, but the individual product approach results in a larger write-down. Principles (a)
If the NRV is $1,050, the value of commercial pumps would be above cost. The written-down amount becomes the new cost for that inventory and Englehart would not be allowed to write that inventory back up.
(b)
The conceptual trade-off inherent in the accounting for inventory as it relates to lower-of-cost-or-NRV is between relevance and faithful representation. NRV is generally thought to be more relevant than cost. Cost is considered less subjective (and a more faithful representation) than market. Under LCNRV, relevance takes precedence in a down market; however, faithful representation is more important in an up market.
LO: 1, 6, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Reflective Thinking, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 8.1 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to discuss the purpose, the application, and the potential disadvantages of the lower-of-cost-or NRV method. CT 8.2 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to examine ethical issues related to lower-of-costor NRV on an individual-product basis. A relatively straightforward case. CT 8.3 (Time 15–20 minutes) Purpose—to provide the student with a case that requires an application and an explanation of the lowerof-cost-or NRV rule and a differentiation of the FIFO and the average cost methods. CT 8.4 (Time 15–20 minutes) Purpose—to provide the student with a case that requires an application and an explanation of the lower-ofcost-or-net realizable value rule and a differentiation of the LIFO and the average cost methods. CT 8.5 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the main features of the retail inventory system. In this case, the following must be explained: (a) accounting features of the method, (b) conditions that may distort the results under the method, (c) advantages of using the retail method versus using a cost method, and (d) the accounting theory underlying net markdowns and net markups. A relatively straightforward case. CT 8.6 (Time 15–25 minutes) Purpose—the student discusses which costs are inventoriable, the theoretical arguments for the lowerof-cost-or-market rule, and the amount that should be used to value inventories when replacement cost is below the net realizable value less a normal profit margin. The treatment of beginning inventories and net markdowns when using the conventional retail inventory method must be explained. CT 8.7 (Time 10–15 minutes) Purpose—to provide the student with a case that allows examination of ethical issues related to the recording of purchase commitments.
Solutions to Critical-Thinking Cases CT8.1 (a) The purpose of using the LCNRV method is to reflect the decline of inventory value below its original cost. A departure from cost is justified on the basis that a loss of utility should be reported as a charge against the revenues in the period in which it occurs. (b) The term “net realizable value” in LCNRV generally means the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. (c) The LCNRV method may be applied either directly to each inventory item, to a category, or to the total inventory. The application of the rule to the inventory total, or to the total components of each category, ordinarily results in an amount that more closely approaches cost than it would if the rule were applied to each individual item. Under the first two methods, increases in net realizable value offset, to some extent, decreases in net realizable value. The most common practice is to price the inventory on an item-by-item basis. Many companies favor the individual item approach because tax rules in certain jurisdictions require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet. (d) Conceptually, the LCNRV method has some deficiencies. First, decreases in the value of the asset and the charge to expense are recognized in the period in which loss in utility occurs—not in the period of sale. On the other hand, increases in the value of the asset are recognized only at the point of sale. This situation is inconsistent and can lead to distortions in the presentation of income. Second, net realizable value reflects the future service potential of the asset and, for that reason, it is conceptually sound. But net realizable value cannot often be measured with any certainty. From the standpoint of accounting theory, there is little to justify the LCNRV rule. Although conservative from the statement of financial position point of view, it permits the income statement to show a larger net income in future periods than would be justified if the inventory were carried forward at cost. The rule is applied only in those cases where strong evidence indicates that market declines in inventory prices have occurred that will result in losses when such inventories are sold. LO: 1, Bloom: C, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT8.2
(a) The accountant’s ethical responsibility is to provide fair and complete financial information. In this case, the cost-of-goods-sold method distorts the cost of goods sold and hides the decline in market value. (b) If Ortiz’s cost-of-goods-sold method is used, management could distort calculations that involve the cost of goods sold. While useful to management in establishing profit margins and determining selling prices; this method is not a good policy from the investors’ and shareholders’ viewpoint because it hides declines in market value.
CT8.2 (Continued) (c) Conan should use the loss method to disclose the decline in market value and avoid distorting cost of goods sold. However, he faces an ethical dilemma if Ortiz will not accept the method Conan wants to use. He should consider various alternatives including the extremes of simply accepting his boss’s decision, going to the audit committee or quitting, if Ortiz will not change his mind. Conan should assess the consequences of each possible alternative and weigh them carefully before he decides what to do. LO: 1, Bloom: E, Difficulty: Moderate, Time: 20-30, AACSB: Ethics, Analytic, Communication, AICPA BB: Ethical Conduct, AICPA FC: Reporting, AICPA PC: Communication
CT8.3
(a) Ogala’s inventory should be reported at net realizable value consistent with the LCNRV rule since net realizable value is below original cost.
(b) The LCNRV rule is used to report the inventory in the balance sheet at its future utility value. It also recognizes a decline in the utility of inventory in the income statement in the period in which the decline occurs.
(c) Generally, ending inventory would have been higher and cost of goods sold would have been lower had Ogala used the average cost inventory method in a period of declining prices. Inventory quantities increased and average cost associates all purchase prices with inventory. However, in this instance, there would have been no effect on ending inventory or cost of goods sold had Ogala used the average-cost inventory method because Ogala’s inventory would have been reported at net realizable value according to the LCNRV rule. Net realizable value of the inventory is less than either its average cost or FIFO cost. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT8.4 (a) 1. Steele's inventory should be reported at net realizable value. According to the lower-of-cost-ornet realizable value (LCNRV) rule, inventory cannot be reported above NRV. In this instance, net realizable value is below original cost. 2. The lower-of-cost-or-NRV rule is used to report the inventory in the balance sheet at its future utility value. It also recognizes a decline in the utility of inventory in the income statement in the period in which the decline occurs. (b) Generally, ending inventory would have been higher and cost of goods sold would have been lower had Steele used the LIFO inventory method in a period of declining prices. Inventory quantities increased and LIFO associates the oldest purchase prices with inventory. However, in this instance, there would have been no effect on ending inventory or cost of goods sold had Steele used the LIFO inventory method because Steele’s inventory would have been reported at net realizable value according to the lower-of-cost-or-market rule. Net realizable value of the inventory is less than either its average cost or LIFO cost. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Reflective Thinking, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT8.5 A report will contain the following elements. (a) The retail inventory method can be employed to estimate retail, wholesale, and manufacturing finished goods inventories. The valuation of inventory under this method is arrived at by reducing the ending inventory at retail to an estimate of the lower-of-cost-or-market. The retail value of ending inventory can be computed by (1) taking a physical inventory, or by (2) subtracting net sales and net markdowns from the total retail value of merchandise available for sale (i.e., the sum of beginning inventory at retail, net purchases at retail, and net markups). The reduction of ending inventory at retail to an estimate of the lower-of-cost-or-market is accomplished by applying to it an estimated cost ratio arrived at by dividing the retail value of goods available for sale as computed in (2) above into the cost of goods available for sale (i.e., the sum of beginning inventory, net purchases, and other inventoriable costs). (b) Since the retail method is based on an estimated cost ratio involving total merchandise available during the period, its validity depends on the underlying assumption that the merchandise in ending inventory is a representative mixture of all merchandise handled. If this condition does not exist, the cost ratio may not be appropriate for the merchandise in ending inventory and can result in significant error. Where there are a number of inventory subdivisions for which differing rates of markup are maintained, there is no assurance that the ending inventory mix will be representative of the total merchandise handled during the period. In such cases, accurate results can be obtained by subclassifications by rate of markup. Seasonal variations in the rate of markup will nullify the ending inventory “representative mix” assumption. Since the estimated cost ratio is based on total merchandise handled during the period, the same rate of markup should prevail throughout the period. Because of seasonal variations it may be necessary to use data for the last six months, quarter, or month to compute a cost ratio that is appropriate for ending inventory. Material quantities of special sale merchandise handled during the period may also bias the result of this method because merchandise data included in arriving at the estimated cost ratio may not be proportionately represented in ending inventory. This condition may be avoided by accumulating special sale merchandise data in separate accounts. Distortion of the ending inventory approximation under this method is often caused by an inadequate system of inventory control. Adequate accounting controls are necessary for the accurate accumulation of the data needed to arrive at a valid cost ratio. Physical controls are equally important because, for interim purposes, this method is usually applied without taking a physical inventory. (c) The advantages of using the retail method as compared to cost methods include the following: 1. Approximate inventory values can be determined without maintaining perpetual inventory records. 2. The preparation of interim financial statements is facilitated. 3. Losses due to fire or other casualty are readily determined. 4. Clerical work in pricing the physical inventory is reduced. 5. The cost of merchandise can be kept confidential in intracompany transfers. (d) The treatments to be accorded net markups and net markdowns must be considered in light of their effects on the estimated cost ratio. If both net markups and net markdowns are used in arriving at the cost ratio, ending inventory will be converted to an estimated average cost figure. Excluding net markdowns will result in the inventory being stated at an estimate of the lower-of-cost-or-market.
CT8.5 (Continued) The lower cost ratio arrived at by excluding net markdowns permits the pricing of inventory at an amount that reflects its current utility. The assumption is that net markdowns represent a loss of utility that should be recognized in the period of markdown. Ending inventory is therefore valued on the basis of its revenue-producing potential and may be expected to produce a normal gross profit if sold at prevailing retail prices in the next period. LO: 5, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Reflective Thinking, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT8.6 (a) 1. Olson’s inventoriable cost should include all costs incurred to get the lighting fixtures ready for sale to the customer. It includes not only the purchase price of the fixtures but also the other associated costs incurred on the fixtures up to the time they are ready for sale to the customer, for example, freight-in. 2. No, administrative costs are assumed to expire with the passage of time and not to attach to the product. Furthermore, administrative costs do not relate directly to inventories but are incurred for the benefit of all functions of the business. (b) 1. The use of the lower-of-cost-or-market rule is justified for valuing inventories by the concept of conservatism and by the expense recognition principle. The decline in the utility of the inventories below their cost should be recognized as a loss in the current period. 2. The net realizable value less a normal profit margin should be used to value the inventories because market should not be less than net realizable value less a normal profit margin. To carry the inventories at net realizable value less a normal profit margin provides a means of measuring residual usefulness of an inventory expenditure. (c) Olson’s beginning inventories at cost and at retail would be included in the calculation of the cost ratio. Net markdowns would be excluded from the calculation of the cost ratio. This procedure reduces the cost ratio because there is a larger denominator for the cost ratio calculation. Thus, the concept of conservatism (prudence) is being followed and a lower-of-cost-or-market valuation is approximated. LO: 1, 2, 5, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Reflective Thinking, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT8.7 (a) Accounting standards require that when a contracted price is in excess of market, as it is in this case (market is $5,000,000 and the contract price is $6,000,000), and it is expected that losses will occur when the purchase is effected, losses should be recognized in the period during which such declines in market prices take place. It would be unethical to ignore recognition of the loss now if a loss is expected to occur when the purchase is made. (b) If the loss is material, new and continuing shareholders are harmed by nonrecognition of the loss. Herman’s position as an accounting professional also is affected if he accepts a financial report he knows violates GAAP.
CT 8.7 (Continued) (c) If the preponderance of the evidence points to a loss when the purchase is effected, the controller should recognize the amount of the loss in the period in which the price decline occurs. In this case the loss is measured at $1,000,000 and recorded as follows: Loss on Purchase Commitments ....................................................... 1,000,000 Estimated Liability on Purchase Commitments ........................
1,000,000
Herman should insist on statement preparation in accordance with GAAP. If Hands will not accept Herman’s position, Herman will have to consider alternative courses of action such as contacting higher-ups at Prophet and assess the consequences of each course of action. LO: 3, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Ethics, Reflective Thinking, Communication, AICPA BB: Ethical Conduct, AICPA FC: Reporting, AICPA PC: Communication
Codification Exercises CE8.1 (a)
According to the Master Glossary, Inventory is defined as the aggregate of those items of tangible personal property that have any of the following characteristics: 1. Held for sale in the ordinary course of business 2. In process of production for such sale 3. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.
(b)
According to the Master Glossary, the phrase lower-of-cost-or-market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meets both of the following conditions. 1. Market shall not exceed the net realizable value 2. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.
(c)
According to the Master Glossary, two definitions are provided for the phrase net realizable value 1. Estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal.
LO: 1, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE8.2 According to FASB ASC 330-10-35: Adjustments to Lower-of-Cost-and Net Realizable Value 35-1A The subsequent measurement of inventory depends on the cost method and is different for the following: • a. Inventory measured using any method other than last-in, first-out (LIFO) or the retail inventory method (see paragraph 330-10-35-1B) • b. Inventory measured using LIFO or the retail inventory method (see paragraphs 330-10-35-1C through 35-7). Paragraphs 330-10-35-7A through 35-11 apply to all inventory. Inventory Measured Using Any Method Other Than LIFO or the Retail Inventory Method 35-1B Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out (FIFO) or average cost) shall be measured at the lower of cost and net realizable value. When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs.
CE8.2 (Continued)
That loss may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes. Subsequent Measurement Guidance Applicable to All Inventory 35-7A If inventory has been the hedged item in a fair value hedge, the inventory’s cost basis for purposes of subsequent measurement shall reflect the effect of the adjustments of its carrying amount made pursuant to paragraph 815-25-35-1(b). 35-8 Depending on the character and composition of the inventory, the guidance in paragraphs 330-10-35-1A through 35-7 that is applicable to the inventory being measured may properly be applied either directly to each item or to the total of the inventory (or, in some cases, to the total of the components of each major category). The method shall be that which most clearly reflects periodic income. 35-9 The purpose of reducing the carrying amount of inventory is to reflect fairly the income of the period. The most common practice is to apply the applicable subsequent measurement guidance separately to each item of the inventory. However, if there is only one end-product category, the application of the applicable subsequent measurement guidance to inventory in its entirety may have the greatest significance for accounting purposes. Accordingly, the remeasurement of individual items may not always lead to the most useful result if the market value (for inventory measured using LIFO or the retail inventory method) or net realizable value (for all other inventory) of the total inventory is not below its cost. This might be the case, for example, if selling prices are not affected by temporary or small fluctuations in current costs of purchase or manufacture. 35-10 Similarly, where more than one major product or operational category exists, the application of the applicable subsequent measurement guidance to the total of the items included in such major categories may result in the most useful determination of income. When no loss of income is expected to take place as a result of a reduction of cost prices of certain goods because others forming components of the same general categories of finished products have a market value (for inventory measured using LIFO or the retail inventory method) or net realizable value (for all other inventory) equally in excess of cost, such components need not be adjusted to the extent that they are in balanced quantities. Thus, in such cases, the guidance on subsequent measurement may be applied directly to the totals of the entire inventory, rather than to the individual inventory items, if they enter into the same category of finished product and if they are in balanced quantities, provided the procedure is applied consistently from year to year. 35-11 To the extent, however, that the stocks of particular materials or components are excessive in relation to others, the more widely recognized procedure of applying the guidance on subsequent measurement to the individual items constituting the excess shall be followed. This would also apply in cases in which the items enter into the production of unrelated products or products having a material variation in the rate of turnover. Unless an effective method of classifying categories is practicable, the rule shall be applied to each item in the inventory. Note to the instructor: The determination of the amount of the write-off should be based on factors that relate to the net realizable value of the inventory, not the amount that will maximize the loss in the current period. Note that the sale manager’s proposed accounting is an example of “cookie jar” reserves, as discussed in Chapter 3. By writing the inventory down to an unsupported low value, the company can report higher gross profit and net income in subsequent periods when the inventory is sold. LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE8.3 According to FASB ASC 330-10-35, if inventory has been the hedged item in a fair value hedge, the inventory’s cost basis used in the lower-of-cost-or-market accounting shall reflect the effect of the adjustments of its carrying amount made pursuant to paragraph 815-25-35-1(b). And, according to 8152-35-1(b), gains and losses on a qualifying fair value hedge shall be accounted for as follows: The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings. LO: 3, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE8.4 See FASB ASC 210-10-S99—Regulation S-X Rule 5-02, Balance Sheets S99-1 The following is the text of Regulation S-X Rule 5-02, Balance Sheets. The purpose of this rule is to indicate the various line items and certain additional disclosures which, if applicable, and except as otherwise permitted by the Commission, should appear on the face of the balance sheets or related notes filed for the persons to whom this article pertains (see § 210.4–01(a)). • ASSETS AND OTHER DEBITS • Current Assets, when appropriate • • 6. Inventories. – (a) State separately in the balance sheet or in a note thereto, if practicable, the amounts of major classes of inventory such as: • 1. Finished goods; • 2. inventoried cost relating to long-term contracts or programs (see paragraph (d) of this section); • 3. work in process • 4. raw materials; and • 5. supplies. – If the method of calculating a LIFO inventory does not allow for the practical determination of amounts assigned to major classes of inventory, the amounts of those classes may be stated under cost flow assumptions other that LIFO with the excess of such total amount over the aggregate LIFO amount shown as a deduction to arrive at the amount of the LIFO inventory. – (b) The basis of determining the amounts shall be stated. If cost is used to determine any portion of the inventory amounts, the description of this method shall include the nature of the cost elements included in inventory. Elements of cost include, among other items, retained costs representing the excess of manufacturing or production costs over the amounts charged to cost of sales or delivered or in-process units, initial tooling or other deferred startup costs, or general and administrative costs. – The method by which amounts are removed from inventory (e.g., average cost, first-in, firstout, last-in, first-out, estimated average cost per unit) shall be described. If the estimated average cost per unit is used as a basis to determine amounts removed from inventory under a total program or similar basis of accounting, the principal assumptions (including, where meaningful, the aggregate number of units expected to be delivered under the program, the number of units delivered to date and the number of units on order) shall be disclosed.
CE8.4 (Continued)
– If any general and administrative costs are charged to inventory, state in a note to the financial statements the aggregate amount of the general and administrative costs incurred in each period and the actual or estimated amount remaining in inventory at the date of each balance sheet. – (c) If the LIFO inventory method is used, the excess of replacement or current cost over stated LIFO value shall, if material, be stated parenthetically or in a note to the financial statements. – (d) For purposes of §§ 210.5–02.3 and 210.5–02.6, long-term contracts or programs include • 1. all contracts or programs for which gross profits are recognized on a percentageof-completion method of accounting or any variant thereof (e.g., delivered unit, cost to cost, physical completion), and • 2. any contracts or programs accounted for on a completed contract basis of accounting where, in either case, the contracts or programs have associated with them material amounts of inventories or unbilled receivables and where such contracts or programs have been or are expected to be performed over a period of more than twelve months. Contracts or programs of shorter duration may also be included, if deemed appropriate. – For all long-term contracts or programs, the following information, if applicable, shall be stated in a note to the financial statements: (i) The aggregate amount of manufacturing or production costs and any related deferred costs (e.g., initial tooling costs) which exceeds the aggregate estimated cost of all inprocess and delivered units on the basis of the estimated average cost of all units expected to be produced under long-term contracts and programs not yet complete, as well as that portion of such amount which would not be absorbed in cost of sales on existing firm orders at the latest balance sheet date. In addition, if practicable, disclose the amount of deferred costs by type of cost (e.g., initial tooling, deferred production, etc.) (ii) The aggregate amount representing claims or other similar items subject to uncertainty concerning their determination or ultimate realization, and include a description of the nature and status of the principal items comprising such aggregate amount. (iii) The amount of progress payments netted against inventory at the date of the balance sheet. LO: 3, 6, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
Codification Research Case (a)
The codification provides guidance at: FASB ASC 330-10-05 (Codification String: Assets > 330 Inventory > 10 Overall > 05 Overview and Background). The primary predecessor literature is: “Restatement and Revision of Accounting Research Bulletins.” Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4.
(b)
According to the FASB ASC 330-10-20, the Glossary indicates the following. Inventory is the aggregate of those items of tangible personal property that have any of the following characteristics: a. Held for sale in the ordinary course of business b. In process of production for such sale c. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.
Codification Research Case (Continued) (c)
According to the FASB ASC 330-10-20, the Glossary indicates the following for the term Market: As used in the phrase lower-of-cost-or-market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meet both of the following conditions: a. Market shall not exceed the net realizable value. b. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.
(d)
According to FASB ASC 330-10-35: 35-15 Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability. For: Goods Stated Above Cost 50-3
Where goods are stated above cost this fact shall be fully disclosed.
35-16 It is generally recognized that income accrues only at the time of sale, and that gains may not be anticipated by reflecting assets at their current sales prices. However, exceptions for reflecting assets at selling prices are permissible for both of the following: a. Inventories of gold and silver, when there is an effective government-controlled market at a fixed monetary value b. Inventories representing agricultural, mineral, and other products, with any of the following criteria: (1) Units of which are interchangeable (2) Units of which have an immediate marketability at quoted prices (3) Units for which appropriate costs may be difficult to obtain. Where such inventories are stated at sales prices, they shall be reduced by expenditures to be incurred in disposal. LO: 1, 2, 3, 6, Bloom: C, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CHAPTER 9 Acquisition and Disposition of Property, Plant, and Equipment Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises 1, 2, 3
Exercises
Critical Problems Thinking
1, 2, 3, 4, 5, 6, 14
1, 2, 3, 4, 5, 6
1. Valuation and classification of land, buildings, and equipment.
1, 2, 3, 4, 6, 7, 8, 14, 22
1, 5, 6
2. Self-constructed assets, capitalization of overhead.
5, 9, 21, 22
4, 7, 13, 17
3. Capitalization of interest.
6, 9, 10, 11, 4, 5, 6 12, 22
6, 8, 9, 10, 11, 17
6, 7, 8
3
4. Exchanges of assets.
13, 17, 18
10, 11, 12, 13, 14
12, 17, 18, 19, 20, 23
5, 9, 10, 11, 12
4
5. Lump-sum purchases, issuance of stock, deferred-payment contracts.
13, 14, 15, 16
7, 8, 9
3, 12, 13, 14, 15, 16, 17
3, 12
6. Costs subsequent to acquisition.
19, 20
15
22, 23, 24
7. Alternative valuations.
23
8. Disposition of assets.
24
*9. Accounting for contributions
25, 26
2
13
4
16, 17
25, 26
5
18, 19, 20
7, 13, 25
5
1
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Identify property, plant, and equipment and its related costs.
1, 2, 3, 4, 5, 6, 7, 8, 21, 22
1, 2, 3
1, 2, 3, 4, 5, 6, 7, 12, 13, 14
1, 2, 3, 4, 5, 6, 7, 12
1, 2, 5, 6
2.
Discuss the accounting problems associated with interest capitalization.
6, 9, 10, 11, 12, 22
4, 5, 6
6, 8, 9, 10, 11, 17
6, 7, 8
3
3.
Explain the accounting issues related to acquiring and valuing plant assets.
13, 14, 15, 16, 17, 18,
7, 8, 9, 10, 11, 12, 13, 14
7, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21
4, 5, 9, 10, 11, 12
4
4.
Describe the accounting treatment for costs subsequent to acquisition.
19, 20
15
22, 23, 24
5.
Describe the accounting treatment for the disposal of property, plant, and equipment.
23, 24
16, 17
23, 25, 26
3, 5
1
*6
Describe the accounting for contributions.
25, 26
18, 19, 20
7, 13, 25
5
Assignment Characteristics Table Item
Description
Level of Difficulty
E9.1 E9.2 E9.3 E9.4 E9.5 E9.6 E9.7 E9.8 E9.9 E9.10 E9.11 E9.12 E9.13 E9.14 E9.15 E9.16 E9.17 E9.18 E9.19 E9.20 E9.21 E9.22 E9.23 E9.24 E9.25 E9.26
Acquisition costs of realty. Acquisition costs of realty. Acquisition costs of trucks. Purchase and self-constructed cost of assets. Asset retirement obligation Treatment of various costs. Correction of improper cost entries. Capitalization of interest. Capitalization of interest. Capitalization of interest. Capitalization of interest. Entries for equipment acquisitions. Entries for asset acquisition, including self-construction. Entries for acquisition of assets. Purchase of equipment with zero-interest-bearing debt. Purchase of computer with zero-interest-bearing debt. Asset acquisition. Nonmonetary exchange. Nonmonetary exchange. Nonmonetary exchange. Nonmonetary exchange. Analysis of subsequent expenditures. Analysis of subsequent expenditures. Analysis of subsequent expenditures. Entries for disposition of assets. Disposition of assets.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Difficult Moderate Moderate Moderate Moderate Difficult Moderate Difficult Moderate Difficult Difficult Difficult Difficult Difficult Moderate Difficult Moderate Moderate Moderate
15–20 10–15 10–15 20–25 10–15 30–40 15–20 20–25 20–25 20–25 20–25 10–15 15–20 20–25 15–20 15–20 25–35 10–15 20–25 15–20 15–20 20–25 15–20 10–15 20–25 15–20
P9.1 P9.2 P9.3 P9.4 P9.5
Classification of acquisition and other asset costs. Asset retirement obligation. Classification of acquisition costs. Classification of land and building costs. Dispositions, including condemnation, demolition, and trade-in. Classification of costs and interest capitalization. Interest during construction. Capitalization of interest. Nonmonetary exchanges. Nonmonetary exchanges. Nonmonetary exchanges. Purchases by deferred payment, lump-sum, and nonmonetary exchanges.
Moderate Moderate Difficult Difficult Moderate
35–40 20–25 40–55 35–45 35–40
Moderate Difficult Moderate Difficult Difficult Difficult Moderate
20–30 25–35 20–30 35–45 30–40 30–40 35–45
P9.6 P9.7 P9.8 P9.9 P9.10 P9.11 P9.12
Time (minutes)
Assignment Characteristics Table (Continued) Item
Description
Level of Difficulty
Time (minutes)
CT9.1 CT9.2 CT9.3 CT9.4 CT9.5 CT9.6
Acquisition, improvements, and sale of realty. Accounting for self-constructed assets. Capitalization of interest. Nonmonetary exchanges. Costs of acquisition. Cost of land vs. building—ethics.
Moderate Moderate Moderate Difficult Moderate Moderate
20–25 20–25 30–40 30–40 20–25 20–25
Answers to Questions 1. The major characteristics of plant assets are (1) that they are acquired for use in operations and not for resale, (2) that they are long-term in nature and usually subject to depreciation, and (3) that they have physical substance. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
2. The company should report the asset at its historical cost of $450,000, not its current value. The main reasons for this position are (1) at the date of acquisition, cost reflects fair value; (2) historical cost involves actual, not hypothetical transactions, and as a result is extremely reliable; and (3) gains and losses should not be anticipated but should be recognized when the asset is sold. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
3. (a) The acquisition costs of land may include the purchase or contract price, the broker’s commission, title search and recording fees, assumed taxes or other liabilities, surveying, demolition (less salvage), and landscaping costs that are permanent in nature. (b) Machinery and equipment costs may properly include freight and handling, taxes on the purchase, insurance in transit, installation, and expenses of testing and breaking-in. (c) If a building is purchased, all repair charges, alterations, and improvements necessary to ready the building for its intended use should be included as a part of the acquisition cost. Building costs in addition to the amount paid to a contractor may include excavation, permits and licenses, architect’s fees, interest accrued on funds obtained for construction purposes (during construction period only) called avoidable interest, insurance premiums applicable to the construction period, temporary buildings and structures, and property taxes levied on the building during the construction period. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
4. (a) Land. (b) Land Improvements. (c) Land. (d) Machinery. The only controversy centers on whether fixed overhead should be allocated as a cost to the machinery. (e) Land Improvements, should be depreciated. (f) Buildings. (g) Buildings, provided the benefits in terms of information justify the additional cost involved in providing the information. (h) Land. (i) Land. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
5. (a) The position that no fixed overhead should be capitalized assumes that the construction of plant (fixed) assets will be timed so as not to interfere with normal operations. If this were not the case, the savings anticipated by constructing instead of purchasing plant assets would be nullified by reduced profits on the product that could have been manufactured and sold. Thus, construction of plant assets during periods of low activity will have a minimal effect on the total amount of overhead costs. To capitalize a portion of fixed overhead as an element of the cost of constructed assets would, under these circumstances, reduce the amount assignable to operations and therefore overstate net income in the construction period and understate net income in subsequent periods because of increased depreciation charges.
Questions Chapter 9 (Continued) (b) Capitalizing overhead at the same rate as is charged to normal operations is defended by those who believe that all manufacturing overhead serves a dual-purpose during plant asset construction periods. Any attempt to assign construction activities less overhead than the normal rate implies costing favors and results in the misstatement of the cost of both plant assets and finished goods. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
6. (a) Disagree. Organization and promotion expenses should be expensed. (b) Agree. Architect’s fees for plans actually used in the construction of the building should be charged to the building account as part of the cost. (c) Agree. GAAP recommends that avoidable interest or actual interest cost, whichever is lower, be capitalized as part of the cost of acquiring an asset if a significant period of time is required to bring the asset to a condition or location necessary for its intended use. Interest costs are capitalized starting with the first expenditure related to the asset and capitalization would continue until the asset is substantially completed and ready for its intended use. Property taxes during construction should also be charged to the building account. (d) Disagree. Interest revenue is not considered part of the acquisition cost of the building and should be recorded as revenue. LO: 1, 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
7. Since the land for the plant site will be used in the operations of the firm, it is classified as property, plant, and equipment. The other tract is being held for speculation. It is classified as an investment. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
8. An asset retirement obligation must be recognized when a company has an existing legal obligation associated with the retirement of a long-lived asset and when the amount can be reasonably estimated. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
9. A common accounting justification is that all costs associated with the construction of an asset, including interest, should be capitalized in order that the costs can be matched to the revenues, which the new asset will help generate. LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
10. Assets that do not qualify for interest capitalization are (1) assets that are in use or ready for their intended use, and (2) assets that are not being used in the earnings activities of the firm. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
11. The avoidable interest is determined by multiplying (an) interest rate(s) by the weighted-average amount of accumulated expenditures on qualifying assets. For the portion of weighted-average accumulated expenditures which is less than or equal to any amounts borrowed specifically to finance construction of the assets, the capitalization rate is the specific interest rate incurred. For the portion of weighted-average accumulated expenditures, which is greater than specific debt incurred, the interest rate is a weighted-average of all other interest rates incurred. The amount of interest to be capitalized is the avoidable interest, or the actual interest incurred, whichever is lower. As indicated in the chapter, an alternative to the specific rate is to use an average borrowing rate. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 9 (Continued) 12. The total interest cost incurred during the period should be disclosed, indicating the portion capitalized and the portion charged to expense. Interest revenue from temporarily invested excess funds should not be offset against interest cost when determining the amount of interest to be capitalized. The interest revenue would be reported in the same manner customarily used to report any other interest revenue. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
13. (a) Assets acquired by issuance of capital stock—when property is acquired by issuance of common stock, the cost of the property is not measured by par or stated value of such stock. If the stock is actively traded on the market, then the market value of the stock is a fair indication of the cost of the property because the market value of the stock is a good measure of the current cash equivalent price. If the market value of the common stock is not determinable, then the market value of the property should be established and used as the basis for recording the asset and issuance of common stock. (b) Assets acquired by gift or donation—when assets are acquired in this manner a strict cost concept would dictate that the valuation of the asset be zero. However, in this situation, accountants record the asset at its fair value. The credit should be made to Contribution Revenue. Contributions received should be credited to revenue unless the contribution is from a governmental unit. Even in that case, we believe that the credit should be to Contribution Revenue. (c) Cash discount—when assets are purchased subject to a cash discount, the question of how the discount should be handled occurs. If the discount is taken, it should be considered a reduction in the asset cost. Different viewpoints exist, however, if the discount is not taken. One approach is that the discount must be considered a reduction in the cost of the asset. The rationale for this approach is that the terms of these discounts are so attractive that failure to take the discount must be considered a loss because management is inefficient. The other view is that failure to take the discount should not be considered a loss, because the terms may be unfavorable, or the company might not be prudent to take the discount. Presently both methods are employed in practice. The former approach is conceptually correct. (d) Deferred payments—assets should be recorded at the present value of the consideration exchanged between contracting parties at the date of the transaction. In a deferred payment situation, there is an implicit (or explicit) interest cost involved, and the accountant should be careful not to include this amount in the cost of the asset. (e) Lump-sum or basket purchase—sometimes a group of assets is acquired for a single lumpsum. When a situation such as this exists, the accountant must allocate the total cost among the various assets on the basis of their relative fair values. (f) Trade or exchange of assets—when one asset is exchanged for another asset, the accountant is faced with several issues in determining the value of the new asset. The basic principle involved is to record the new asset at the fair value of the new asset or the fair value of what is given up to acquire the new asset, whichever is more clearly evident. However, the accountant must also be concerned with whether the exchange has commercial substance and whether monetary consideration is involved in the transaction. The commercial substance issue rests on whether the expected cash flows on the assets involved are significantly different. In addition, monetary consideration may affect the amount of gain recognized on the exchange under consideration. LO: 3, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 9 (Continued) 14. The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembly and installation costs, and costs of conducting trial runs. Costs thus include all expenditures incurred in acquiring the equipment and preparing it for use. When plant assets are purchased subject to cash discounts for prompt payment, the question of how the discount should be handled arises. The appropriate view is that the discount, whether taken or not, is considered a reduction in the cost of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash equivalent price of the asset. Similarly, assets purchased on long-term payment plans should be accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction. LO: 3, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
15.
Fair value of land Fair value of building and land
x Cost = Cost allocated to land
$500,000 x $2,200,000 = $440,000 $2,500,000
(Cost allocated to land)
Fair value of building Fair value of building and land $2,000,000 $2,500,000
x Cost = Cost allocated to building
x $2,200,000 = $1,760,000 (Cost allocated to building)
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
16. $10,000 (cash payment) + $4,208 (present value of note) = $14,208 LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
17. Ordinarily accounting for the exchange of nonmonetary assets should be based on the fair value of the asset given up or the fair value of the asset received, whichever is more clearly evident. Thus, any gains and losses on the exchange should be recognized immediately. If the fair value of either asset is not reasonably determinable, the book value of the asset given up is usually used as the basis for recording the nonmonetary exchange. This approach is always employed when the exchange has commercial substance. The general rule is modified when exchanges lack commercial substance. In this case, the enterprise is not considered to have completed the earnings process and therefore a gain should not be recognized. However, a loss should be recognized immediately. In certain situations, gains on an exchange that lacks commercial substance may be recorded when monetary consideration is received. When monetary consideration is received, it is assumed that a portion of the earnings process is completed, and therefore, a partial gain is recognized. LO: 3, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
18. In accordance with GAAP which requires losses to be recognized immediately, the entry should be: Trucks (new) ....................................................................................... Accumulated Depreciation .................................................................. Loss on Disposal of Trucks ................................................................. Trucks (old) ................................................................................... Cash .............................................................................................
42,000 12,200* 1,800** 30,000 26,000
Questions Chapter 9 (Continued) *[($30,000 – $6,000) x (61 months/120 months) = $12,200] **(Book value $30,000 – $12,200) – $16,000 trade-in = $1,800 loss) LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
19. Ordinarily such expenditures include (1) the recurring costs of servicing necessary to keep property in good operating condition, (2) cost of renewing structural parts of major plant units, and (3) costs of major overhauling operations which may or may not extend the life beyond original expectation. The first class of expenditures represents the day-to-day service and in general is chargeable to operations as incurred. These expenditures should not be charged to the asset accounts. The second class of expenditures may or may not affect the recorded cost of property. If the asset is rigidly defined as a distinct unit, the renewal of parts does not usually disturb the asset accounts; however, these costs may be capitalized and apportioned over several fiscal periods on some equitable basis. If the property is conceived in terms of structural elements subject to separate replacement, such expenditures should be charged to the plant asset accounts. The third class of expenditures, major overhauls, is usually entered through the asset accounts because replacement of important structural elements is usually involved. Other than maintenance charges mentioned above are those expenditures which add some physical aspect not a part of the asset at the time of its original acquisition. These expenditures may be capitalized in the asset account. An expenditure which extends the life but not the usefulness of the asset is often charged to the Accumulated Depreciation account. A more appropriate treatment requires retiring from the asset and accumulated depreciation accounts the appropriate amounts (original cost from the asset account) and to capitalize in the asset account the new cost. Often it is difficult to determine the original cost of the item being replaced. For this reason, the replacement or renewal is charged to the Accumulated Depreciation account. LO: 4, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
20. (a) Additions. Additions represent entirely new units or extensions and enlargements of old units. Expenditures for additions are capitalized by charging either old or new asset accounts depending on the nature of the addition. (b) Major Repairs. Expenditures to replace parts or otherwise to restore assets to their previously efficient operating condition are regarded as repairs. To be considered a major repair, several periods must benefit from the expenditure. The cost should be handled as an addition, improvement or replacement depending on the type of major repair made. (c) Improvements. An improvement does not add to existing plant assets. Expenditures for such betterments represent increases in the quality of existing plant assets by rearrangements in plant layout or the substitution of improved components for old components so that the facilities have increased productivity, greater capacity, or longer life. The cost of improvements is accounted for by charges to the appropriate property accounts, the elimination of the cost, and accumulated depreciation associated with the replaced components, if any. Replacements. Replacements involve an “in kind” substitution of a new asset or part for an old asset or part. Accounting for major replacements requires entries to retire the old asset or part and to record the cost of the new asset or part. Minor replacements are treated as period costs. LO: 4, Bloom: C, Difficulty: Moderate, Time: 5-7, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 9 (Continued) 21. The cost of installing the machinery should be capitalized, but the extra month’s wages paid to the dismissed employees should not, as this payment did not add any value to the machinery. The extra wages should be charged off immediately as an expense; the wages could be shown as a separate item in the income statement for disclosure purposes. LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
22. (a) Overhead of a business that builds its own equipment. Some accountants have maintained that the equipment account should be charged only with the additional overhead caused by such construction. However, a more realistic figure for the cost of equipment results if the plant asset account is charged for overhead applied on the same basis and at the same rate as used for production. (b) Cash discounts on purchases of equipment. Some accountants treat all cash discounts as financial or other revenue, regardless of whether they arise from the payment of invoices for merchandise or plant assets. Others take the position that only the net amount paid for plant assets should be capitalized on the basis that the discount represents a reduction of price and is not income. The latter position seems more logical in light of the fact that plant assets are purchased for use and not for sale and that they are written off to expense over a long period of time. (c) Interest paid during construction of a building. GAAP requires that avoidable or actual interest cost, whichever is lower, be capitalized as part of the cost of acquiring an asset if a significant period of time is required to bring the asset to a condition and location necessary for its intended use. (d) Cost of a safety device installed on a machine. This is an addition to the machine and should be capitalized in the machinery account if material. (e) Freight on equipment returned before installation, for replacement by other equipment of greater capacity. If ordering the first equipment was an error, whether due to judgment or otherwise, the freight should be regarded as a loss. However, if information became available after the order was placed which indicated purchase of the new equipment was more advantageous, the cost of the return freight may be viewed as a necessary cost of the new equipment. (f) Cost of moving machinery to a new location. Normally, only the cost of one installation should
be capitalized for any piece of equipment. Thus, the original installation and any accumulated depreciation relating thereto should be removed from the accounts and the new installation costs (i.e., cost of moving) should be capitalized. In cases where this is not possible and the cost of moving is substantial, it is capitalized and depreciated appropriately over the period during which it contributes to operations. (g) Cost of plywood partitions erected in the remodeling of the office. This is a part of the remodeling cost and may be capitalized as part of the remodeling itself is of such a nature that it is an addition to the building and not merely a replacement or repair. (h) Replastering of a section of the building. This seems more in the nature of a repair than anything else and as such should be treated as an expense. (i) Cost of a new motor for one of the trucks. This probably extends the useful life of the truck. As such it may be viewed as an extraordinary repair and charged against the accumulated depreciation on the truck. The remaining service life of the truck should be estimated and the depreciation adjusted to write off the new book value, less salvage, over the remaining useful
Questions Chapter 9 (Continued) life. A more appropriate treatment is to remove the cost of the old motor and related depreciation and add the cost of the new motor if possible. (j) Cost to restore land after extracting ore. This future cost is an example of an asset retirement obligation (ARO). The company includes the cost associated with the ARO in the carrying amount of the land and records a liability for the same amount. An asset retirement cost is part of the related land because these costs are directly related to operating the asset (extracting the ore) and are necessary to prepare the asset for its intended use. LO: 1 2, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
23. This approach is not correct since at the very minimum the investor should be aware that certain assets are used in the business, which are not reflected in the main body of the financial statements. Either the company should keep these assets on the balance sheet or they should be recorded at salvage value and the resulting gain recognized. In either case, there should be a clear indication that these assets are fully depreciated but are still being used in the business. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
24. Gains or losses on plant asset retirements should be shown in the income statement along with other items that arise from customary business activities-usually as other revenues and gains or other expenses and losses. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*25. The criteria for evaluating whether contributions are unconditional (and thus recognized immediately in income) or conditional (for which income recognition is deferred) depend on the terms of the gift or grant agreement. The focus is on whether a gift or grant agreement has the following terms. (1) specifies a “barrier or hurdle” that the recipient must overcome to be entitled to the resources. A barrier is the inclusion of a measurable performance requirement such as the degree of completion or specific output or outcome. (2) releases the donor from its obligation to transfer resources (or if assets are advanced, a right to demand their return) if the barrier or hurdle is not achieved. An agreement that contains both is a conditional contribution. An agreement that omits one or both is unconditional. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*26. The distinction between a conditional and unconditional contribution is important from an accounting point of view because it affects when expense and revenue are reported. In an unconditional contribution revenue is recognized immediately whereas in a conditional contribution, revenue is deferred. LO: 6, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 9.1 $27,000 + $1,400 + $10,200 = $38,600 LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.2 Dec. 31
Land Improvements ........................................ Asset Retirement Obligation ..................
84,000 84,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.3 Oil Platform ...................................................... Asset Retirement Obligation ..................
450,000 450,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.4 Expenditures Date 3/1 6/1 12/31
Amount $1,800,000 1,200,000 3,000,000 $6,000,000
Capitalization Period 10/12 7/12 0
Weighted-Average Accumulated Expenditures $1,500,000 700,000 0 $2,200,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.5 10%, 5-year note 11%, 4-year note
Principal $2,000,000 3,500,000 $5,500,000
Weighted-average interest rate =
x .10 x .11
Interest $200,000 385,000 $585,000
$585,000 $5,500,000
= 10.64%
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.6 Weighted-Average Accumulated Expenditures $1,000,000 1,200,000 $2,200,000
x
Interest Rate .12* .1064
=
Avoidable Interest $120,000 127,680 $247,680
*The annual interest rate is used, as weighted-average expenditures have been adjusted for the part of the annual period the interest expense is incurred on project-specific debt. Actual total interest incurred is $685,000: $585,000 [on general debt] + $100,000 [$1,000,000 x .12 x 10/12]). Thus, $247,680 of interest cost will be capitalized. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.7 Trucks ($80,000 x .68301 (PVF 4, 10%)) ..................................................................... Discount on Notes Payable ................................. Notes Payable .............................................
54,641 25,359 80,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.8
Land Building Equipment
Fair Value $ 60,000 220,000 80,000 $360,000
% of Total 60/360 220/360 80/360
x x x
Cost $315,000 $315,000 $315,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Recorded Amount $ 52,500 192,500 70,000 $315,000
Brief Exercise 9.9 Land (2,000 x $40) ...................................................................... Common Stock (2,000 x $10)...................... Paid-in Capital in Excess of Par— Common Stock [2,000 x ($40 – $10)] ....
80,000 20,000 60,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.10 Equipment ............................................................ Accumulated Depreciation—Trucks ................... Trucks .......................................................... Cash ............................................................. Gain on Disposal of Trucks* ......................
3,300 18,000 20,000 500 800
*[($3,300 – $500) – ($20,000 – $18,000)] LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.11 Equipment ($3,300 – $800) .................................. Accumulated Depreciation—Trucks ................... Trucks .......................................................... Cash .............................................................
2,500 18,000 20,000 500
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.12 Equipment ............................................................ Accumulated Depreciation—Machinery ............. Loss on Disposal of Machinery* ......................... Machinery .................................................... Cash .............................................................
5,000 3,000 4,000
*[($5,000 – $3,000) – ($9,000 – $3,000)] LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
9,000 3,000
Brief Exercise 9.13 Trucks (new)........................................................... Accumulated Depreciation—Trucks ..................... Loss on Disposal of Trucks* ................................. Trucks (used) ................................................ Cash ............................................................... *[($37,000 – $36,000) – ($30,000 – $27,000)]
37,000 27,000 2,000 30,000 36,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.14 Trucks (new)......................................................... Accumulated Depreciation—Trucks ................... Loss on Disposal of Trucks* ............................... Trucks (used) .............................................. Cash ............................................................. *[($35,000 – $33,000) – ($20,000 – $17,000)]
35,000 17,000 1,000 20,000 33,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.15 Only cost (c), which represents a maintenance charge that occurs regularly, is expensed when incurred. It is a revenue expenditure. All other costs are capital expenditures. LO: 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 9.16 (a) (b)
Depreciation Expense ($2,400 x 8/12) ................... Accumulated Depreciation—Machinery ......
1,600
Cash……………………………………………………... Accumulated Depreciation—Machinery ($8,400 + $1,600) ................................................ Machinery....................................................... Gain on Disposal of Machinery* ...................
10,500
1,600
10,000
*[$10,500 – ($20,000 – $10,000)] LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
20,000 500
Brief Exercise 9.17 (a) (b)
Depreciation Expense ($2,400 x 8/12) ................... Accumulated Depreciation—Machinery.......
1,600
Cash …………………………………………………….. Loss on Disposal of Machinery ............................. Accumulated Depreciation—Machinery ($8,400 + $1,600) ................................................ Machinery .......................................................
5,200 4,800
1,600
10,000 20,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 9.18 This transaction should be considered an exchange transaction. This is an arrangement in which commensurate value is exchanged between two parties and it should follow the accounting for an exchange transaction. LO: 6, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Knowledge AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 9.19 This transaction is a conditional contribution. The grant includes a measurable barrier (6,000 square feet) that must be achieved and a right of return of unused assets for unmet requirements. LO: 6, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 9.20 This grant is considered a nonexchange transaction accounted for under the contribution accounting model. The foundation does not receive direct commensurate value in exchange for the resources provided. The university retains all rights to the research and findings; therefore, Knowledge University and the general public receive the primary benefits. LO: 6, Bloom: C, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 9.1 (15–20 minutes) Item (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p)
Land
Land Improvements
Building
Other Accounts ($275,000) Notes Payable
$275,000 $
8,000 7,000 6,000 (1,000) 22,000 250,000 9,000 $ 4,000 11,000 (5,000) 13,000 19,000 14,000 3,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.2 (10–15 minutes) The allocation of costs would be as follows: Land Razing costs Salvage Legal fees Survey Plans Title insurance Liability insurance Construction Interest
Land $400,000 42,000 (6,300) 1,850
Building
$
2,200 68,000
1,500
$439,050 LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
900 2,740,000 170,000 $2,981,100
Exercise 9.3 (10–15 minutes) 1. 2.
3.
Trucks .............................................................. Cash........................................................
13,900.00
Trucks .............................................................. Discount on Notes Payable ............................ Cash........................................................ Notes Payable ........................................ *PV of $14,000 @ 10% for 1 year = $14,000 x .90909 = $12,727.26 $12,727.26 + $2,000.00 = $14,727.26
14,727.26* 1,272.74
Trucks .............................................................. Cost of Goods Sold ........................................ Inventory ................................................ Sales Revenue .......................................
15,200.00 12,000.00
13,900.00
2,000.00 14,000.00
12,000.00 15,200.00
[Note to instructor: The selling (retail) price of the computer system appears to be a better gauge of the fair value of the consideration given than the list price of the truck as a gauge of the fair value of the consideration received (truck). Vehicles are often sold at a price below the list price.] 4.
Trucks .............................................................. 13,000.00* Common Stock ...................................... Paid-in Capital in Excess of Par – Common Stock ...................................
* (1,000 shares x $13 = $13,000) ** (1,000 shares x $10) *** [1,000 shares x ($13 – $10)] LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
10,000.00** 3,000.00***
Exercise 9.4 (20–25 minutes) Purchase Cash paid for equipment, including sales tax of $5,000 Freight and insurance while in transit Cost of moving equipment into place at factory Wage cost for technicians to test equipment Special plumbing fixtures required for new equipment Total cost
$105,000 2,000 3,100 4,000 8,000 $122,100
The insurance premium of $1,500 paid during the first year of operation of this equipment should be reported initially as prepaid insurance and then adjusted to insurance expense, and not be capitalized. Repair cost of $1,300 incurred in the first year of operations related to this equipment should be reported as repair and maintenance expense, and not be capitalized. Both these costs relate to periods subsequent to purchase. Construction Material and purchased parts ($200,000 x .98) Labor costs Overhead costs Cost of installing equipment Total cost
$196,000 190,000 50,000 4,400 $440,400
Note that the cost of material and purchased parts is reduced by the amount of cash discount not taken (.02 x $200,000 = $4,000) because the equipment should be reported at its cash equivalent price. The imputed interest on funds used during construction related to stock financing of $14,000 should not be capitalized or expensed. This item is an opportunity cost that is not reported. Profit on self-construction of $30,000 should not be reported. Profit should only be reported when the asset is sold. LO: 1 Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.5 (25–30 minutes) (a)
(b)
Plant Assets ............................................................. Cash .................................................................
600,000
Plant Assets ............................................................. Asset Retirement Obligation ..........................
41,879
Depreciation Expense ......................................................................... Accumulated Depreciation – Plant Assets....
60,000
Depreciation Expense ............................................. Accumulated Depreciation – Plant Assets....
4,188
Interest Expense ...................................................... Asset Retirement Obligation ..........................
2,513
600,000 41,879
60,000 4,188* 2,513**
*$41,879/10. **$41,879 x .06. (c)
Asset Retirement Obligation .................................................................... Loss on ARO Settlement .................................... Cash ............................................................
75,000
LO: 1, Bloom: AP, Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
5,000 80,000
Exercise 9.6 (30–40 minutes) Land Abstract fees Architect’s fees Cash paid for land and old building Removal of old building ($20,000 – $5,500) Interest on loans during construction
$
M&E
Other
520 $
3,170
87,000 14,500 7,400
Excavation before construction Machinery purchased Freight on machinery Storage charges caused by noncompletion of building New building Assessment by city Hauling charges—machinery Installation—machinery Landscaping
Buildings
19,000 $53,900 1,340
$1,100
—Misc. expense (Discount Lost)
2,180
—Misc. expense (Loss)
620
—Misc. expense (Loss)
485,000 1,600 2,000 5,400 $109,020
$514,570
$57,240
$3,900
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.7 (15–25 minutes) 1.
Land a .................................................................. Buildingsb........................................................... Equipmentc......................................................... Cash ..........................................................
131,250 306,250 262,500
$700,000 x
$150,000 $800,000
= $131,250a
$700,000 x
$350,000 $800,000
= $306,250b Buildings
$700,000 x
$300,000 $800,000
= $262,500c
Exercise 9.7 (Continued)
Land
Equipment
700,000
2.
3.
*4.
5.
Equipment .......................................................... Cash........................................................... Notes Payable ...........................................
25,000
Equipment .......................................................... Accounts Payable ($20,000 x .98) ............
19,600
Land ................................................................... Contribution Revenue ..............................
27,000
Buildings ............................................................ Cash...........................................................
600,000
2,000 23,000
19,600
27,000
600,000
LO: 1,3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.8 (20–25 minutes) (a)
Avoidable Interest Weighted-Average Accumulated Expenditures
x Interest Rate = Avoidable Interest
$2,000,000 1,600,000 $3,600,000
.12 .1042
Weighted-average interest rate computation
Principal
10% short-term loan 11% long-term loan
$1,400,000 1,000,000 $2,400,000
Total Interest Total Principal
=
$250,000 $2,400,000
$240,000 166,720 $406,720 Interest x .10 x .11
$140,000 110,000 $250,000
= 10.42%
Exercise 9.8 (Continued) (b)
Actual Interest $2,000,000 x .12 = $1,400,000 x .10 = $1,000,000 x .11 = Total
Construction loan Short-term loan Long-term loan
$240,000 140,000 110,000 $490,000
Because avoidable interest is lower than actual interest, use avoidable interest. Cost $5,200,000 Interest capitalized 406,720 Total cost $5,606,720 Depreciation Expense
$5,606,720 – $300,000 = $176,891 30 years
=
LO: 2, Bloom: AP, Difficulty: Difficult, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.9 (20–25 minutes) (a)
Computation of Weighted-Average Accumulated Expenditures Expenditures Date
Amount
March 1 June 1 July 1 December 1
$ 360,000 600,000 1,500,000 1,500,000 $3,960,000
X
Capitalization Period
=
Weighted-Average Accumulated Expenditures
10/12 7/12 6/12 1/12
$ 300,000 350,000 750,000 125,000 $1,525,000
Computation of Avoidable Interest Weighted-Average Accumulated Expenditures X $1,525,000
Interest Rate .12 (Construction loan)
=
Avoidable Interest $183,000
Exercise 9.9 (Continued) Computation of Actual Interest Actual interest $3,000,000 x .12 $4,000,000 x .13 $1,600,000 x .10
$ 360,000 520,000 160,000 $1,040,000
Note: Use avoidable interest for capitalization purposes because it is lower than actual.
(b)
Buildings ............................................................ Interest Expense* ............................................... Cash ($360,000 + $520,000 + $160,000) ... *Actual interest for year Less: Amount capitalized Interest expense debit
183,000 857,000 1,040,000
$1,040,000 183,000 $ 857,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.10 (20–25 minutes) (a)
Computation of Weighted-Average Accumulated Expenditures Expenditures Date
Amount
July 31 November 1
$200,000 100,000
x
Capitalization Period 3/12 0
=
Weighted-Average Accumulated Expenditures $50,000 0 $50,000*
Exercise 9.10 (Continued) Avoidable interest Weighted-Average Accumulated Expenditures x $50,000*
Interest Rate
=
Avoidable Interest
.12
$6,000**
Actual Interest $300,000 x .12 x 5/12 =
$15,000
$30,000 x .08
2,400 $17,400***
=
Note to instructor: Interest revenue is not netted against actual interest. Interest capitalized
(b)
(1)
(2)
(3)
$ 6,000**
7/31 Cash ................................................ Notes Payable........................
300,000
Machinery ....................................... Trading Securities .......................... Cash .......................................
200,000 100,000
11/1 Machinery ....................................... Cash .......................................
100,000
12/31 Machinery ....................................... Interest Expense ($17,400*** – $6,000**) ................. Cash ($30,000 x .08) .............. Interest Payable ($300,000 x .12 x 5/12) ........
6,000
300,000
300,000
100,000
11,400
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
2,400 15,000
Exercise 9.11 (20–25 minutes) Situation I. $80,000—The requirement is the amount Ohno should report as capitalized interest at 12/31/25. The amount of interest eligible for capitalization is Weighted-Average Accumulated Expenditures x Interest Rate = Avoidable Interest
Since Ohno has outstanding debt incurred specifically for the construction project, in an amount greater than the weighted-average accumulated expenditures of $800,000, the interest rate of 10% is used for capitalization purposes. Therefore, the avoidable interest is $80,000, which is less than the actual interest. $800,000 x .10 = $80,000 Finally, per FASB ASC 835-20-30-1 the interest earned of $250,000 is irrelevant to the question addressed in this problem because such interest earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization. Situation II. $39,000—The requirement is total interest costs to be capitalized. GAAP identifies assets which qualify for interest capitalization: assets constructed for an enterprise’s own use and assets intended for sale or lease that are produced as discrete projects. Inventories that are routinely produced in large quantities on a repetitive basis do not qualify for interest capitalization. Therefore, only $30,000 and $9,000 are capitalized.
Exercise 9.11 (Continued) Situation III. $385,000—The requirement is to determine the amount of interest to be capitalized on the financial statements at April 30, 2026. The GAAP requirements are met: (1) expenditures for the asset have been made, (2) activities that are necessary to get the asset ready for its intended use are in progress, and (3) interest cost is being incurred. The amount to be capitalized is determined by applying an interest rate to the weightedaverage amount of accumulated expenditures for the asset during the period. Because the $7,000,000 of expenditures incurred for the year ended April 30, 2026, were incurred evenly throughout the year, the weightedaverage amount of expenditures for the year is $3,500,000, ($7,000,000 ÷ 2). Therefore, the amount of interest to be capitalized is $385,000 ($3,500,000 x .11). In any period, the total amount of interest cost to be capitalized shall not exceed the total amount of interest cost incurred by the enterprise. (Total interest is $1,100,000 = $10,000,000 x .11). Finally, the interest earned of $650,000 is irrelevant to the question addressed in this problem because such interest earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.12 (10–15 minutes) (a)
(b)
Equipment .......................................................... Accounts Payable .....................................
10,000
Accounts Payable .............................................. Equipment ($10,000 x .02) ........................ Cash...........................................................
10,000
Equipment (new) ................................................ Loss on Disposal of Equipment ....................... Accumulated Depreciation—Equipment .......... Accounts Payable ..................................... Equipment (old) ........................................
9,900 * 1,600** 6,000***
*Cost ($9,500 + $400)
$9,900
**Cost Less: Accumulated depreciation*** Book value of equipment (old) Less: Fair value of equipment (old) Loss on disposal of equipment
$8,000 6,000 2,000 400 $1,600
10,000 200 9,800
9,500 8,000
***Cost – Book Value = ($8,000 – $2,000) Accounts Payable .............................................. Cash........................................................... (c)
Equipment ($10,800 x .91743 PV of 1@ 9% for 1 year) ................................................................. Discount on Notes Payable ($10,800 – $9,908) Notes Payable ........................................... Interest Expense ................................................ Notes Payable .................................................... Discount on Notes Payable...................... Cash...........................................................
9,500 9,500 9,908 892 10,800 892 10,800
LO: 1, 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
892 10,800
Exercise 9.13 (15–20 minutes) (a) (b)
Land .................................................................... Contribution Revenue ..............................
81,000
Land* .................................................................. Buildings*........................................................... Common Stock ($50 x 13,000) ................. Paid-in Capital in Excess of Par—Common Stock** ..........................
180,000 630,000
81,000
650,000 160,000
*Since the market value of the stock is not determinable, the fair value of the property is used as the basis for recording the asset and issuance of the stock. **[($180,000 + $630,000) – $650,000] (c)
Machinery ........................................................... Materials .................................................... Direct Labor .............................................. Factory Overhead ..................................... *Fixed overhead applied Additional overhead Factory supplies used
(.60 x $15,000)
40,100** 12,500 15,000 12,600* $ 9,000 2,700 900 $12,600
**($12,500 + $15,000 + $12,600) LO: 1, 3, Bloom: AP, Difficulty: Difficult, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.14 (20–25 minutes) 1.
Land ................................................................... Buildings ............................................................ Equipment .......................................................... Common Stock (12,500 x $100) ............... Paid-in Capital in Excess of Par—Common Stock ($2,100,000 – $1,250,000).......................
350,000 1,050,000 700,000 1,250,000 850,000
The cost of the property, plant and equipment is $2,100,000 ($12,500 x $168). This cost is allocated based on appraisal values as follows:
2.
Land
$400,000 x $2,100,000 = $350,000 $2,400,000
Buildings
$1,200,000 x $2,100,000 = $1,050,000 $2,400,000
Equipment
$800,000 x $2,100,000 = $700,000 $2,400,000
Buildings ($105,000 plus $161,000) .................. Equipment .......................................................... Land Improvements ........................................... Land ................................................................... Cash........................................................... *
3.
266,000 135,000 122,000 18,000 541,000*
($266,000 + $135,000 + $122,000 + $18,000)
Equipment .......................................................... Cash........................................................... *($10,500 plus $254,800, which is 98% (1.00 – .02) of $260,000.)
265,300*
LO: 1, 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
265,300*
Exercise 9.15 (15–20 minutes) (a)
(b)
Equipment .......................................................... Discount on Notes Payable............................... Notes Payable ........................................... *PV of $160,000 ordinary annuity @ 12% for 5 years ($160,000 x 3.60478) = $576,765 **($800,000 – $576,765)
576,765* 223,235**
Interest Expense ................................................ Notes Payable .................................................... Discount on Notes Payable ..................... Cash .......................................................... ***(.12 x $576,765*)
69,212*** 160,000
Year 1/2/25 12/31/25 12/31/26 (c)
(d)
800,000
69,212 160,000
Note Payment
12% Interest
Reduction of Principal
$160,000 160,000
$69,212 58,317
$ 90,788 101,683
Interest Expense ................................................ Notes Payable .................................................... Discount on Notes Payable ..................... Cash ..........................................................
58,317 160,000
Depreciation Expense ($576,765* ÷ 10) ............ Accumulated Depreciation—Equipment.
57,677
Balance $576,765* 485,977 384,294
58,317 160,000
LO: 3, Bloom: AP, Difficulty: Difficult, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
57,677
Exercise 9.16 (15–20 minutes) (a)
(b)
Equipment .......................................................... 86,861.85a Discount on Notes Payable ............................... 18,138.15b Cash........................................................... Notes Payable ($105,000 – $30,000) ............. a PV of $15,000 ordinary annuity @ 10% for 5 years ($15,000 x 3.79079) $56,861.85 Down payment 30,000.00 Capitalized value of equipment $86,861.85 b ($105,000 – $86,861.85) Notes Payable .................................................... Interest Expense (see schedule) ...................... Cash........................................................... Discount on Notes Payable ......................
Year 12/31/24 12/31/25 12/31/26 (c)
Note Payment e
$15,000.00 15,000.00e
10% Interest c
$5,686.19 4,754.80d
30,000.00 75,000.00
15,000.00e 5,686.19c 15,000.00 5,686.19
Reduction of Principal
Balance
$ 9,313.81 10,245.20
$56,861.85 47,548.04 37,302.84
Notes Payable .................................................... Interest Expense (see schedule) ...................... Cash........................................................... Discount on Notes Payable ......................
15,000.00e 4,754.80d
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
15,000.00 4,754.80
Exercise 9.17 (25–35 minutes) Hayes Industries Acquisition of Assets 1 and 2 Use Appraised values to break-out the lump-sum purchase
Description Machinery Equipment
Appraisal
Percentage
Lump-Sum
Value on Books
$ 90,000 30,000 $120,000
90/120 30/120
$100,000 $100,000
$75,000 $25,000
Machinery ............................................................. Equipment ............................................................ Cash .............................................................
75,000 25,000 100,000
Acquisition of Asset 3 Use the cash price as a basis for recording the asset with a discount recorded on the note. Machinery ............................................................. Discount on Notes Payable ($40,000 – $35,900) ... Cash ............................................................ Notes Payable .............................................
35,900 4,100 10,000 30,000
Exercise 9.17 (Continued) Acquisition Asset 4 Since the exchange lacks commercial substance, a gain will be recognized in the proportion of cash received ($10,000a/$80,000b) times the $20,000c gain (FV of $80,000 minus BV of $60,000). The gain recognized will then be $2,500d with $17,500 of it being unrecognized and used to reduce the basis of the asset acquired. ($70,000 + $10,000)
Machinery ($70,000 – $17,500) (New) ............... Accumulated Depreciation—Machinery ........... Cash .................................................................... Machinery (Old) ........................................ Gain on Disposal of Machinery................ c
52,500 40,000 10,000a 100,000 2,500d
[($70,000 + $10,000) – ($100,000 – $40,000)] Acquisition of Asset 5
In this case the equipment should be placed on Hayes’s books at the fair market value of the stock. The difference between the stock’s par value and its fair value should be credited to Paid-in Capital in Excess of Par—Common Stock. Equipment (100 shares $11)........................... Common Stock (100 shares $ 8 par) .... Paid-in Capital in Excess of Par— Common Stock [100 shares x ($11 – $8)] ...
1,100 800 300
Exercise 9.17 (Continued) Construction of Building Schedule of Weighted-Average Accumulated Expenditures
Date
Amount
February 1 February 1 June 1 September 1 November 1
$ 150,000 120,000 360,000 480,000 100,000 $1,210,000
Current Year Capitalization Period
Weighted-Average Accumulated Expenditures
9/12 9/12 5/12 2/12 0/12
$112,500 90,000 150,000 80,000 0 $432,500
Note that the Land cost even though incurred in the prior year is included in the schedule but the capitalization is only 9 months. Avoidable Interest Weighted-Average Accumulated Expenditures $432,500
Interest Rate x
.12
Avoidable Interest =
$51,900f
Actual Interest: $600,000 x 12% = $72,000 The weighted-average expenditures are less than the amount of specific borrowing; the specific borrowing rate is used. Buildings ............................................................ Cash .......................................................... Interest Expense ....................................... e
1,111,900e 1,060,000 51,900f
Building Cost = $ 1,111,900 [($120,000 + $360,000 + $480,000 + $100,000) + $51,900f]
LO: 2, 3, Bloom: AP, Difficulty: Difficult, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.18 (10–15 minutes) Busytown Corporation Machinery ($340 + $85) ........................................ Accumulated Depreciation – Machinery............. Loss on Disposal of Machinery........................... Machinery .................................................... Cash ............................................................. *Computation of loss: Book value of old machine ($290 – $140) Less: Fair value of old machine Loss on disposal of machinery Dick Tracy Business Machine Company Cash ...................................................................... Inventory ............................................................... Cost of Goods Sold .............................................. Sales Revenue............................................. Inventory......................................................
425 140 65* 290 340
$150 85 $ 65
340 85 270
LO: 3, Bloom: AP, Difficulty: Difficult, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
425 270
Exercise 9.19 (20–25 minutes) (a)
Exchange has commercial substance: Depreciation Expense .......................................... Accumulated Depreciation—Equipment.... ($11,200 – $700 = $10,500; $10,500 ÷ 5 = $2,100; $2,100 x 4/12 = $700) Equipment ............................................................. Accumulated Depreciation—Equipment ............. Gain on Disposal of Equipment.................. Equipment .................................................... Cash ............................................................. *Cost of old asset Less: Accumulated depreciation ($6,300 + $700) Book value of equipment (old) Less: Fair value of old asset Gain on disposal of equipment
$11,200
**Cash paid Fair value of old asset Cost of new asset
$10,000 5,200 $15,200
7,000 4,200 5,200 $ 1,000
700 700
15,200** 7,000 1,000* 11,200 10,000
Exercise 9.19 (Continued) (b)
Exchange lacks commercial substance: Depreciation Expense ............................................ Accumulated Depreciation—Equipment ...... ($11,200 – $700 = $10,500; $10,500 ÷ 5 = $2,100; $2,100 x 4/12 = $700) Equipment ............................................................... Accumulated Depreciation—Equipment ............... Gain on Disposal of Equipment .................... Equipment ...................................................... Cash................................................................ *Cash paid Fair value of old asset Cost of new asset **Cost of old asset Less: Accumulated depreciation ($6,300 + $700) Book value of equipment (old) Less: Fair value of old asset Gain on disposal of equipment
700 700
15,200* 7,000 1,000** 11,200 10,000
$10,000 5,200 $15,200 $11,200 7,000 4,200 (5,200) $ 1,000
Note that the entries are the same for both (a) and (b). Gain is not deferred because cash boot is greater than 25% of the total amount given up, which makes the transaction monetary in nature. LO: 3, Bloom: AP, Difficulty: Difficult, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.20 (15–20 minutes) (a) Exchange lacks commercial substance. Arruza Company: Equipment ...................................................... Accumulated Depreciation—Equipment ...... Equipment ............................................. Cash ....................................................... *Valuation of equipment Book value of equipment given up Fair value of boot given up (cash paid) New equipment
12,000* 19,000 28,000 3,000
$ 9,000a
($28,000 – $19,000)
3,000 $12,000
OR Fair value received Less: Gain deferred New equipment
$15,500 3,500* $12,000
**Fair value of old equipment Less: Book value of old equipment Gain on disposal
$12,500 9,000a $ 3,500
Note: Cash paid is less than 25% of the total amount given up, the transaction is nonmonetary, so the gain is deferred. Lo Bianco Company: Cash .................................................................... Equipment ($15,500 – $3,000) ........................... Accumulated Depreciation—Equipment .......... Loss on Disposal of Equipment ........................ Equipment ................................................. ***Computation of loss: Book value of old equipment Less: Fair value of old equipment Loss on disposal of equipment
3,000 12,500 10,000 2,500*** 28,000
$18,000 ($28,000 – $10,000) 15,500 $ 2,500
Exercise 9.20 (Continued) (b)
Exchange has commercial substance Arruza Company Equipment .......................................................... Accumulated Depreciation—Equipment .......... Equipment ................................................. Cash........................................................... Gain on Disposal of Equipment ...............
15,500* 19,000 28,000 3,000 3,500**
*Cost of new equipment: Cash paid Fair value of old equipment Cost of new equipment
$ 3,000 12,500 $15,500
**Computation of gain on disposal of equipment: Fair value of old equipment Less: Book value of old equipment ($28,000 – $19,000) Gain on disposal of equipment
$12,500 9,000 $ 3,500
LoBianco Company Cash .................................................................... Equipment .......................................................... Accumulated Depreciation—Equipment .......... Loss on Disposal of Equipment ....................... Equipment .................................................
3,000 12,500* 10,000 2,500**
*Cost of new equipment: Fair value of equipment Less: Cash received Cost of new equipment
$15,500 3,000 $12,500
**Computation of loss on disposal of equipment: Book value of old equipment ($28,000 – $10,000) Less: Fair value of equipment (Old) Loss on disposal of equipment
$18,000 15,500 $ 2,500
LO: 3, Bloom: AP, Difficulty: Difficult, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
28,000
Exercise 9.21 (15–20 minutes) (a)
Exchange has commercial substance Equipment .......................................................... Accumulated Depreciation—Equipment .......... Gain on Disposal of Equipment............... Equipment ................................................. Cash .......................................................... *Valuation of equipment Cash Installation cost Fair value of used equipment Cost of new equipment
56,900* 20,000 5,800** 62,000 9,100
$ 8,000 1,100 47,800 $56,900
**Computation of gain Fair value of old asset Cost of old asset Less: Accumulated depreciation Book value of old asset Gain on disposal of equipment a
(b)
$47,800 $62,000 20,000a (42,000) $ 5,800
Cost – Book value = ($62,000 – $42,000) Fair value information not determinable Equipment .......................................................... Accumulated Depreciation—Equipment .......... Equipment ................................................. Cash ..........................................................
51,100* 20,000
*Basis of new equipment Book value of old equipment Cash paid (including installation costs) Basis of new equipment
$42,000 9,100 $51,100
LO: 3, Bloom: AP, Difficulty: Difficult, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
62,000 9,100
Exercise 9.22 (20–25 minutes) (a)
Any addition to plant assets is capitalized because a new asset has been created. This addition increases the service potential of the plant.
(b)
Expenditures that do not increase the service benefits of the asset are expensed. Painting costs are considered ordinary repairs because they maintain the existing condition of the asset or restore it to normal operating efficiency.
(c)
The approach to follow is to remove the old book value of the roof and substitute the cost of the new roof. It is assumed that the expenditure increases the future service potential of the asset.
(d)
Conceptually, the book value of the old electrical system should be removed. However, practically it is often difficult if not impossible to determine this amount. In this case, one of two approaches is followed. One approach is to capitalize the replacement on the theory that sufficient depreciation was taken on the old system to reduce the carrying amount to almost zero. A second approach is to debit accumulated depreciation on the theory that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. In our present situation, the problem specifically states that the useful life is not extended and therefore debiting Accumulated Depreciation is inappropriate. Thus, this expenditure should be added to the cost of the plant facility.
(e)
See discussion in (d) above. In this case, because the useful life of the asset has increased, a debit to Accumulated Depreciation would appear to be the most appropriate.
LO: 4, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.23 (15–20 minutes) 1/30 Accumulated Depreciation—Buildings ........... Loss on Disposal of Buildings ........................ Buildings .................................................. Cash .........................................................
112,200* 24,900** 132,000 5,100
*(.05 x $132,000 = $6,600; $6,600 x 17 = $112,200) **($132,000 – $112,200) + $5,100 3/10 Cash ($2,900 – $300) ........................................ Accumulated Depreciation—Machinery ......... Loss on Disposal of Machinery ....................... Machinery ................................................
2,600 11,200* 2,200** 16,000
*(.10 x $16,000 = $1,600; $1,600 x 7 = $11,200) **($16,000 – $11,200) + $300 – $2,900 3/20 Machinery ......................................................... Cash .........................................................
2,000
5/18 Machinery ......................................................... Accumulated Depreciation—Machinery ......... Loss on Disposal of Machinery ....................... Machinery ................................................ Cash ......................................................... *(.10 x $3,500 = $350; $350 x 6 = $2,100) **($3,500 – $2,100)
5,500 2,100* 1,400**
6/23 Maintenance and Repairs Expense ................. Cash .........................................................
6,900
2,000
3,500 5,500
LO: 4, 5, Bloom: AP, Difficulty: Difficult, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
6,900
Exercise 9.24 (20–25 minutes) (a) C (b) E (immaterial) (c) C (d) C (e) C (f) C (g) C (h) E LO: 4, Bloom: C, Difficulty: Moderate, Time: 10-15, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.25 (20–25 minutes) (a)
(b)
Depreciation Expense (8/12 x $60,000) ............... Accumulated Depreciation—Machinery ....
40,000
Loss on Disposal of Machinery ........................... ($1,300,000 – $400,000) – $430,000 Cash ...................................................................... Accumulated Depreciation—Machinery ($360,000 + $40,000) .......................................... Machinery.....................................................
470,000
Depreciation Expense (3/12 x $60,000) ............... Accumulated Depreciation—Machinery ....
15,000
40,000
430,000 400,000 1,300,000
15,000
Cash ...................................................................... 1,040,000 Accumulated Depreciation—Machinery ($360,000 + $15,000) .......................................... 375,000 Machinery..................................................... 1,300,000 Gain on Disposal of Machinery .................. 115,000* *$1,040,000 – ($1,300,000 – $375,000)
Exercise 9.25 (Continued) (c)
Depreciation Expense (7/12 x $60,000) ............. Accumulated Depreciation—Machinery ..
35,000
Contribution Expense ........................................ Accumulated Depreciation—Machinery ........... ($360,000 + $35,000) Machinery .................................................. Gain on Disposal of Machinery ................ *$1,100,000 – ($1,300,000 – $395,000)
1,100,000 395,000
35,000
1,300,000 195,000*
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 9.26 (15–20 minutes) April 1 Cash ................................................................ Accumulated Depreciation—Buildings ......... Land ........................................................ Buildings ................................................ Gain on Disposal of Plant Assets ......... *Computation of gain: Less: Cash received Book value of land $ 60,000 Book value of buildings ($280,000 – $160,000) 120,000 Book value of land and buildings Gain on disposal Aug. 1 Land ................................................................. Buildings ......................................................... Cash ........................................................
430,000 160,000 60,000 280,000 250,000*
$430,000
(180,000) $250,000 90,000 400,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
490,000
Time and Purpose of Problems Problem 9.1 (Time 35–40 minutes) Purpose—to provide a problem involving the proper classification of costs related to property, plant, and equipment. Property, plant, and equipment must be segregated into land, buildings, leasehold improvements, and machinery and equipment for purposes of the analysis. Such costs as demolition costs, real estate commissions, imputed interest, minor and major repair work, and royalty payments are presented. An excellent problem for reviewing the first part of this chapter. Problem 9.2 (Time 20–25 minutes) Purpose—to provide the student with a problem involving journal entries for an asset retirement obligation. A good problem for applying time value of money concepts to compute cost of asset retirement obligation. Problem 9.3 (Time 40–55 minutes) Purpose—to provide a problem involving the proper classification of costs related to property, plant, and equipment. Such costs as land, freight and unloading, installation, parking lots, sales and use taxes, and machinery costs must be identified and appropriately classified. An excellent problem for reviewing the first part of this chapter. Problem 9.4 (Time 35–45 minutes) Purpose—to provide a problem involving the proper classification of costs related to land and buildings. Typical transactions involve the allocation of the cost of removal of a building, legal fees paid, general expenses, cost of organization, special tax assessments, etc. A good problem for providing a broad perspective as to the types of costs expensed and capitalized. Problem 9.5 (Time 35–40 minutes) Purpose—to provide a problem involving the method of handling the disposition of certain properties. The dispositions include a condemnation, demolition, trade-in, contribution, and sale to a stockholder. Therefore, the problem involves a number of situations and provides a good overview of the accounting treatment accorded property dispositions. Problem 9.6 (Time 20–30 minutes) Purpose—to provide the student with a problem in which schedules must be prepared on the costs of acquiring land and the costs of constructing a building. Interest costs are included. Problem 9.7 (Time 25–35 minutes) Purpose—to provide the student with a problem to determine costs to include in the value of land and plant, including interest capitalization. Problem 9.8 (Time 20–30 minutes) Purpose—to provide the student with a problem to compute capitalized interest and to present disclosures related to capitalized interest. Problem 9.9 (Time 35–45 minutes) Purpose—to provide the student with a problem involving the exchange of machinery. Four different exchange transactions are possible, and journal entries are required for each possible transaction. The exchange transactions cover the receipt and disposition of cash as well as the purchase of a machine from a dealer of machinery. Problem 9.10 (Time 30–40 minutes) Purpose—to provide a problem on the accounting treatment for exchanges of assets that have and do not have commercial substance involving gain situations. Problem 9.11 (Time 30–40 minutes) Purpose—to provide the student with another problem involving the exchange of productive assets. This problem is unusual because the size of the boot is greater than 25%. As a result, the entire transaction is monetary in nature and all gains and losses are recognized. Problem 9.12 (Time 35–45 minutes) Purpose—to provide a property, plant, and equipment problem consisting of three transactions that have to be recorded— (1) an asset purchased on a deferred-payment contract, (2) a lump-sum purchase, and (3) a nonmonetary exchange.
Solutions to Problems Problem 9.1
(a)
REAGAN COMPANY Analysis of Land Account for 2025 Balance at January 1, 2025 ................. Land site number 621 Acquisition cost ................................... Commission to real estate agent ........ Clearing costs ...................................... Less: Amounts recovered .................. Total land site number 621 ...... Land site number 622 Land value ............................................ Building value ...................................... Demolition cost .................................... Total land site number 622 ...... Balance at December 31, 2025 ............
$ 230,000 $850,000 51,000 $35,000 13,000
22,000 923,000 300,000 120,000 41,000 461,000 $1,614,000
REAGAN COMPANY Analysis of Buildings Account for 2025 Balance at January 1, 2025 ................. $ 890,000 Cost of new building constructed on land site number 622 Construction costs ..................... $330,000 Excavation fees........................... 38,000 Architectural design fees ........... 11,000 Building permit fee ..................... 2,500 381,500 Balance at December 31, 2025 ............ $1,271,500
Problem 9.1 (Continued) REAGAN COMPANY Analysis of Leasehold Improvements Account for 2025 Balance at January 1, 2025 ............................... Office space improvements .............................. Balance at December 31, 2025 .......................... REAGAN COMPANY Analysis of Equipment Account for 2025 Balance at January 1, 2025 ............................... Cost of the new equipment acquired Invoice price ............................................ $ 87,000 Freight costs ............................................ 3,300 Installation costs ..................................... 2,400 Balance at December 31, 2025 .......................... (b)
$660,000 89,000 $749,000
$875,000
92,700 $967,700
Items in the fact situation which were not used to determine the answer to (a) above are as follows: 1.
Interest imputed on equity (stock) financing of $8,500 is not permitted by GAAP and thus does not appear in any financial statement.
2.
Land site number 623, which was acquired for $650,000, should be included in Reagan’s balance sheet as land held for resale (investment section).
3.
Royalty payments of $17,500 should be included as a normal operating expense in Reagan’s income statement.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 9.2 1/1/25 Plant Assets .......................................... Cash .............................................
5,000,000 5,000,000
1/1/25 Plant Assets .......................................... Asset Retirement Obligation ...... ($192,770 = $500,000 x 0.38554) 12/31/25 Depreciation Expense .......................... Acc. Depr.—Plant Assets............ ($519,277 = [$5,000,000 + $192,770]/10) 12/31/25 Interest Expense................................... Asset Retirement Obligation ...... ($19,277 = $192,770 x .10)
192,770 192,770
519,277 519,277
19,277
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
19,277
Problem 9.3 (a)
LOBO CORPORATION Analysis of Land Account 2025 Balance at January 1, 2025 ................................ Plant facility acquired from Mendota Company—portion of fair value allocated to land (Schedule 1) ............................................. Balance at December 31, 2025........................... LOBO CORPORATION Analysis of Land Improvements Account 2025 Balance at January 1, 2025 ................................ Parking lots, streets, and sidewalks ................. Balance at December 31, 2025........................... LOBO CORPORATION Analysis of Buildings Account 2025 Balance at January 1, 2025 ................................ Plant facility acquired from Mendota Company—portion of fair value allocated to building (Schedule 1) ...................................... Balance at December 31, 2025...........................
$ 300,000
185,000 $ 485,000
$ 140,000 95,000 $ 235,000
$1,100,000
555,000 $1,655,000
LOBO CORPORATION Analysis of Equipment Account 2025 Balance at January 1, 2025 ................................ $ 960,000 Cost of new equipment acquired Invoice price .............................................. $400,000 Freight and unloading costs ..................... 13,000 Sales taxes ................................................. 20,000 Installation costs ....................................... 26,000 459,000 1,419,000
Problem 9.3 (Continued) Deduct cost of equipment disposed of Equipment scrapped June 30, 2025 ...... Equipment sold July 1, 2025.................. Balance at December 31, 2025 .......................
$ 80,000* 44,000*
124,000 $1,295,000
*The accumulated depreciation account can be ignored for this part of the problem. Schedule 1 Computation of Fair Value of Plant Facility Acquired from Mendota Company and Allocation to Land and Building 20,000 shares of Lobo common stock at $37 quoted market price on date of exchange (20,000 x $37)
$740,000
Allocation to land and building accounts in proportion to appraised values at the exchange date:
Land Building Total Land Building Total (b)
Amount $230,000 690,000 $920,000 ($740,000 x .25) ($740,000 x .75)
Percentage of total 25% (230/920) 75% (690/920) 100% $185,000 555,000 $740,000
Items in the fact situation that were not used to determine the answer to (a) above, are as follows: 1.
The tract of land, which was acquired for $150,000 as a potential future building site, should be included in Lobo’s balance sheet as an investment in land.
2.
The $110,000 and $320,000 book values respective to the land and building carried on Mendota’s books at the exchange date are not used by Lobo since they are not relevant.
Problem 9.3 (Continued) 3.
The $12,080 loss (Schedule 2) incurred on the scrapping of a machine on June 30, 2025, should be included in the other expenses and losses section in Lobo’s income statement. The $67,920 accumulated depreciation (Schedule 3) should be deducted from the Accumulated Depreciation—Equipment account in Lobo’s balance sheet.
4.
The $3,000 loss on sale of equipment on July 1, 2025 (Schedule 4) should be included in the other expenses and losses section of Lobo’s income statement. The $21,000 accumulated depreciation (Schedule 4) should be deducted from the Accumulated Depreciation—Equipment account in Lobo’s balance sheet.
Schedule 2 Loss on Scrapping of Machine June 30, 2025 Cost, January 1, 2017 ................................................................... Less: Accumulated depreciation (double-declining-balance method, 10-year life) January 1, 2017, to June 30, 2025 (Schedule 3) ..................................................................... Asset book value June 30, 2025 …………………………………… Loss on scrapping of machine.....................................................
$80,000 67,920 $12,080 $12,080
Problem 9.3 (Continued) Schedule 3 Accumulated Depreciation Using Double-Declining-Balance Method June 30, 2025 (Double-declining-balance rate is 20%)
Year 2017 2018 2019 2020 2021 2022 2023 2024 2025 (6 months)
Book Value at Beginning of Year $80,000 64,000 51,200 40,960 32,768 26,214 20,971 16,777 13,422
Depreciation Expense $16,000 12,800 10,240 8,192 6,554 5,243 4,194 3,355 1,342* *(2,684 x 6/12)
Accumulated Depreciation $16,000 28,800 39,040 47,232 53,786 59,029 63,223 66,578 67,920
Schedule 4 Loss on Sale of Machine July 1, 2025 Cost, January 1, 2022 .............................................................. Less: Depreciation (straight-line method, salvage value of $2,000, 7-year life) January 1, 2022, to July 1, 2025 [31/2 years ($44,000 – $2,000) ÷ 7] .................... Asset book value July 1, 2025.................................................
$44,000
Asset book value ..................................................................... Less: Proceeds from sale........................................................ Loss on sale .............................................................................
$23,000 20,000 $ 3,000
LO: 1, 5, Bloom: AP, Difficulty: Difficult, Time: 40-55, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
21,000 $23,000
Problem 9.4 (a)
1. Land (Schedule A) ............................................. Buildings (Schedule B) ..................................... Insurance Expense (6 months x $95)............... Prepaid Insurance (16 months x $95) .............. Organization Expense ....................................... Retained Earnings ............................................. Salaries and Wages Expense ........................... Land and Buildings .................................. Paid-in Capital in Excess of Par— Common Stock [800 shares x ($117- $100)] ............
188,700 136,250 570 1,520 610 53,800 32,100 399,950 13,600
Schedule A Amount Consists of: Acquisition Cost ($80,000 + [800 x $117]) ......................... Removal of Old Building .......................... Legal Fees (Examination of title) ............. Special Tax Assessment.......................... Total.....................................................
$173,600 9,800 1,300 4,000 $188,700
Schedule B Amount Consists of: Legal Fees (Construction contract) ........ Construction Costs (First payment)........ Construction Costs (Second payment) .. Insurance (2 months) ([2,280 ÷ 24] = $95 x 2 = $190) ............... Plant Superintendent’s Salary ................. Construction Costs (Final payment) ....... Total..................................................... 2. Land and Buildings (See Schedule C) ................. Depreciation Expense .............................. Accumulated Depreciation—Buildings ...
$
1,860 60,000 40,000
190 4,200 30,000 $136,250 4,000 2,637 1,363
Problem 9.4 (Continued) Schedule C Depreciation taken ............................... Depreciation that should be taken (.01 x $136,250) ................................. Depreciation adjustment ..................... (b)
Property, Plant, and Equipment: Land .............................................................. Buildings .............................................. Less: Accumulated depreciation ....... Total ...............................................
$ 4,000 (1,363) $ 2,637
$188,700 $136,250 1,363
LO: 1, 3, Bloom: AP, Difficulty: Difficult, Time: 35-45, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
134,887 $323,587
Problem 9.5 The following accounting treatment appears appropriate for these items: Land—The loss on the condemnation of the land of $9,000 ($40,000 – $31,000) should be reported as an unusual and/or infrequent item on the income statement. The $35,000 land purchase has no income statement effect. Building—There is no recognized gain or loss on the demolition of the building. The entire purchase cost ($15,000), decreased by the demolition proceeds ($3,600), is allocated to land. Warehouse—The gain on the destruction of the warehouse should be reported as an unusual and/or infrequent item. The gain is computed as follows: Insurance proceeds ..................................... Deduct: Warehouse cost ............................ Less: Accumulated depreciation ........... Realized gain ................................................
$74,000 $70,000 16,000
54,000 $20,000
Some contend that a portion of this gain should be deferred because the proceeds are reinvested in similar assets. We do not believe such an approach should be permitted. Deferral of the gain in this situation is not permitted under GAAP. Machine—The recognized gain on the transaction would be computed as follows: Fair value of old machine ............................. Deduct: Book value of old machine Cost .......................................................... Less: Accumulated depreciation .......... Total gain ....................................................... Total gain recognized = $2,000 x
$8,000 2,800
$900 = $250 $900 + $6,300*
The gain deferred is $1,750 ($2,000 – $250) *($7,200 – $900)
$7,200 5,200 $2,000
Problem 9.5 (Continued) This gain would probably be reported in other revenues and gains. It might be reported as an unusual item if the company believes that such a situation occurs infrequently and if material. The cost of the new machine would be capitalized at $4,550. Fair value of new machine ($7,200 – $900) .................. Less: Gain deferred ($2,000 – $250) ............................ Cost of new machine .....................................................
$6,300 1,750 $4,550
Furniture—The contribution of the furniture would be reported as a contribution expense of $3,100 with a related gain on disposition of furniture of $950: $3,100 – ($10,000 – $7,850). The contribution expense and the related gain may be netted, if desired. Automobile—The loss on sale of the automobile of $2,580: [$2,960 – ($9,000 – $3,460)] should probably be reported in the other expenses or losses section. LO: 1, 3, 5, Bloom: AN, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 9.6 (a)
(b)
BLAIR CORPORATION Cost of Land (Site #101) As of September 30, 2026 Cost of land and old building .................................... Real estate broker’s commission ............................. Legal fees ................................................................... Title insurance ............................................................ Removal of old building............................................. Cost of land ............................................................
$500,000 36,000 6,000 18,000 54,000 $614,000
BLAIR CORPORATION Cost of Building As of September 30, 2026 Fixed construction contract price ............................. Plans, specifications, and blueprints ....................... Architects’ fees .......................................................... Interest capitalized during 2025 (Schedule 1) .......... Interest capitalized during 2026 (Schedule 2) .......... Cost of building .....................................................
$3,000,000 21,000 82,000 130,000 190,000 $3,423,000
Schedule 1 Interest Capitalized During 2025 and 2026
2025:
Weighted-average accumulated construction expenditures $1,300,000
x x
Interest rate .10
= =
Interest to be capitalized $130,000*
*Actual interest: $3,000,000 x .10 x 10/12 = $250,000. 2026:
$1,900,000
x
.10
=
$190,000**
**Actual interest: ($3,000,000 x .10 x 2/12) + ($2,700,000a x .10 x 10/12) = $275,000. ($3,000,000 – $300,000)a LO: 1,2, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 9.7 INTEREST CAPITALIZATION Balance in the Land Account Purchase Price ...................................................................... Surveying Costs.................................................................... Title Insurance Policy ........................................................... Demolition Costs .................................................................. Salvage .................................................................................. Total Land Cost ...............................................................
Expenditures (2025) Date
Amount
Fraction
Dec. 1 Dec. 1 Dec. 1
$147,000 30,000 3,000 $180,000
1/12 1/12 1/12
Weighted—Average Accumulated Expenditures $12,250 2,500 250 $15,000
Interest Capitalized for 2025 Weighted—Average Accumulated Expenditures $15,000 x
Interest Rate .08
Interest charged to Interest Expense [($600,000 x .08 x 1/12) – $1,200]
$139,000 2,000 4,000 3,000 (1,000) $147,000
Amount Capitalizable $1,200
$2,800
Problem 9.7 (Continued) Expenditures (2026) Date Amount Jan. 1 $180,000 Jan. 1 1,200 Mar. 1 240,000 May 1 330,000 Jul. 1 60,000 $811,200
Weighted Expenditure $ 90,000 600 80,000 55,000 0 $225,600
Fraction 6/12 6/12 4/12 2/12 0
Interest Capitalized for 2026 WeightedAverage Expenditure $225,600
x x
Interest Rate .08
= =
Amount Capitalizable $18,048
Interest charged to Interest Expense [($600,000 x .08) – $18,048] (a) (b) (c)
$29,952
Balance in Land Account—2025 and 2026 ........ Balance in Building—2025 .................................. Balance in Building—2025 .................................. Balance in Interest Expense—2025.................... Balance in Interest Expense—2026....................
147,000 34,200* 682,248** 2,800 29,952
*$30,000 + $3,000 + $1,200 **$34,200 + $240,000 + $330,000 + $60,000 + $18,048 LO: 1,2, Bloom: AP, Difficulty: Difficult, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 9.8 (a)
Computation of Weighted-Average Accumulated Expenditures Expenditures
(b)
Capitalization Weighted-Average x Period = Accumulated Expenditures
Date
Amount
July 30, 2025 January 30, 2026 May 30, 2026
$ 900,000 1,500,000 1,600,000 $4,000,000
Weighted-Average Accumulated Expenditures $1,250,000
10/12 4/12 0
Weighted-Average Interest Rate x .112
$ 750,000 500,000 0 $1,250,000
=
Avoidable interest $140,000
Loans Outstanding During Construction Period
10% five-year note 12% ten-year bond
Total interest Total principal (c)
=
Principal $2,000,000 3,000,000 $5,000,000 $560,000 $5,000,000
Actual Interest $200,000 360,000 $560,000
= 11.2% (weighted-average rate)
(1) and (2) Total actual interest cost
$560,000
Total interest capitalized
$140,000
Total interest expensed ($560,000 – $140,000)
$420,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 9.9 1.
Holyfield Corporation Cash ...................................................................... Machinery ($92,000 – $23,000) ............................ Accumulated Depreciation—Machinery ............. Loss on Disposal of Machinery .......................... Machinery .....................................................
23,000 69,000 60,000 8,000* 160,000
*Computation of loss: Book value ($160,000
–
$100,000
$60,000) Less: Fair value Loss
92,000 $ 8,000
Dorsett Company Machinery ............................................................. Accumulated Depreciation—Machinery ............. Loss on Disposal of Machinery .......................... Cash .............................................................. Machinery .....................................................
92,000 45,000 6,000** 23,000 120,000
**Computation of loss: Book value ($120,000 – $45,000) Less: Fair value Loss 2.
$ 75,000 69,000 $ 6,000
Holyfield Corporation Machinery ............................................................. Accumulated Depreciation—Machinery ............. Loss on Disposal of Machinery .......................... Machinery ..................................................... Winston Company Machinery ($92,000 – $11,000***) ........................ Accumulated Depreciation—Machinery ............. Machinery ..................................................... *** Computation of gain deferred: Fair value $92,000 Less: Book value ($152,000 – $71,000) 81,000 Gain deferred $11,000
92,000 60,000 8,000 160,000 81,000 71,000 152,000
Problem 9.9 (Continued) 3.
Holyfield Corporation Machinery ............................................................ Accumulated Depreciation—Machinery............ Loss on Disposal of Machinery ......................... Machinery .................................................... Cash............................................................. Liston Company Machinery ($95,000 – $3,000) ............................. Accumulated Depreciation—Machinery............ Cash..................................................................... Machinery .................................................... Gain on Disposal of Machinery.................. ****Fair value Less: Book value ($160,000 – $75,000) Gain
95,000 60,000 8,000 160,000 3,000 92,000 75,000 3,000 160,000 10,000****
$95,000 85,000 $10,000
Because the exchange has commercial substance, the entire gain should be recognized. 4.
Holyfield Corporation Machinery ............................................................ Accumulated Depreciation—Machinery............ Loss on Disposal of Machinery ......................... Machinery .................................................... Cash............................................................. Greeley Company Cash..................................................................... Inventory ............................................................. Sales Revenue ............................................ Cost of Goods Sold ............................................ Inventory .....................................................
185,000 60,000 8,000 160,000 93,000 93,000 92,000 185,000 130,000
LO: 3, Bloom: AP, Difficulty: Difficult, Time: 35-45, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
130,000
Problem 9.10 (a)
Exchange has commercial substance: Hyde, Inc.’s Books Machinery (B) ...................................................... Accumulated Depreciation—Machinery (A) ...... Machinery (A) ............................................. Gain on Disposal of Machinery ($60,000 – [$96,000 – $40,000])............... Cash ............................................................
75,000 40,000 96,000 4,000 15,000
Wiggins, Inc.’s Books Cash ..................................................................... Machinery (A) ...................................................... Accumulated Depreciation—Machinery (B) ...... Machinery (B) ............................................. Gain on Disposal of Machinery ($75,000 – [$110,000 – $47,000])............. (b)
15,000 60,000 47,000 110,000 12,000
Exchange lacks commercial substance: Hyde, Inc.’s Books Machinery (B) ($75,000 – $4,000) ....................... Accumulated Depreciation—Machinery (A) ...... Machinery (A) ............................................. Cash ............................................................ *Computation of gain deferred: Fair value Less: Book value ($96,000 – $40,000) Gain deferred
71,000* 40,000 96,000 15,000 $60,000 56,000 $ 4,000
Problem 9.10 (Continued) Wiggins, Inc.’s Books Cash .................................................................... Machinery (A)...................................................... Accumulated Depreciation—Machinery (B) ..... Machinery (B) .............................................. Gain on Disposal of Machinery.................. Computation of total gain: Fair value of Asset B Less: Book value of Asset B Gain on disposal of assets *Gain recognized =
15,000 50,400** 47,000 110,000 2,400*
$75,000 63,000 $12,000
$15,000 x $12,000 = $2,400 $15,000 + $60,000
**Fair value of asset acquired Less: Gain deferred ($12,000 – $2,400) Basis of Machinery A
$60,000 9,600 $50,400
OR Book value of Machinery B Less: Portion of book value sold
$63,000 12,600 $50,400
Note to instructor: This illustrates the exception to no gain or loss recognition for exchanges that lack commercial substance. Although it would be rare for an exchange to lack commercial substance when cash is received, a gain can be recognized based on the proportion of cash received to the overall fair value. LO: 3, Bloom: AP, Difficulty: Difficult, Time: 30-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 9.11 (a)
Has Commercial Substance
1.
2.
Marshall Construction Equipment ($82,000 + $118,000) ................... 200,000 Accumulated Depreciation—Equipment ...... 50,000 Loss on Disposal of Equipment .................... 8,000* Equipment ............................................. Cash ....................................................... *Computation of loss: Book value of old crane ($140,000 – $50,000) $90,000 Less: Fair value of old crane 82,000 Loss on disposal of equipment $ 8,000 Brigham Manufacturing Cash ................................................................ Inventory......................................................... Sales Revenue....................................... Cost of Goods Sold ....................................... Inventory ................................................
(b)
140,000 118,000
118,000 82,000 200,000 165,000 165,000
Lacks Commercial Substance 1.
Marshall Construction should record the same entry as in part (a) above since the exchange resulted in a loss.
2.
Brigham should record the same entry as in part (a) above. No gain is deferred because we are assuming that Marshall is a customer. In addition, because the cash involved is greater than 25% of the value of the exchange, the entire transaction is considered a monetary transaction and a gain is recognized.
Problem 9.11 (Continued) (c)
Has Commercial Substance
1.
2.
(d) 1.
Marshall Construction Equipment ($98,000 + $102,000) ................... Accumulated Depreciation—Equipment ...... Equipment ............................................. Cash ....................................................... Gain on Disposal of Equipment ........... *Computation of gain: Fair value of old crane $98,000 Less: Book value of old crane ($140,000 – $50,000) 90,000 Gain on Disposal of Equipment $ 8,000
200,000 50,000 140,000 102,000 8,000*
Brigham Manufacturing Cash ................................................................ 102,000 Inventory ........................................................ 98,000 Sales Revenue ......................................
200,000
Cost of Goods Sold ....................................... Inventory................................................
165,000
Marshall Construction Equipment ...................................................... Accumulated Depreciation—Equipment ...... Cash ....................................................... Equipment ............................................. Gain on Disposal of Equipment ...........
165,000
200,000 50,000 103,000 140,000 7,000*
*[Fair Value–Old ($97,000) – Book Value–Old ($90,000)] Note: Cash involved is greater than 25% of the value of the exchange, so the gain is not deferred.
Problem 9.11 (Continued)
2.
Brigham Manufacturing Cash .............................................................. 103,000 Inventory....................................................... 97,000 Sales Revenue .....................................
200,000
Cost of Goods Sold ..................................... Inventory ..............................................
165,000
165,000
Same reasons as cited in (b) (2) on the previous pages. Note: Even though the exchange lacks commercial substance, cash paid exceeds 25% of total fair value so the transaction is treated as a monetary exchange and recorded at fair value. Note that with this much cash involved, it is unlikely that the exchange would lack commercial substance. LO: 3, Bloom: AP, Difficulty: Difficult, Time: 30-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 9.12 (a)
(b)
The major characteristics of plant assets, such as land, buildings, and equipment, which differentiate them from other types of assets are presented below. 1.
Plant assets are acquired for use in the regular operations of the enterprise and are not for resale.
2.
Property, plant, and equipment possess physical substance or existence and are thus differentiated from intangible assets such as patents and goodwill. Unlike other assets that possess physical substance (i.e., raw material), property, plant, and equipment do not physically become part of the product held for resale.
3.
These assets are durable and long-term in nature and are usually subject to depreciation.
Transaction 1. To properly reflect cost, assets purchased on deferred payment contracts should be accounted for at the present value of the consideration exchanged between the contracting parties at the date of the consideration. When no interest rate is stated, interest must be imputed at a rate that approximates the rate that would be negotiated in an arm’s-length transaction. In addition, all costs necessary to ready the asset for its intended use are considered to be costs of the asset.
Asset cost = Present value of ordinary annuity (4 periods) for the note + Freight + Installation $28,000 X 3.17 + $425 + $500 = 4 = $22,190 + $925 = $23,115
Problem 9.12 (Continued) Transaction 2. The lump-sum purchase of a group of assets should be accounted for by allocating the total cost among the various assets on the basis of their relative fair values. The $8,000 of interest expense incurred for financing the purchase is a period cost and is not a factor in determining asset cost. Inventory $220,000 x ($50,000/$250,000) = $ 44,000 Land $220,000 x ($80,000/$250,000) = $ 70,400 Building $220,000 x ($120,000/$250,000) = $105,600 Transaction 3. The cost of a nonmonetary asset acquired in an exchange that has commercial substance should be recorded at the fair value of the asset given up plus any cash paid. Furthermore, any gain on the exchange is also recognized. Fair value of trucks ................................................. Cash paid ................................................................ Cost of land ............................................................. (c)
$46,000 19,000 $65,000
1.
A building purchased for speculative purposes is not a plant asset as it is not being used in normal operations. The building is more appropriately classified as an investment.
2.
The two-year insurance policy covering plant equipment is not a plant asset because it has no physical substance and is not durable. This policy is more appropriately classified as a current asset (for the portion to be used up within the next 12 months), and as an Other asset for the long-term portion.
3.
The rights for the exclusive use of a process used in the manufacture of ballet shoes are not plant assets as they have no physical substance. The rights should be classified as an intangible asset.
LO: 1, 3, Bloom: AN, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
UYJ 9.1 Financial Statement Analysis Case
JOHNSON & JOHNSON ($ millions) (a)
The cost of building and building equipment at the end of the current year was $11,240.
(b)
As indicated in footnote number 1 to the financial statements, the company utilizes the straight-line method for financial statement purposes for all additions to property, plant, and equipment. Given that straight-line depreciation provides a lower charge for depreciation as compared to an accelerated method in the early years of an asset’s life, the accounting appears to be less conservative.
(c)
The cash flow statement reports the amount of interest paid in cash ($960).
(d)
Free cash flow is defined as net cash flows provided by operating activities less capital expenditures and dividends. Free cash flow is the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity. In Johnson & Johnson’s situation, free cash flow is computed as follows: Net cash flows from operating activities ..................... Less: Additions to property, plant and equipment .... Dividends ........................................................... Free cash flow ...............................................................
$21,056 3,279 8,943 $ 8,834
As indicated from the above computation, Johnson & Johnson has considerable free cash flows. The company has excellent financial flexibility. For example, the company is able to pay its dividends without resorting to external financing. Secondly, even if operations decline, it appears that the company will be able to fund additions to property, plant, and equipment. Thirdly, the company is using its free cash flow to expand its operations by acquiring new businesses. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
UYJ 9.2 Accounting, Analysis, and Principles Accounting Equipment**............................................................. Accumulated Depreciation—Equipment .............. Equipment ...................................................... Cash ................................................................ Gain on Disposal of Equipment * .................. *Fair value of old asset Less: Cost of old asset Less: Accumulated depreciation ( [$112,000 – $12,000] x 4/5) Gain on disposal of equipment **Cash paid Fair value of old equipment Cost of new equipment
62,000 80,000 112,000 12,000 18,000 $50,000
$112,000 80,000
(32,000) $18,000
$ 12,000 50,000 $ 62,000
Analysis The gain on the disposal increases income, leading to a one-time increase in the return on assets (ROA) in the year of the exchange. In essence, the gain reflects the extent to which prior years’ depreciation was overstated related to the decline in the fair value of the asset traded in. As a result, in the year of the exchange, Durler’s ROA will appear higher than in prior years. Some analysts will adjust these nonrecurring gains out of income when conducting analysis using ROA. Principles The concept of commercial substance is a fundamental element in the accounting for exchanges. If the transaction above lacked commercial substance, the gain on the exchange would be deferred. That is, if the expected cash flows arising from the assets exchanged are not significantly different, Durler is in the same economic position after the exchange with respect to exchanged assets. As a result, no gain is reported, and the nonrecurring gain will not affect analysts’ comparisons of a company’s ROA across years with and without exchanges. LO: 3, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 9.1 (Time 20–25 minutes) Purpose—to provide the student with a problem to decide which expenditures related to purchasing land, constructing a building, and adding to the building should be capitalized and how each should be depreciated. When the land and building are sold, the student discusses how the book value is determined and how a gain would be reported. CT 9.2 (Time 20–25 minutes) Purpose—to provide the student with a situation involving the proper allocation of costs to selfconstructed machinery. As part of this case, the student is required to discuss the propriety of including overhead costs in the construction costs. Finally, the proper accounting treatment accorded the development costs associated with the construction of a new machine must be evaluated. CT 9.3 (Time 30–40 minutes) Purpose—to provide the student with a situation to determine capitalization of interest and to explain in a memorandum the conceptual basis for interest capitalization. CT 9.4 (Time 30–40 minutes) Purpose—to provide the student with a situation in which to examine differences in accounting for exchanges that have or lack commercial substance. CT 9.5 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the proper accounting treatment involving incidental costs associated with the purchase of a machine. The student must be able to defend why certain costs might be capitalized even though this valuation has no relationship to net realizable value. In addition, the costs may be charged off immediately for tax purposes and the student is required to analyze why these costs may still be capitalized for book purposes. CT 9.6 (Time 20–25 minutes) Purpose—to provide the student with a case involving allocation of costs between land and buildings, including ethical issues.
Solutions to Critical Thinking CT 9.1 (a) Expenditures should be capitalized when they benefit future periods. The cost to acquire the land should be capitalized and classified as land, a non-depreciable asset. Since tearing down the small factory is readying the land for its intended use, its cost is part of the cost of the land and should be capitalized and classified as land. As a result, this cost will not be depreciated as it would if it were classified with the capitalizable cost of the building. Since rock blasting and removal is required for the specific purpose of erecting the building, these costs are part of the cost of the building and should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the estimated useful life of the building. The road and the parking lot are land improvements, and these costs should be capitalized and classified separately as land improvements. These costs should be depreciated over their estimated useful lives. The added four stories are an addition, and its cost should be capitalized and classified with the capitalizable cost of the building. This cost should be depreciated over the remaining life of the original office building because that life is shorter than the estimated useful life of the addition. (b) A gain should be recognized on the sale of the land and building because income is realized whenever the earning process has been completed and a sale has taken place. The net book value at the date of sale would be composed of the capitalized cost of the land, the land improvement, and the building, as determined above, less the accumulated depreciation on the land improvement and the building. The excess of the proceeds received from the sale over the net book value at the date of sale would be accounted for as a gain in continuing operations in the income statement. LO: 1, 5, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 9.2 (a) Materials and direct labor used in the construction of the equipment definitely should be charged to the equipment account. It should be emphasized that no gain on self-construction should be recorded because such an approach violates the historical cost principle. The controversy centers on the assignment of indirect costs, called overhead or burden, consisting of power, heat, light, insurance, property taxes on factory buildings, etc. The suggested approaches are discussed below. (b) 1. Many believe that only the variable overhead costs that increase as a result of the construction should be assigned to the cost of the asset. This approach assumes that the company will have the same fixed costs regardless of whether the company constructs the asset or not, so to charge a portion of the fixed overhead costs to the equipment will usually decrease current expenses and consequently overstate income of the current period. Therefore, only the incremental costs should be charged. 2. Proponents of alternative (2) argue that such assets should be given the same treatment as inventory items and that all costs should be allocated thereto just as if saleable goods were being produced. They state that no special favor should be granted in the allocation of any cost, as long as sufficient facts are available to enable the allocation to be made. They argue that allocation of overhead to fixed assets is similar to allocation to joint products and byproducts and should be made at regular rates. Of course, no item should be capitalized at an amount greater than that prevailing in the market.
CT 9.2 (Continued) (c) It could be argued that because costs of development are usually higher on the first few units, the additional costs of $273,000 should be allocated to all four machines. If these costs are due to inefficiency and not development costs, the additional costs should be expensed. LO: 1, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 9.3 To:
Jane Esplanade, President
From:
Good Student, Manager of Accounting
Date:
January 15, 2025
Subject:
Capitalization of avoidable interest on the warehouse construction project
I am writing in response to your questions about the capitalized interest costs for the warehouse construction project. This brief explanation of my calculations should facilitate your understanding of these costs. Generally, the accounting profession does not allow accrued interest to be capitalized along with an asset’s cost. However, the FASB made an exception for interest costs incurred during construction. In order to qualify for this treatment, the constructed asset must require a period of time to become ready for its intended use. Because interest capitalization is allowed in special circumstances only, the company must be especially careful to capitalize only that interest which is associated with the construction itself. Thus, GAAP provides guidance indicating how much interest may be associated with the construction, i.e., the lower of actual or avoidable interest. On the surface, this standard seems simple. Actual interest incurred during the construction period equals all interest which accrued on any debt outstanding during that period. Avoidable interest equals the amount of interest which would not have been incurred if the construction project had not been undertaken. The amount of interest capitalized is the smaller of the two. To determine the amount capitalized, we must calculate both the actual and the avoidable interest during 2024. Actual interest is computed by applying the interest rates of 12%, 10%, and 11% to their related debt. Thus, total actual interest for this period is $490,000 (see Schedule #1).
CT 9.3 (Continued) Calculations for avoidable interest are more complex. First, interest can be capitalized only on the weighted-average amount of accumulated expenditures. Although total costs amounted to $5,200,000 for the project, an average of only $3,500,000 was outstanding during the period of construction. Second, of the total $4,400,000 debt outstanding during this period, only $2,000,000 of it can be associated with the actual construction project. Therefore, rather than arbitrarily choose the interest rate for one of the other loans, we must calculate the weighted-average interest rate. This rate is the ratio of accrued interest on the other loans to the total amount of their principal. For the $1,500,000 balance of weightedaverage accumulated expenditures, this interest rate equals 10.42% (see Schedule #2). Third, we compute our avoidable interest as follows: calculate the interest on the loan directly associated with the construction. Apply the weighted-average interest rate to the remainder of the weighted-average accumulated expenditures. Add these products. Avoidable interest for 2024 amounts to $396,300 (see Schedule #3). So as not to overstate the interest associated with the construction, we capitalize the smaller of the two—$396,300—along with the other construction costs. The remainder of the interest ($490,000 –- $396,300 = $93,700) is expensed. I hope that this explanation has answered any questions you may have had about capitalized interest. If any further questions should arise, please contact me. Schedule #1 Actual Interest Construction loan Short-term loan Long-term loan
$2,000,000 x .12 = $1,400,000 x .10 = $1,000,000 x .11 = Total
$240,000 140,000 110,000 $490,000
CT 9.3 (Continued) Schedule #2 Weighted-Average Interest Rate Weighted-average interest rate computation 10% short-term loan 11% long-term loan Total Interest Total Principal
=
Principal $1,400,000 1,000,000 $2,400,000
$250,000 $2,400,000
Interest $140,000 110,000 $250,000
= 10.42%
Schedule #3 Avoidable Interest Weighted-Average Accumulated Expenditures $2,000,000 1,500,000 $3,500,000
x
Interest Rate .12 .1042
=
Avoidable Interest $240,000 156,300 $396,300
Schedule #4 Interest Capitalized Because avoidable interest is lower than actual interest, use avoidable interest. Cost .......................................................................................... Interest capitalized .................................................................... Total cost ..................................................................................
$5,200,000 396,300 $5,596,300
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 9.4 (a) Client A Treatment if the exchange has commercial substance Client A would recognize a gain of $20,000 on the exchange. The basis of the asset acquired would be $100,000. The entry would be as follows: Machinery ($80,000 + $20,000) ......................................................... Accumulated Depreciation—Machinery.............................................. Cash ........................................................................................... Gain on Disposal of Machinery ................................................... Machinery................................................................................... *Fair value of old machinery Less: Book value of old machinery ($100,000 – $40,000) Gain on disposal of machinery
100,000 40,000 20,000 20,000* 100,000
$80,000 60,000 $20,000
(b) Treatment if the exchange lacks commercial substance Client A would be prohibited from recognizing a $20,000 gain on the exchange. This is because the transaction lacks commercial substance. The new asset on their books would have a basis of $80,000 ($100,000 less the $20,000 unrecognized gain). The entry would be as follows: Machinery ($100,000 – $20,000)........................................................ Accumulated Depreciation—Machinery.............................................. Cash ........................................................................................... Machinery...................................................................................
80,000 40,000 20,000 100,000
(c) Memo to the Controller: TO:
The Controller
RE:
Exchanges of Assets—Commercial Substance Issues.
Financial statement effect of treating the exchange as having commercial substance versus not. 1. The income statement will reflect a before-tax gain of $20,000. This gain will increase the reported income on this year’s financial statements. Future income statements will show a higher depreciation deduction because of an increased book value of the new asset. Thus, future income statements will reflect lower income. 2. The current balance sheet will show a $20,000 higher value for plant assets, a higher liability for taxes payable and higher retained earnings if the exchange has commercial substance. This difference will disappear gradually as the asset is depreciated.
CT 9.4 (Continued) (d) Client B Treatment if the exchange has commercial substance In this situation, the full $30,000 gain would be recognized on this year’s income statement. The new asset would go on the books at its fair value. The entry is as follows: Machinery ......................................................................................... Accumulated Depreciation—Machinery ............................................ Cash ................................................................................................. Machinery.................................................................................. Gain on Disposal of Machinery .................................................. *Fair value of old machinery Less: Book value of old machinery ($150,000 – $80,000) Gain on disposal of machinery
80,000 80,000 20,000 150,000 30,000*
$100,000 70,000 $ 30,000
(e) Treatment if the exchange lacks commercial substance Machinery ($80,000 – $24,000) ....................................................... Accumulated Depreciation—Machinery ........................................... Cash ................................................................................................ Machinery ................................................................................ Gain on Disposal of Machinery ................................................
56,000 80,000 20,000 150,000 6,000*
* A partial gain will be recognized in the ratio of cash received to the fair value of all assets received. In this case, a gain of $6,000 will be recognized ($20,000/$100,000 times the gain of $30,000). The unrecognized portion of $24,000 will be used to reduce the basis of the new asset. The entry to record the exchange is as above. (f)
Memo to the Controller: TO:
The Controller
RE:
Asset Exchanges—Commercial Substance
1. The income statement will reflect a before-tax gain of $30,000 if the exchange has commercial substance. This gain will increase the reported income on this year’s financial statements. Future income statements will show a higher depreciation deduction because of an increased book value of the new asset. Thus, future income statements will reflect lower income. The reported gain will only be $6,000 if the exchange lacks commercial substance. 2. The current balance sheet will show a $24,000 higher value for plant assets, a higher liability for taxes payable and higher retained earnings if the exchange has commercial substance. This difference will disappear gradually as the asset is depreciated. LO: 3, Bloom: AN, Difficulty: Difficult, Time: 30-40, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 9.5 In general, the inclusion of the $7,500 as part of the cost of the machine is justified because the primary purpose in accounting for plant asset costs is to secure an equitable allocation of incurred costs over the period of time when the benefits are being received from the use of the assets. These costs—both the $50,000 and the $7,500—are much like prepaid expenses, to be matched against the revenue emerging through their use. The purpose of accounting for plant assets then is not primarily aimed at determining the fair valuation of the asset for balance sheet purposes, but proper matching of incurred costs with revenue resulting from use of the assets. (1) It may be true that these installation costs could not be recovered if the machine were to be sold. This is not important, however, because presumably the machine was acquired to be used, not to be sold. Assuming approximately equal utilization of the machine in each of the ten years, the owner properly could allocate $5,750 (10% of $57,500) against each year’s operations. If the owner’s suggestion was followed, the first year would be charged with $12,500 ($7,500 plus 10% of $50,000), and the following nine years with $5,000 per year, hence overstating expenses by $6,750 the first year and understating expenses by $750 per year for the succeeding nine years. This could hardly be defended as proper matching of costs and revenue. (2) Again, the purpose of accounting for plant assets is not to arrive at an approximation of fair value of the assets each year over the life of the assets. However, even if this were an objective, the question of which method would come closer to stating current market value at some later date would revolve around the general trend of the price level over the years involved. (3) Assuming that the $7,500 could properly be deducted, there would be some tax savings over the years unless the tax rates applicable to the business were reduced during the following years. There is some value to taking the $7,500 deduction right now because of the present value of money. If the rates increased, there would be an increase in total taxes, due to higher rates applicable during the period when depreciation deductions would be reduced. However, generally accepted accounting principles are not determined by income tax effects. In many instances, GAAP requires different accounting treatment of an item than the IRS Revenue Code does. LO: 1, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 9.6 (a) If the land is undervalued so that a higher depreciation expense is assigned to the building, management interests are served. The lower net income and reduced tax liability save cash to be used for management purposes. By contrast, stockholders and potential investors are misled by the inaccurate cost values. They will have been deprived of information concerning the significant impact of changing real estate values on this holding. (b) The ethical question centers on whether to allocate the cost of the purchase on the fair value of land and building or whether to determine the allocation in view of the potential effect on net income. Carter faces an ethical dilemma if Ankara will not accept Carter’s position. Carter should specify alternative courses of action and carefully assess the consequences of each before deciding what to do. (c) For basket (lump-sum) purchases of land and buildings, costs should be allocated on the ratio of fair values of the land and buildings. LO: 1, Bloom: E, Difficulty: Moderate, Time: 20-25, AACSB: Ethics, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Ethical Conduct, Communication
Solutions to Codification Exercises CE9.1 Master Glossary (a)
Capitalize is used to indicate that the cost would be recorded as the cost of an asset. That procedure is often referred to as deferring a cost, and the resulting asset is sometimes described as a deferred cost.
(b)
Nonmonetary assets are assets other than monetary ones. Examples are inventories, investments in common stocks, and property, plant, and equipment.
(c)
A nonreciprocal transfer is a transfer of assets or services in one direction, either from an entity to its owners (whether or not in exchange for their ownership interests) or to another entity, or from owners or another entity to the entity. An entity’s reacquisition of its outstanding stock is an example of a nonreciprocal transfer.
(d)
A contribution is an unconditional transfer of cash or other assets to an entity or a settlement or cancellation of its liabilities in a voluntary nonreciprocal transfer by another entity acting other than as an owner. Those characteristics distinguish contributions from exchange transactions, which are reciprocal transfers in which each party receives and sacrifices approximately equal value; from investments by owners and distributions to owners, which are nonreciprocal transfers between an entity and its owners; and from other nonreciprocal transfers, such as impositions of taxes or fines and thefts, which are not voluntary transfers. In a contribution transaction, the value, if any, returned to the resource provider is incidental to potential public benefits. In an exchange transaction, the potential public benefits are secondary to the potential proprietary benefits to the resource provider. The term contribution revenue is used to apply to transactions that are part of the entity’s ongoing major or central activities (revenues) or are peripheral or incidental to the entity (gains).
LO: 4, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Technology and Tools, AICPA PC: Communication
CE9.2 According to FASB ASC 835-20-15-8 (Capitalization of Land Expenditures), it depends: Land that is not undergoing activities necessary to get it ready for its intended use is not a qualifying asset. If activities are undertaken for the purpose of developing land for a particular use, the expenditures to acquire the land qualify for interest capitalization while those activities are in progress. The interest cost capitalized on those expenditures is a cost of acquiring the asset that results from those activities. If the resulting asset is a structure, such as a plant or a shopping center, interest capitalized on the land expenditures is part of the acquisition cost of the structure. If the resulting asset is developed land, such as land that is to be sold as developed lots, interest capitalized on the land expenditures is part of the acquisition cost of the developed land. LO: 4, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Technology and Tools, AICPA PC: Communication
CE9.3 According to FASB ASC 360-10-25-5, (Planned Major Maintenance Activities) The use of the accrue-in-advance (accrual) method of accounting for planned major maintenance activities is prohibited in annual and interim financial reporting periods. LO: 5, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Technology and Tools, AICPA PC: Communication
CE9.4 According to FASB ASC 845-10-15-5 (Purchases and Sales of Inventory with the Same Counterparty), the accounting for these exchanges is similar to other nonmonetary exchanges: The Purchases and Sales of Inventory with the Same Counterparty Subsections follow the same Scope and Scope Exceptions as outlined in the General Subsection of this Subtopic, see paragraph 845-10-15-1, with specific transaction exceptions noted below. With respect to recognition, FASB ASC 845-10-30 Initial Measurement 30-15
A nonmonetary exchange whereby an entity transfers finished goods inventory in exchange for the receipt of raw materials or work-in-process inventory within the same line of business is not an exchange transaction to facilitate sales to customers for the entity transferring the finished goods, as described in paragraph 845-10-30-3(b), and, therefore, shall be recognized by that entity at fair value if both of the following conditions are met: a. Fair value is determinable within reasonable limits. b. The transaction has commercial substance (see paragraph 845-10-30-4).
30-16
All other nonmonetary exchanges of inventory within the same line of business shall be recognized at the carrying amount of the inventory transferred. That is, a nonmonetary exchange within the same line of business involving either of the following shall not be recognized at fair value: a. The transfer of raw materials or work-in-process inventory in exchange for the receipt of raw materials, work-in-process, or finished goods inventory. b. The transfer of finished goods inventory for the receipt of finished goods inventory.
LO: 4, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Technology and Tools, AICPA PC: Communication
Codification Research Case (a) Yes; according to FASB ASC 835-20-05, it is required to capitalize interest into the cost of assets that meet selected criteria (see (c) below). (b) According to FASB ASC 835-20-10-1, The objectives of capitalizing interest are to obtain a measure of acquisition cost that more closely reflects an entity’s total investment in the asset and to charge a cost that relates to the acquisition of a resource that will benefit future periods against the revenues of the periods benefited. (c) According to FASB ASC 835-20-15-5, Interest shall be capitalized for the following types of assets (qualifying assets): a. Assets that are constructed or otherwise produced for an entity’s own use, including assets constructed or produced for the entity by others for which deposits or progress payments have been made. b. Assets intended for sale or lease that are constructed or otherwise produced as discrete projects (for example, ships or real estate developments). [FAS 034, paragraph 9, sequence 35] c. Investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations provided that the investee’s activities include the use of funds to acquire qualifying assets for its operations. (d) According to FASB ASC 835-20-30-6, The total amount of interest cost capitalized in an accounting period shall not exceed the total amount of interest cost incurred by the entity in that period. In consolidated financial statements, that limitation shall be applied by reference to the total amount of interest cost incurred by the parent entity and consolidated subsidiaries on a consolidated basis. In any separately issued financial statements of a parent entity or consolidated subsidiaries and in the financial statements (whether separately issued or not) of unconsolidated subsidiaries and other investees accounted for by the equity method, the limitation shall be applied by reference to the total amount of interest cost (including interest on intra-entity borrowings) incurred by the separate entity.
Professional Research (Continued) (e) According to FASB ASC 835-20-50-1, An entity shall disclose the following information with respect to interest cost in the financial statements or related notes: a. For an accounting period in which no interest cost is capitalized, the amount of interest cost incurred and charged to expense during the period. b. For an accounting period in which some interest cost is capitalized, the total amount of interest cost incurred during the period and the amount thereof that has been capitalized. LO: 3, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Technology and Tools, AICPA PC: Communication
CHAPTER 10 Depreciation, Impairments, and Depletion Assignment Classification Table (By Topic) Topics
Questions
1. Depreciation methods; meaning of depreciation; choice of depreciation methods.
1, 2, 3, 4, 5, 6, 10, 14, 20,
2. Computation of depreciation.
7, 8, 9, 13
3. Depreciation base.
Brief Exercises
Exercises
Critical Thinking
Problems
1, 2, 3, 4, 5, 1, 2, 3 8, 14, 15, 16
1, 2, 3, 4, 5
1, 2, 3, 4
1, 2, 3, 4, 5, 6, 7,8 10, 15
1, 2, 3, 4, 8, 10, 11, 12
1, 2, 3, 5
6, 7
5
8, 14
1, 2, 8, 10
3
4. Errors; changes in estimate.
13
7
11, 12, 13, 14
3, 4
3
5. Depreciation of partial periods.
15
2, 3, 4
3, 4, 5, 6, 7, 15
1, 2, 3,4,5 10, 11
6. Group and Composite methods.
11, 12
6
9
7. Impairments..
16, 17, 18, 19
8, 9
16, 17, 18
9
8. Depletion.
21, 22, 23,
10
19, 20, 21, 22, 23
5, 6, 7
9. Ratio analysis.
24
11
24
*10. Tax depreciation (MACRS).
25
12
25, 26
*This material is covered in an Appendix to the chapter.
2
12
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
1.
Describe depreciation concepts and methods of depreciation.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 20
1, 2, 3, 4, 5, 6, 7
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15,
1, 2, 3, 4, 5, 7, 8, 10, 11, 12
2.
Identify the accounting issues related to asset impairment.
16, 17, 18, 19
8, 9
16, 17, 18
9
3.
Explain the accounting procedures for depletion of natural resources.
21, 22, 23,
10
19, 20, 21, 22, 23
5, 6, 7
4.
Demonstrate how to report and analyze property, plant, equipment, and natural resources.
24
11
24
*5.
Describe income tax methods of depreciation.
25
12
25, 26
12
Critical Thinking 1, 2, 3, 4, 5
Assignment Characteristics Table Level of Difficulty
Time (minutes)
Depreciation computations—SL, SYD, DDB. Depreciation—conceptual understanding. Depreciation computations—SYD, DDB—partial periods. Depreciation computations—five methods. Depreciation computations—four methods. Depreciation computations—five methods, partial periods. Different methods of depreciation. Depreciation computation—replacement, nonmonetary exchange. Composite depreciation. Depreciation computations, SYD. Depreciation—change in estimate. Depreciation computation—addition, change in estimate. Depreciation—replacement, change in estimate. Error analysis and depreciation, SL and SYD. Depreciation for fractional periods. Impairment. Impairment. Impairment. Depletion computations—timber. Depletion computations—oil. Depletion computations—timber. Depletion computations—mining. Depletion computations—minerals. Ratio analysis. Book vs. tax (MACRS) depreciation. Book vs. tax (MACRS) depreciation.
Simple Moderate Simple
15–20 20–25 15–20
Simple Simple Moderate
15–25 20–25 20–30
Simple Moderate
25–35 20–25
Simple Simple Simple Simple
15–20 10–15 10–15 20–25
Simple Moderate Moderate Simple Simple Simple Simple Simple Simple Simple Simple Moderate Moderate Moderate
15–20 20–25 25–35 10–15 15–20 15–20 15–20 10–15 15–20 15–20 15–20 15–20 20–25 15–20
Depreciation for partial period—SL, SYD, and DDB. Depreciation for partial periods—SL, ACT., SYD, and DDB. Depreciation—SYD, ACT., SL, and DDB. Depreciation and error analysis. Depletion and depreciation—mining. Depletion, timber, and unusual loss. Natural resources—timber. Comprehensive fixed asset problem. Impairment. Comprehensive depreciation computations.
Simple Simple
25–30 25–35
Moderate Complex Moderate Moderate Moderate Moderate Moderate Complex
40–50 45–60 25–30 25–30 25–35 25–35 15–25 45–60
Item
Description
E10.1 E10.2 E10.3 E10.4 E10.5 E10.6 E10.7 E10.8 E10.9 E10.10 E10.11 E10.12 E10.13 E10.14 E10.15 E10.16 E10.17 E10.18 E10.19 E10.20 E10.21 E10.22 E10.23 E10.24 *E10.25 *E10.26 P10.1 P10.2 P10.3 P10.4 P10.5 P10.6 P10.7 P10.8 P10.9 P10.10
Assignment Characteristics Table (Continued)
Level of Difficulty
Time (minutes)
Moderate
30–35
*P10.12
Depreciation for partial periods—SL, ACT., SYD, and DDB. Depreciation—SL, DDB, SYD, ACT., and MACRS.
Moderate
25–35
CT10.1 CT10.2 CT10.3 CT10.4 CT10.5
Depreciation basic concepts. Unit, group, and composite depreciation. Depreciation—strike, units-of-production, obsolescence. Depreciation concepts. Depreciation choice—ethics.
Moderate Simple Moderate Moderate Moderate
25–35 20–25 25–35 25–35 20–25
Item
Description
P10.11
Answers to Questions 1. The terms depreciation, depletion, and amortization all imply a cost allocation of different types of assets. Depreciation is employed to indicate that tangible plant assets have decreased in carrying value. Where natural resources (wasting assets) such as timber, oil, coal, and lead are involved, the term depletion is used. The expiration of intangible assets such as patents or copyrights is referred to as amortization. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
2. The factors relevant in determining the annual depreciation for a depreciable asset are the depreciation base (initial cost less estimated salvage value), estimated useful life, and depreciation method. Assets are typically recorded at their acquisition cost, which is in most cases objectively determinable. But cost assignment in other cases—“basket purchases” and the selection of an implicit interest rate in asset acquisitions under deferred payment plans—may be quite subjective, involving considerable judgment. The salvage value is the estimated amount that a company will receive when the asset is sold or when the asset is retired from service. The estimate is based on judgment and is affected by the length of the useful life of the asset. The useful life is also based on judgment. It involves selecting the “unit” of measure of service life and estimating the number of such units embodied in the asset based on the company’s experience with such assets. Such units may be measured in terms of time periods or terms of activity (for example, years or machine hours). When selecting the life, one should select the lower (shorter) of the physical life or the economic life. Physical life involves wear and tear and casualties; economic life involves such things as technological obsolescence and inadequacy. Selecting the depreciation method is generally a judgment decision, but a method may be inherent in the definition adopted for the units of service life, as discussed earlier. For example, if such units are machine hours, the method is a function of the number of machine hours used during each period. A method should be selected that will best measure the portion of services expiring each period. Once a method is selected, it may be objectively applied by using a predetermined, objectively derived formula. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
3. Disagree. Accounting depreciation is defined as the accounting process of allocating the cost of a tangible asset to expense in a systematic and rational manner to the periods expected to benefit from the use of the asset. Thus, depreciation is not a matter of valuation but a means of cost allocation. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
4. The carrying value of a fixed asset is its cost less accumulated depreciation. If the company estimates that the asset will have an unrealistically long life, the result will be to lower periodic depreciation charges and hence accumulated depreciation. As a result, the carrying value of the asset will be higher. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
5. A change in the amount of annual depreciation recorded does not change the facts about the decline in economic usefulness. It merely changes reported figures. Depreciation in accounting consists of allocating the cost of an asset over its useful life in a systematic and rational manner. Abnormal obsolescence, as suggested by the plant manager, would justify more rapid depreciation, but increasing the depreciation charge would not necessarily result in funds for replacement. It would not increase revenue but simply make reported income lower than it would have been, thus preventing the overstatement of net income.
Questions Chapter 10 (Continued) Recording depreciation on the books does not set aside any assets for the eventual replacement of the depreciated assets. Fund segregation can be accomplished but it requires additional managerial action. Unless an increase in depreciation is accompanied by an increase in the sales price of the product, or unless it affects management’s decision on dividend policy, it does not affect funds. Ordinarily higher depreciation will not lead to higher sales prices and thus to more rapid “recovery” of the cost of the asset, and the economic factors present would have permitted this higher price regardless of the excuse given or the particular rationalization used. The price could have been increased without a higher depreciation charge. The funds of a firm operating profitably do increase. The measure of the increase in cash from operations is not merely net income, but that figure plus non-cash expenses such as depreciation. The fact that net income alone does not measure the increase in funds from profitable operations leads some non-accountants to the erroneous conclusion that a fund is being created and that the amount of depreciation recorded affects the fund accumulation. Acceleration of depreciation for purposes of income tax calculation stands in a slightly different category since this is not merely a matter of recordkeeping. Increased depreciation will tend to postpone tax payments, and thus temporarily increase funds (although the liability for taxes may be the same or even greater in the long run than it would have been) and generate gain to the firm to the extent of the value of the use of the extra funds. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
6. Assets are retired for one of two reasons: physical factors or economic factors—or a combination of both. Physical factors are the wear and tear, decay, and casualty factors that hinder the asset from performing indefinitely. Economic factors can be interpreted to mean any other constraint that develops to hinder the service life of an asset. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
7. Before the amount of the depreciation charge can be computed, three basic questions must be answered: (1) What is the depreciation base to be used for the asset? (2) What is the asset’s useful life? (3) What method of cost apportionment is best for this asset? LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,, AICPA BC: None, AICPA AC: Measurement Anaysis and Interpretation, Reporting, AICPA PC: None
8. Cost Depreciation rate Depreciation for 2025 2025 Depreciation 2026 Depreciation Accumulated depreciation at December 31, 2026
$800,000 x .30* $240,000 $240,000 168,000
Cost Depreciation for 2025 Undepreciated cost in 2026 Depreciation rate Depreciation for 2026
$800,000 (240,000) 560,000 x .30* $168,000
$408,000 *[(1 ÷ 5 years) x 150%]
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 10 (Continued) 9. Depreciation base: Cost Salvage
$162,000 (15,000) $147,000
Straight-line, $147,000 ÷ 20 =
Units-of-output,
$147,000 x
Working hours,
$147,000 x
$ 7,350 20,000 = 84,000 14,300
$35,000
= 42,000 Sum-of-the-years-digits, $147,000 x 20/210* =
$50,050
Double-declining-balance, $162,000 x .10** =
$16,200
$14,000
**[(1 ÷ 20) x 2] LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
10. From a conceptual point of view, the method which best matches revenue and expenses should be used; in other words, the answer depends on how the service potential of the asset declines. If the service potential decline is faster in the earlier years, an accelerated method is more desirable. On the other hand, if the decline is more uniform with the passage of time, a straight-line approach should be used. If the service potential declines as a function of use, the activity method should be used. Some companies use accelerated methods for tax purposes but straight-line for book purposes because a higher net income figure is shown on the books in the earlier years, but a lower tax is paid to the government. Others attempt to use the same method for tax and accounting purposes because it eliminates some recordkeeping costs. Tax policy sometimes also plays a role. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
11. The composite method is appropriate for a company that owns a large number of heterogeneous plant assets and which would find it impractical to keep detailed records for them. The principal advantage is that the composite method simplifies the bookkeeping process and tends to average out errors caused by over-or under depreciation. As a result, gains or losses on disposals of assets do not distort periodic income. The principal disadvantage is that after a period of time, the book value of the plant assets may not reflect the proper carrying value of the assets. Since the Accumulated Depreciation account is debited or credited for the difference between the cost of the asset and the cash received from the retirement of the asset (i.e., no gain or loss on disposal is recognized), the account is self-correcting over time. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
12. Cash ................................................................................................... Accumulated Depreciation—Plant Assets ........................................... Plant Assets.......................................................................
14,000 36,000
No gain or loss is recognized under the composite method. LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
13. Original estimate: $2,500,000 ÷ 50 = $50,000 per year Depreciation to January 1, 2026: $50,000 x 14 = $700,000 Depreciation in 2026 ($2,500,000 – $700,000) ÷ 15 = $120,000 LO: 1, Bloom:APK, Difficulty: Simple, Time: 3-5, AACSBAnalytic,, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
50,000
Questions Chapter 10 (Continued) 14. No, depreciation does not provide cash; revenues do. The funds for the replacement of the assets come from the revenues; without the revenues, no income materializes, and no cash inflow results. A separate decision must be made by management to set aside cash to accumulate asset replacement funds. Depreciation is added to net income on the statement of cash flows (indirect method) because it is a noncash expense, not because it is a cash inflow. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
15. 1.0 ÷ 4 years = 25% straight-line rate x 2 = 50%* double-declining rate $8,000 x 50%* = $4,000 depreciation for first full year. $4,000 x 6/12 = $2,000 depreciation for half a year (first year), 2025. $6,000 ($8,000-$2,000) x 50%* = $3,000 depreciation for 2026. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
16. The accounting standards require that if events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, then the carrying amount of the asset should be assessed. The assessment or review takes the form of a recoverability test that compares the sum of the expected future cash flows from the asset (undiscounted) to the carrying amount. If the cash flows are less than the carrying amount, the asset has been impaired. The impairment loss is measured as the amount by which the carrying amount exceeds the fair value of the asset. The fair value of assets is measured by their market value if an active market for them exists. If no market price is available, the present value of the expected future net cash flows from the asset may be used. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
17. No. Under U.S. GAAP, impairment losses on assets held for use may not be restored. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
18. An impairment is deemed to have occurred if, in applying the recoverability test, the carrying amount of the asset exceeds the expected future net cash flows from the asset. In this case, the expected future net cash flows of $705,000 exceed the carrying amount of the equipment of $700,000, so no impairment is assumed to have occurred; thus, no measurement of the loss is made or recognized even though the fair value is $590,000. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
19. Impairment losses are reported as part of income from continuing operations, generally in the “Other expenses and losses” section. Impairment losses (and recovery of losses for assets to be disposed of) are similar to other costs that would flow through operations. Thus, gains (recoveries of losses) on assets to be disposed of should be reported as part of income from continuing operations in the “Other revenues and gains” section. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
20. In a decision to replace or not to replace an asset, the undepreciated cost of the old asset is not a factor to be considered. Therefore, the decision to replace plant assets should not be affected by the amount of depreciation that has been recorded. The relative efficiency of new equipment as compared with that presently in use, the cost of the new facilities, the availability of capital for the new asset, etc., are the factors entering into the decision. Normally, the fact that the asset had been fully depreciated through the use of some accelerated depreciation method, although the asset was still in use, should not cause management to decide to replace the asset. If the new asset under consideration for replacement was not any more efficient than the old, or if it cost a good deal more in relation to its efficiency, it is illogical for management to replace it merely because all or the major portion of the cost had been charged off for tax and accounting purposes.
Questions Chapter 10 (Continued) If depreciation rates were higher, it might be true that a business would be financially more able to replace assets, since during the earlier years of the asset’s use a larger portion of its cost would have been charged to expense, and hence during this period a smaller amount of income tax paid. By selling the old asset, which might result in a capital gain, and purchasing a new asset, the higher depreciation charge might be continued for tax purposes. However, if the asset were traded in, having taken higher depreciation would result in a lower basis for the new asset. It should be noted that expansion (not merely replacement) might be encouraged by increased depreciation rates. Management might be encouraged to expand, believing that in the first few years when they are reasonably sure that the expanded facilities will be profitable, they can charge off a substantial portion of the cost as depreciation for tax purposes. Similarly, since a replacement involves additional capital outlays, the tax treatment may have some influence. Also, because of the inducement to expand or to start new businesses, there may be a tendency in the economy as a whole for the accounting and tax treatment of the cost of plant assets to influence the retirement of old plant assets. It should be noted that increased depreciation may cause management to alter its decision about replacement. LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-10, AACSB: knowledge,Communication, Reflective Thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
21. (a) Depreciation and depletion are similar accounting concepts in that: 1. The cost of the asset is the starting point from which computation of the amount of the periodic charge to operations is made. 2. The estimated life is based on the asset’s economic or productive life. 3. The accumulated total of past charges to operations is deducted from the original cost of the asset on the balance sheet. 4. When output methods of computing depreciation charges are used, the formulas are essentially the same as those used in computing depletion charges. 5. Both represent an apportionment of the cost under the process of matching costs with revenue. 6. Assets subject to either are reported in the same classification on the balance sheet. 7. Salvage value is properly recognized in computing the charge to operations. 8. Depreciation and depletion may be included in inventory if the related asset contributed to the production of the inventory. 9. The rates may be changed upon revision of the estimated productive life used in the original rate computations. (b) Depreciation and cost depletion are dissimilar accounting concepts in that: 1. Depletion is almost always based on output while depreciation is usually based on time. 2. Many formulas are used in computing depreciation but only one is used to any extent in computing depletion. 3. Depletion applies to natural resources while depreciation applies to plant and equipment.
Questions Chapter 10 (Continued) 4. Depletion refers to the physical exhaustion or consumption of the asset while depreciation refers to the wear, tear, and obsolescence of the asset. 5. The computation of the depletion rate is usually much less precise than the computation of depreciation rates because of the greater uncertainty in estimating the productive life. LO: 3, Bloom: C, Difficulty: Simple, Time: 5-10, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
22. This practice can be justified for companies that expect to extract natural resources and not purchase additional properties. In effect, such companies are distributing gradually to stockholders their original investments by paying a liquidating dividend. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
23. Using full-cost accounting, the cost of unsuccessful ventures, as well as those that are successful, is capitalized, because the cost of drilling a dry hole is a cost that is needed to find the commercially profitable wells. Successful efforts accounting capitalizes only those costs related to successful projects. They contend that to measure cost and effort accurately for a single property unit, the only measure is in terms of the cost directly related to that unit. In addition, it is argued that full-cost is misleading because capitalizing all costs will make an unsuccessful company over a short period of time show no less income than does a successful one. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
24. Asset turnover: $77,130 = 1.83 times $42,035 Return on assets: $3,281 = 7.81% $42,035 LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*25. The modified accelerated cost recovery system (MACRS) has been adopted by the Internal Revenue Service. It applies to depreciable assets acquired in 1987 and later. MACRS eliminates the need to determine each asset’s useful life. The selection of a depreciation method and a salvage value is also unnecessary under MACRS. The taxpayer determines the recovery deduction for an asset by applying a statutory percentage to the historical cost of the property. MACRS was adopted to permit a faster write-off of tangible assets to provide additional tax incentives and to simplify the depreciation process. The simplification should end disputes related to estimated useful life and salvage value. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: knowledge,Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 10.1 2025:
($50,000 – $2,000) x 23,000 160,000
= $6,900
2026:
($50,000 – $2,000) x 31,000 160,000
= $9,300
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.2 (a)
$80,000 – $8,000 8
= $9,000
(b)
$80,000 – $8,000 8
x 4/12 = $3,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.3 (a)
($80,000 – $8,000) x 8/36* = $16,000
(b)
[($80,000 – $8,000) x 8/36] X 9/12 = $12,000 *[8(8 + 1)] ÷ 2
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.4 (a)
$80,000 x .25* = $20,000
(b)
($80,000 x .25) x 3/12 = $5,000 *(1/8 x 2)
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.5
Depreciable Base = ($28,000 + $200 + $125 + $500 + $475) – $3,000 = $26,300. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.6 Asset A B C
Depreciation Expense ($70,000 – $7,000)/10 = $ 6,300 ($50,000 – $5,000)/5 = 9,000 ($82,000 – $4,000)/12 = 6,500 $202,000 $21,800
Composite rate = $21,800/$202,000 = 10.8% Composite life = $186,000*/$21,800 = 8.5 years *($63,000 + $45,000 + $78,000) LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.7 Annual depreciation expense: ($8,000 – $1,000)/5 = $1,400 Book value, 1/1/26: $8,000 – (2 x $1,400) = $5,200* Depreciation expense, 2026: ($5,200* – $500)/2 = $2,350 LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.8 Recoverability test: Future net cash flows ($550,000) > Carrying amount ($520,000*); therefore, the asset is not impaired and no impairment loss will be recorded. *($900,000 - $380,000) LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.9 Recoverability test: Future net cash flows ($500,000) < Carrying amount ($520,000*); therefore, the asset has been impaired. Journal entry: Loss on Impairment ..................................................................... Accumulated Depreciation— Equipment ($520,000 – $400,000) ......... *($900,000 - $380,000)
120,000 120,000
LO: 2 Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.10 Inventory............................................................... Coal Mine..................................................... ($400,000 + $100,000 + $80,000 – $160,000) 4,000
73,500** 73,500 = $105* per ton
700 x $105* = $73,500** LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 10.11 (a) Asset turnover: $8,691 = .6811 times ($13,148 + $12,372) 2 (b)
Profit margin on sales: $1,628 = 18.73% $8,691
(c)
Return on assets: 1.
.6811 x .1873 = 12.76%
2.
$1,628 ($13,148 + $12,372) 2
= 12.76%
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 10.12 2025: 2026: 2027: 2028: 2029: 2030:
$50,000 x 20% $50,000 x 32% $50,000 x 19.2% $50,000 x 11.52% $50,000 x 11.52% $50,000 x 5.76%
= = = = = =
$10,000 16,000 9,600 5,760 5,760 2,880 $50,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 10.1 (a)
Straight-line method depreciation for each of Years 1 through 3 = ($469,000 – $40,000) = $35,750 12
(b)
Sum-of-the-Years’-Digits =
(c)
[12 x (12 +1)] 2
= 78
12/78 x ($469,000 – $40,000) = $66,000
depreciation Year 1
11/78 x ($469,000 – $40,000) = $60,500
depreciation Year 2
10/78 x ($469,000 – $40,000) = $55,000
depreciation Year 3
Double-Declining-Balance method = (depreciation rate)
1.0 12
x 2 = 16.67%
$469,000 x .1667 =
$78,182 depreciation Year 1
($469,000 – $78,182) x .1667 =
$65,149 depreciation Year 2
($469,000 – $78,182 – $65,149) X .1667 =
$54,289 depreciation Year 3
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.2 (a)
If there is any salvage value and the amount is unknown (as is the case here), the cost would have to be determined by looking at the data for the double-declining balance method. 100% 5
= 20% Straight-line rate; 20% x 2 = 40% Double-decliningbalance rate
Cost x 40% = $20,000 $20,000 ÷ .40 = $50,000 Cost of asset (b)
$50,000 cost [from (a)] – $45,000 total depreciation = $5,000 salvage value.
Exercise 10.2 (Continued) (c)
The highest charge to income for Year 1 will be yielded by the doubledeclining-balance method, with depreciation expense of $20,000.
(d)
The highest charge to income for Year 4 will be yielded by the straightline method with depreciation expense of $9,000.
(e)
The method that produces the highest book value at the end of Year 3 would be the method that yields the lowest accumulated depreciation at the end of Year 3, which is the straight-line method. Computations: SL = $50,000 – ($9,000 + $9,000 + $9,000) = $23,000 book value, end of Year 3. SYD = $50,000 – ($15,000 + $12,000 + $9,000) = $14,000 book value, end of Year 3. DDB = $50,000 – ($20,000 + $12,000 + $7,200) = $10,800 book value, end of Year 3.
(f)
The method that will yield the highest gain (or lowest loss) if the asset is sold at the end of Year 3 is the method which will yield the lowest book value at the end of Year 3, which is the double-declining-balance method in this case.
LO: 1, Bloom: AP, Difficulty: Hard, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.3 (a)
[20x (20 + 1)] 2
= 210
9/12 x 20/210 x ($711,000 – $60,000) = $46,500 for 2025
+
3/12 x 20/210 x ($711,000 – $60,000) 9/12 x 19/210 x ($711,000 – $60,000)
= =
$15,500 44,175 $59,675 for 2026
Exercise 10.3 (Continued) (b)
1.0 20
= 5% Straight-line rate; .05 x 2 = 10% DDB rate
9/12 x .10 x $711,000 = $53,325 for 2025 .10 x ($711,000 – $53,325) = $65,768 for 2026 LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.4 (a)
$315,000 – $15,000 = $300,000 Depreciable base; $300,000 ÷ 10 yrs. = $30,000
(b)
$300,000 ÷ 240,000 units = $1.25; 25,500 units x $1.25 = $31,875
(c)
$300,000 ÷ 25,000 hours = $12.00 per hr.; 2,650 hrs. x $12.00 = 31,800 n(n + 1) 2
(d)
(e)
10 x $300,000 x 4/12 = 55
$18,182
9 x $300,000 x 8/12 = 55
32,727
Total for 2026
$50,909
=
[10(10 + 1)] = 55 2
$315,000 x .20* x 4/12 =
$21,000
[$315,000 – ($315,000 x .20)] x .20 x 8/12 =
33,600
Total for 2026
$54,600
[May also be computed as .20 x [$315,000 – (8/12 x .20 x 315,000)] *[(1.0 ÷ 10) x 2] = 20% Double-declining-balance rate LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.5 (a)
($117,900 – $12,900) = $21,000/yr. = $21,000 x 5/12 = $8,750 5 2025 Depreciation—Straight-line = $8,750
(b)
($117,900 – $12,900) = $5.00/hr. 21,000 2025 Depreciation—Machine Usage = 800 x $5.00 = $4,000
(c)
Machine Year Total 1 5/15 x $105,000* = $35,000 2 4/15 x $105,000 = $28,000
Allocated to 2025 2026 $14,583** $20,417*** ______ 11,667**** $14,583 $32,084
[5 x (5 + 1)] / 2 * $117,900 − $12,900 ** $35,000 x 5/12 = $14,583 *** $35,000 x 7/12 = $20,417 **** $28,000 x 5/12 = $11,667 2026 Depreciation—Sum-of-the-Years-Digits = $32,084 (d)
2025 .40 x ($117,900) x 5/12 = $19,650 2026 .40 x ($117,900 – $19,650) = $39,300 OR (1.0 ÷ 5 years) x 2 = DDB rate of 40% 1st full year (.40 x $117,900) = $47,160 2nd full year [.40 x ($117,900 – $47,160)] = $28,296 2025 Depreciation = 5/12 x $47,160 =
$19,650
2026 Depreciation = 7/12 x $47,160 = 5/12 x $28,296 =
$27,510 11,790 $39,300
LO: 1, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.6
(a)
2025 Straight-line
$212,000 – $12,000 = $25,000/year 8
3 months—depreciation $6,250 = ($25,000 x 3/12) (b)
2025 Output
$212,000 – $12,000 = $5.00/output unit 40,000
1,000 units x $5.00 = $5,000 (c)
2025 Working hours
$212,000 – $12,000 20,000
= $10.00/hour
525 hours x $10.00 = $5,250 n (n + 1) 2
(d)
Sum-of-the-years-digits Year 1 8/36 x $200,000 = 2 7/36 x $200,000 = 3 6/36 x $200,000 =
Total $44,444 $38,889 $33,333
2025 $11,111a _______ $11,111
=
8(9) 2
Allocated to 2026 $33,333b 9,722c _______ $43,055
= 36
2027 $29,167d 8,333e $37,500
2027: $37,500 = (9/12 of 2nd year of machine’s life plus 3/12 of 3rd year of machine’s life) a
$44,444 x 3/12 $44,444 x 9/12 c $38,889 x 3/12 d $38,889 x 9/12 e $33,333 x 3/12 b
(e)
Double-declining-balance rate: 1.0/8 x 2 = 25%. 2025: .25 x $212,000 x 3/12 = $13,250 2026: .25 x ($212,000 – $13,250) = $49,688
Exercise 10.6 (Continued) OR 1 full year (.25 x $212,000) = $53,000 st
2nd full year [.25 x ($212,000 – $53,000)] = $39,750 2025 Depreciation 3/12 x $53,000 = $13,250 2026 Depreciation 9/12 x $53,000 = $39,750 3/12 x $39,750 = 9,938 $49,688 LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.7 (a)
Methods of Depreciation
Description
A B C D
Date Purchased
Cost
2/12/25 $142,500 8/15/24 (c) 79,000 7/21/23 75,400 (g) 10/15/25 219,000
Accum. Depr. to 12/31/26
Salvage Value
Usef ul Life
Method
$16,000 21,000 23,500 69,000
10 5 8 5
(a) SYD $33,350 SL 29,000 DDB (e) 47,567 SYD 70,000
Machine A—Testing the methods Straight-Line for 2025
2027 Depr.
(b) $19,550 (d) 11,600 (f) 4,333 (h) 35,000
$ 6,325 [($142,500 – $16,000) ÷ 10] x 1/2
Straight-Line for 2026 Total Straight Line
$12,650 $18,975
Double-Declining-Balance for 2025 Double-Declining-Balance for 2026 Total Double-DecliningBalance
$14,250 ($142,500 x .2 (1/5 years) x 1/2) $25,650 [($142,500 – $14,250) x .20] $39,900
Sum-of-the-Years-Digits for 2025 Sum-of-the-Years-Digits for 2026
$11,500 [($142,500 – $16,000) x 10/55 x 1/2] $21,850 ($126,500 X 10/55 x 1/2) + ($126,500 x 9/55 x 1/2)
Total Sum-of-the-Years-Digits (b) Method used must be Using SYD, 2027 Depreciation is Exercise 10.7 (Continued)
$33,350 SYD $19,550
($126,500 x 9/55 x 1/2) + ($126,500 x 8/55 x 1/2)
(c) Machine B—Computation of the cost Asset has been depreciated for 2 1/2 years using the straight-line method. Annual depreciation is then equal to $29,000 divided by 2.5 or $11,600. 11,600 times 5 plus the salvage value is equal to the cost. Cost is $79,000 [($11,600 x 5) + $21,000]. (d) Using SL, 2025 Depreciation is $11,600 [($79,000 – $21,000)/ 5 years]. (e) Machine C—Using the double-declining-balance method of depreciation 2023’s depreciation is $ 9,425 ($75,400 x .25 x 1/2) 2024’s depreciation is 16,494 ($75,400 – $9,425) x .25 2025’s depreciation is 12,370 ($75,400 – $25,919) X .25 2026’s depreciation is 9,278 ($75,400 – $38,289) x .25 $47,567 (f) Using DDB, 2027 Depreciation is $4,333 ($75,400 – $47,567 – $23,500) (g) Machine D—Computation of Year Purchased 2025 - First Half Year using SYD = $25,000 [($219,000 – $69,000) X 2026 - Second Year using SYD =
5/15 x 1/2] $45,000 ($150,000 x 5/15 x 1/2) + ($150,000 X 4/15 x 1/2)
$70,000 Thus, the asset must have been purchased on October 15, 2025 (h) Using SYD, 2027 Depreciation is $35,000
($150,000 x 4/15 x .5) + ($150,000 x 3/15 x .5)
LO: 1, Bloom: AP, Difficulty: Hard, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.8 Old Machine June 1, 2023
Purchase Freight Installation Total cost
$31,000 200 500 $31,700*
Annual straight-line depreciation charge: ($31,700* – $2,500) ÷ 10 = $2,920** On June 1, 2024, debit the old machine for $1,980; the revised total cost is $33,680 ($31,700* + $1,980); thus, the revised annual depreciation charge is: ($33,680 – $2,500 – $2,920**) ÷ 9 = $3,140***. Book value, old machine, June 1, 2027: [$33,680 – $2,920** – ($3,140*** x 3)] = Less: Fair value Loss on exchange Cost of removal Total loss
$21,340 20,000a 1,340 75 $ 1,415
(Note to instructor: The above computation is done to determine whether there is a gain or loss from the exchange of the old machine with the new machine and to show how the cost of removal might be reported. Also, if a gain occurs, the gain is not deferred (1) because the exchange has commercial substance and (2) the cost paid exceeds 25% of the total value of the property received.) New Machine Basis of new machine Cash paid ($35,000 – $20,000) Fair value of old machine Installation cost Total cost of new machine
$15,000 20,000 1,500 $36,500
Depreciation for the year beginning June 1, 2027 = ($36,500 – $4,000) ÷ 10 = $3,250. LO: 1, Bloom: AP, Difficulty: Hard, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.9 (a) Asset A B C D E
Cost $ 40,500 33,600 36,000 19,000 23,500 $152,600
Estimated Salvage $ 5,500 4,800 3,600 1,500 2,500 $17,900
Depreciable Cost $ 35,000 28,800 32,400 17,500 21,000 $134,700
Estimated Depreciation Life per Year 10 $ 3,500 9 3,200 9 3,600 7 2,500 6 3,500 $16,300
Composite life = $134,700 ÷ $16,300, or 8.26 years Composite rate = $16,300 ÷ $152,600, or approximately 10.7% (b)
(c)
Depreciation Expense ....................................... Accumulated Depreciation—Plant Assets ....................................................
16,300
Cash ................................................................... Accumulated Depreciation—Plant Assets ....... Plant Assets ..............................................
4,800 14,200
16,300
19,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.10 Sum-of-the-years’-digits =
8 x (8 + 1) 2
= 36
Using Y to stand for the years of remaining life: Y/36 x ($430,000 – $70,000) = $60,000 Multiplying both sides by 36: $360,000 x Y = $2,160,000 Y = $2,160,000 ÷ $360,000 Y=6 The year in which there are six remaining years of life at the beginning of that given year is 2024. [(8 – 6) = 2]; (2 + 2022 = 2024). LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.11 (a)
No correcting entry is necessary because changes in estimate are handled in the current and prospective periods.
(b)
Revised annual charge Book value as of 1/1/2026 [$60,000 – ($7,000* x 5)] = $25,000 Remaining useful life, 5 years (10 years – 5 years) Revised salvage value, $4,500 ($25,000 – $4,500) ÷ 5 = $4,100 revised annual depreciation *($60,000 - $4,000) / 8 years = $7,000 annual depreciation (2021-2026) Depreciation Expense ......................................... Accumulated Depreciation—Machinery....
4,100 4,100
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.12 (a)
1999–2008—($2,000,000 – $60,000) ÷ 40 = $48,500/yr.
(b)
2009–2026—Building ($2,000,000 – $60,000) ÷ 40 = Addition ($500,000 – $20,000) ÷ 30 =
(c)
No entry is required.
(d)
Revised annual depreciation Building Book value ($2,000,000 – $1,358,000*) Salvage value Depreciable base Remaining useful life Annual depreciation *$48,500 x 28 years = $1,358,000
$48,500/yr. 16,000/yr. $64,500/yr.
$642,000 60,000 582,000 ÷ 32 years $ 18,188
Exercise 10.12 (Continued) Addition Book value: ($500,000 – $288,000**) Less: Salvage value Depreciable base Remaining useful life Annual depreciation
$ 212,000 20,000 192,000 ÷ 32 years $ 6,000
**$16,000 x 18 years = $288,000 Annual depreciation expense—building ($18,188 + $6,000)
$24,188
LO: 1, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.13 (a)
$2,200,000 ÷ 40 = $55,000
(b)
Loss on Disposal of Plant Assets ($160,000 $80,000) .................................................................. Accumulated Depreciation—Buildings ($160,000 x 20 years /40 years) .............................................. Buildings ....................................................... Buildings ................................................................ Cash ..............................................................
80,000 80,000 160,000 300,000 300,000
Note: The most appropriate entry would be to remove the old roof and record a loss on disposal, because the cost of the old roof is given. Another alternative would be to debit Accumulated Depreciation— Buildings on the theory that the replacement extends the useful life of the building. The entry would be as follows: Accumulated Depreciation—Buildings ............ Cash ..........................................................
300,000 300,000
As indicated, this approach does not seem as appropriate as the first approach.
Exercise 10.13 (Continued) (c)
No entry necessary.
(d)
(Assume the cost of the old roof is removed) Buildings ($2,200,000 – $160,000 + $300,000) Less: Accumulated Depreciation [($55,000 x 20) – $80,000)] Depreciable base Remaining useful life Depreciation—2026 OR (Assume the cost of the new roof is debited to Accumulated Depreciation—Building) Book value of the building prior to the replacement of roof [$2,200,000 – ($55,000 x 20)] Cost of new roof Depreciable base Remaining useful life Depreciation—2026 ($1,400,000 ÷ 25)
$2,340,000 1,020,000 1,320,000 ÷ 25 years $ 52,800
$1,100,000 300,000 1,400,000 ÷ 25 years $ 56,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.14 (a)
(b)
Maintenance and Repairs Expense .................. Equipment .................................................
500
The proper ending balance in the asset account is: January 1 balance Add: New equipment: Purchases $32,000 Freight 700 Installation 2,700 Less: Cost of equipment sold December 31 balance (1) Straight-line: $147,150 ÷ 10 = $14,715
500
$134,750
35,400 23,000 $147,150
Exercise 10.14 (Continued) (2) Sum-of-the-years-digits: (10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1) = 55 OR
n(n + 1) 2
10(10 + 1) 2
=
= 55*
For equipment purchased in 2024: $111,750 ($134,750 – $23,000) of the cost of equipment purchased in 2024, is still on hand. 8/55 x $111,750 = $16,255 For equipment purchased in 2026: 10/55* x $35,400 = 6,436 Total $22,691 LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.15 (a)
2021–2026 Incl.
2020 (1) $192,000 – $16,800 = $175,200 $175,200 ÷ 12 = $14,600 per yr. ($40 per day) 133*/365 x $14,600 = 2021–2026:(6 x $14,600) **68/365 x $14,600 = (2) (3) (4) (5) 4/12 x $14,600 2021–2026 3/12 x $14,600 (6) *(11 + 30 + 31 + 30 + 31)
(b)
2027
Total
$ 2,720 14,600 0 7,300
$ 95,640 102,200 102,200 102,200
3,650 0
96,117 87,600
$ 5,320 $87,600 0 14,600 7,300 4,867
87,600 87,600 87,600 87,600
0
87,600
**(31 + 28 + 9)
The most accurate allocations of cost are given by methods 1 and 5 if it is assumed that straight-line is satisfactory. Reasonable accuracy is normally given by methods 2, 3, or 4. The simplest of the applications are 6, 2, 3, 4, 5, and 1, in about that order. Methods 2, 3, and 4 combine reasonable accuracy with the simplicity of application.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.16 (a)
December 31, 2025 Loss on Impairment ........................................... Accumulated Depreciation—Equipment . Cost Less: Accumulated depreciation Carrying amount Less: Fair value Loss on impairment
3,200,000* 3,200,000
$9,000,000 1,000,000 8,000,000 4,800,000 $3,200,000*
Note: Expected undiscounted future net cash flows ($7,000,000) < carrying value ($8,000,000).
(b)
December 31, 2026 Depreciation Expense ....................................... Accumulated Depreciation—Equipment . New carrying amount Useful life Depreciation per year
(c)
1,200,000 1,200,000
$4,800,000 ÷ 4 years $1,200,000
No entry necessary. Restoration of any impairment loss is not permitted for assets in use.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.17 (a)
Loss on Impairment ........................................... Accumulated Depreciation—Equipment . Cost Accumulated depreciation Carrying amount Less: Fair value Plus: Cost of disposal Loss on impairment
3,220,000 3,220,000
$9,000,000 1,000,000 8,000,000 4,800,000 20,000 $3,220,000
Note: Expected undiscounted future net cash flows ($7,000,000) < carrying value ($8,000,000).
Exercise 10.17 (Continued) (b)
No entry necessary. Depreciation is not taken on assets intended to be sold.
(c)
Accumulated Depreciation—Equipment ......... Recovery of Loss from Impairment ........ Fair value Less: Cost of disposal Less: Carrying amount Recovery of loss on impairment
500,000 500,000 $5,300,000 20,000 $5,280,000 4,780,000 $ 500,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.18 (a)
December 31, 2025 Loss on Impairment........................................... Accumulated Depreciation—Equipment.
270,000* 270,000
*[($900,000 - $400,000) - $230,000]
(b)
It may be reported in the Other expenses and losses section or it may be highlighted as an unusual item in a separate section.
(c)
No entry necessary. Restoration of any impairment loss is not permitted for assets in service.
(d)
Management first had to determine whether there was an impairment. To evaluate this step, management does a recoverability test. The recoverability test estimates the future cash flows expected from use of that asset and its eventual disposition. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the asset is impaired. If the recoverability test indicates that an impairment has occurred, a loss is computed. The impairment loss is the amount by which the carrying amount of the asset exceeds its fair value.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.19 (a)
Depreciation Expense:
$84,000 = $2,800 per year 30 years
Cost of Timber Sold: $1,400 – $400 = $1,000 $1,000 x 9,000 acres = $9,000,000 of value of timber ($9,000,000 ÷ 3,500,000 bd. ft.) x 700,000 bd. ft. = $1,800,000 (b)
Cost of Timber Sold: $9,000,000 – $1,800,000 = $7,200,000 $7,200,000 + $100,000 = $7,300,000 ($7,300,000 ÷ 5,000,000 bd. ft.) x 900,000 bd. ft. = $1,314,000
Note: The spraying costs as well as the costs to maintain the fire lanes and roads are expensed each period and are not part of the depletion base. LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.20 Cost per barrel of oil: Initial payment =
Rental =
$500,000 250,000
=
$31,500 = 18,000
1.75
Premium = 5% of $55 =
Reconditioning of land = Total cost per barrel
$2.00
2.75 $30,000 = 250,000
.12 $6.62
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.21 (a)
$1,300 – $300 = $1,000 per acre for timber $1,000 x 7,000 acres x 850,000 bd. ft. = 8,000 bd. ft. x 7,000 acres $7,000,000 56,000,000 bd. ft.
(b) (c)
x 850,000 bd. ft. = $106,250.
$78,400 x 850,000 bd. ft. = $1,190. 56,000,000 bd. ft. Forda should capitalize the cost of $70,000 ($20 x 3,500 trees) and adjust the depletion the next time the timber is harvested.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.22 Depletion base: $1,190,000 + $90,000 – $100,000 + $200,000 = $1,380,000 Depletion rate: $1,380,000 ÷ 60,000 = $23/ton* (a) (b) (c)
Per unit material cost: $23/ton 12/31/25 inventory: $23 x (30,000 tons – 22,000 tons) = $184,000 Cost of goods sold 2025: $23 x 22,000 tons = $506,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.23 (a)
($970,000 + $170,000 + $40,000* – $100,000) 12,000,000
= $.09 depletion per unit
*Note to instructor: The $40,000 should be depleted because it is an asset retirement obligation. 2,500,000 units extracted x $.09 = $225,000 depletion for 2025 (b)
2,100,000 units sold x $.09 = $189,000 charged to cost of goods sold for 2025
LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 10.24 (a)
Asset turnover: $515.6 ($930.9 + $920.1) 2
(b)
= .557 times
Return on assets: $80.7 ($930.9 + $920.1) 2
= 8.72%
(c)
Profit margin on sales: $80.7 = 15.65% $515.6
(d)
The asset turnover times the profit margin on sales provides the rate of return on assets computed for Tootsie Roll as follows: Profit margin on sales x 15.65%
Asset Turnover .557
=
Return on Assets 8.72%
Note the answer 8.72% is the same as the rate of return on assets computed in (b) above. LO: 4, Bloom: AP, Difficulty: Easy, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 10.25
(a)
(b)
Revenues Operating expenses (excluding depreciation) Depreciation [($27,000 – $6,000) ÷ 7] Income before income taxes
2025 $200,000 130,000 3,000 $ 67,000
2026 $200,000 130,000 3,000 $ 67,000
Revenues Operating expenses (excluding depreciation) Depreciation* Taxable income
2025 $200,000 130,000 5,400 $ 64,600
2026 $200,000 130,000 8,640 $ 61,360
*2025 2026
$27,000 x .20 = $5,400 $27,000 x .32 = $8,640
(c)
Book purposes ($27,000 – $6,000) $21,000 Tax purposes (entire cost of asset) $27,000
(d)
Differences will occur for the following reasons: 1. Different depreciation methods. 2. Half-year convention used for tax purposes. 3. Different estimated useful life and tax life. 4. Tax system ignores salvage value.
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 10.26 (a)
(b)
(1)
($31,000 – $1,000) x 1/10 x 10/12 = $2,500 depreciation expense for book purposes.
(2)
$31,000 x 1/5 x 1/2 = $3,100 depreciation for tax purposes.
(1)
$31,000 x .20* x 10/12 = $5,167 depreciation expense for book purposes. *(1 / 10 years x 2 = DDB rate)
(2)
$31,000 x .20 x 1/2 = $3,100 depreciation expense for tax purposes.
*Exercise 10.26 (Continued) (c)
Differences will occur for the following reasons: 1. Half-year convention used for tax purposes. 2. Different estimated useful life and tax life. 3. Tax system ignores salvage value.
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Time and Purpose of Problems Problem 10.1 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using different depreciation methods. The problem is complicated because the proper cost of the machine to be depreciated must be determined. For example, purchase discounts and freight charges must be considered. In addition, the student is asked to select a depreciation method that will allocate less depreciation in the early years of the machine’s life than in the later years. Problem 10.2 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using the following methods: straight-line, units-of-output, working hours, sum-of-the-years’-digits, and declining- balance. The problem is straightforward and provides an excellent review of the basic computational issues involving depreciation methods. Problem 10.3 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using different depreciation methods. Before the proper depreciation expense can be computed, the accounts must be corrected for a number of errors made by in its accounting for the assets. An excellent problem for reviewing the proper accounting for the company plant assets and related depreciation expense. Problem 10.4 (Time 45–60 minutes) Purpose—to provide the student with an opportunity to correct the improper accounting for semi-trucks and determine the proper depreciation expense. The student is required to compute separately the errors arising in determining or entering depreciation or in recording transactions affecting semi-trucks. Problem 10.5 (Time 25–30 minutes) Purpose—to provide the student with a problem involving the computation of estimated depletion and depreciation costs associated with a tract of mineral land. The student must compute depletion and depreciation on a units-of-production basis (tons mined). A portion of the cost of machinery associated with the product must be allocated over different periods. The student may experience some difficulty with this problem. Problem 10.6 (Time 25–30 minutes) Purpose—to provide the student with a problem involving the proper accounting for depletion cost. This problem involves timberland for which a depletion charge must be computed. In addition, a computation of a loss that occurs because of volcanic activity must be determined. Problem 10.7 (Time 25–35 minutes) Purpose—to provide the student with a problem involving depletion and depreciation computations.
Time and Purpose of Problems (Continued) Problem 10.8 (Time 25–35 minutes) Purpose—to provide the student with a comprehensive problem related to property, plant, and equipment. The student must determine depreciable bases for assets, including capitalized interest, and calculate depreciation expense using various methods of depreciation. Problem 10.9 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to analyze impairments for assets to be used and assets to be disposed of. Problem 10.10 (Time 45–60 minutes) Purpose—to provide the student with an opportunity to solve a complex problem involving a series of plant assets. A number of depreciation computations must be made, specifically straight-line, 150% declining balance, and sum-of-the-years’-digits. In addition, the cost of assets acquired is difficult to determine. Problem 10.11 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to solve a moderate problem involving a machinery purchase and the depreciation computations using straight-line, activity, sum-of-the-years’-digits, and the double-declining-balance methods, first for full periods and then for partial periods. *Problem 10.12 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using different depreciation methods. The purpose of computing the depreciation expense is to determine which method will result in the maximization of net income and which will result in the minimization of net income over a three-year period. An excellent problem for reviewing the fundamentals of depreciation accounting.
Solutions to Problems Problem 10.1 (a)
1.
Depreciation Base Computation: Purchase price ............................... Less: Purchase discount (2%) ...... Plus: Freight-in .............................. Installation ............................ Less: Salvage value ...................... Depreciation base ..........................
$85,000 1,700 800 3,800 87,900 1,500 $86,400
2025—Straight line: ($86,400 ÷ 8 years) x 8/12 year = $7,200 2.
Sum-of-the-years-digits for 2026 Total Machine Year Depreciation 1 8/36 x $86,400 = $19,200 2 7/36 x $86,400 = $16,800
2025 $12,800*
* $19,200 x 8/12 (May – December) = $12,800 ** $19,200 x 4/12 (January – April) = $ 6,400 *** $16,800 x 8/12 (May – December) = $11,200 3.
Double-declining-balance for 2025 [$87,900 x .25* x 8/12 (May – December)] = $14,650 * (1.0 ÷ 8) x 2 = 25%
(b)
An activity method should be recommended.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement, Reporting, AICPA PC: None
2026 $ 6,400** 11,200*** $17,600
Problem 10.2 Depreciation Expense 2025 2026 (a)
(b)
(c)
(d)
Straight-line: ($89,000 – $5,000) ÷ 7 = $12,000/yr. 2025: $12,000 x 7/12 2026: 12/12x $12,000
$7,000 $12,000
Units-of-output: ($89,000 – $5,000) ÷ 525,000 units = $.16/unit 2025: $.16 x 55,000 2026: $.16 x 48,000 Working hours: ($89,000 – $5,000) ÷ 42,000 hrs. = $2.00/hr. 2025: $2.00 x 6,000 2026: $2.00 x 5,500
8,800 7,680
12,000 11,000
Sum-of-the-years-digits: (1 + 2 + 3 + 4 + 5 + 6 + 7) = 28 or 2025: 7/28* x $84,000 x 7/12 2026: 7/28* x $84,000 x 5/12 = 6/28* x $84,000 x 7/12 =
n(n + 1) 7(7 + 1 ) = = 28* 2 2 $12,250 $ 8,750 10,500 $19,250
(e)
Double-declining-balance: Rate = (1.0 ÷ 7) x 2 = 28.57%** 2025: 7/12 x .2857** x $89,000 2026: .2857** x ($89,000 – $14,833) =
$14,833 21,190
LO: 1, Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 10.3 (a)
Depreciation Expense .............................................. Accumulated Depreciation—Machinery (A) (5/55 x [$46,000 – $3,100]) ............................ Accumulated Depreciation—Machinery (A) ($31,200 + $3,900) ..................................................... Machinery (A) ($46,000 – $13,000) .................. Gain on Disposal of Machinery ......................
3,900 3,900
35,100 33,000 2,100*
*([$31,200 + $3,900] – $33,000 = $2,100) (b)
(c)
(d)
Depreciation Expense .............................................. Accumulated Depreciation—Machinery (B) ([$51,000 – $3,000] ÷ 15,000) x 2,100 ...........
6,720
Depreciation Expense .............................................. Accumulated Depreciation—Machinery (C) ([$80,000 – $15,000 – $5,000] ÷ 10) ..............
6,000
Machinery (E) ............................................................ Retained Earnings ...........................................
28,000
Depreciation Expense ($28,000 x .20*)] ................... Accumulated Depreciation—Machinery (E) ...
5,600
*DDB rate = (1.0 ÷ 10) x 2 = 20% LO: 1, Bloom: AP, Difficulty: Moderate, Time: 40-50, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
6,720
6,000 28,000 5,600
Purchase Truck #5
7/1/23
(2,500)
Depreciation Balances
Purchase of Truck #6
Disposal of Truck #4
Depreciation
Balances
Depreciation
Balances
12/31/24 12/31/24
7/1/25
7/1/25
12/31/25
12/31/25
12/31/26
12/31/26
(30,400) $(129,150)
$152,000
(98,750)
(25,050)
(22,500) (73,700)
________
152,000
________
________ 112,500
(3,500)
(51,200)
$98,250
Truck #1: $18,000/5 Truck #2: $22,000/5 Truck #3: $30,000/5 x 1/2 Truck #4:$24,000/5 Truck #5: $40,000/5 x 1/2 Total
2
1
= = = = =
$3,600 4,400 3,000 4,800 4,000 $19,800
$104,000
_______
104,000
67,850 30,400
_______
(24,000)
42,000
_______ 86,000
(18,000)
104,000
_______
(30,000)
40,000
$94,000
Trucks dr. (cr.)
25,050
(700)
22,500 43,500
21,000
$21,000
Retained Earnings dr. (cr.)
Implied fair value of Truck #3 ($40,000 – $22,000) Book value of Truck #3 [$30,000 – ($30,000/5 x 1 1/2 yrs.)] = $30,000 – $9,000 = Loss on Trade
Income effect
42,000
Sale of Truck #1
1/1/24
116,000
Balances
12/31/23
________
Depreciation
(21,000)
$(30,200)
$ 94,000 22,000
Acc. Dep. Trucks dr. (cr.)
Trucks dr. (cr.)
Per Company Books
12/31/23
Trade Truck #3
Balance
1/1/23
(a)
$18,000 (21,000) $ 3,000
$(62,600)
(16,400)
(46,200)
(16,800)
14,400
(17,200) (43,800)
14,400
(41,000)
(19,800)
9,000
$(30,200)
Acc. Dep., Trucks dr, (cr.)
As Adjusted
$(18,550)
(14,000)
16,400 7 $79,700
(4,550)
(8,250)
16,800 6 63,300
7,100
(5,300) (3,400)
17,200 4 40,100
6,400 5
100
100 3
1,800
(1,200)
19,800 2 22,800
$ 3,000
Income Overstated (Understated)
$ 3,000 1
Retained Earnings dr, (cr.)
Net
Problem 10.4
Problem 10.4 (Continued) 3
Book value of Truck #1 [$18,000 – ($18,000/5 x 4 yrs.)] = ($18,000 – $14,400) 1. Cash received on sale Loss on sale
4
Truck #2: Truck #4: Truck #5: Total
$22,000/5 $24,000/5 $40,000/5
= = =
$3,600 3,500 $ 100
$ 4,400 4,800 8,000 $17,200
Book value of Truck #4 [$24,000 – ($24,000/5 x 3 yrs.)] = ($24,000 - $14,400) Cash received ($700 + $2,500) Loss on disposal 5
6
Truck #2: Truck #4: Truck #5: Truck #6: Total
$22,000/5 x 1/2 $24,000/5 x 1/2 $40,000/5 $42,000/5 x 1/2
= = = =
7
Truck #2: Truck #5: Truck #6: Total
(fully dep.) $40,000/5 $42,000/5
$
(b)
= = =
$9,600 3,200 $6,400
$ 2,200 2,400 8,000 4,200 $16,800
0 8,000 8,400 $16,400
Compound journal entry on December 31, 2026: Accumulated Depreciation—Trucks ......................... Trucks ................................................................ Retained Earnings ............................................. Depreciation Expense ......................................
66,550 48,000 4,550 14,000
Problem 10.4 (Continued) Summary of Adjustments: Per Books $152,000 $129,150
Trucks Accumulated Depreciation Prior Years’ Income Retained Earnings, 2023 $ 21,000 Retained Earnings, 2024 22,500 Retained Earnings, 2025 24,350 Totals $ 67,850 Depreciation Expense, 2026 $ 30,400
As Adjusted $104,000 $ 62,600
Adjustment Dr. or (Cr.) $(48,000) $ 66,550
$ 22,800 17,300 23,200 $ 63,300 $ 16,400
$ 1,800 (5,200) (1,150) $ (4,550) $(14,000)
LO: 1, Bloom: AP, Difficulty: Complex, Time: 45-60, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 10.5 (a)
Estimated depletion:
Depletion Base $870,000*
Estimated Depletion/Year Per 1ST & 11th Each of Yrs. Ton Yrs. 2-10 Incl. $7.25 $43,500** $87,000***
Estimated Yield 120,000 tons
* ($900,000 – $30,000) ** ($7.25 x 6,000) *** ($7.25 x 12,000) Estimated annual depreciation:
Asset Building Machinery (1/2) Machinery (1/2)
Cost
Per ton Mined
$36,000 $.30* 30,000 .25** 30,000 .50***
1st Yr.
Yrs. 2–5
6th Yr.
Yrs. 7–10
11th Yr.
$1,800 1,500 3,000
$3,600 3,000 6,000
$3,600 3,000 3,000
$3,600 3,000 0
$1,800 1,500 0
* $36,000 ÷ 120,000 = $.30 ** $30,000 ÷ 120,000 = $.25 *** ($30,000 ÷ [120,000 ÷ 2]) = $.50 (b)
Depletion: $7.25 x 5,000 tons = $36,250 Depreciation:
Building $.30 x 5,000 = Machinery $.25 x 5,000 = Machinery $.50 x 5,000 = Total depreciation
$1,500 1,250 2,500 $5,250
LO: 1, 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 10.6 (a)
Original cost Deduct residual value of land
$550 x 3,000 = $200 x 3,000 =
Cost of logging road Depletion base
$1,650,000 600,000 1,050,000 150,000 $1,200,000
$1,200,000 = $2.40 depletion per board foot 500,000 ft. (b)
Inventory .......................................................... Timber .....................................................
240,000 240,000
Depletion, 2025: .20 x 500,000 bd. ft. = 100,000 bd. ft.; 100,000 bd. ft. x $2.40 = $240,000 (c)
Loss of timber [$1,050,000 – ($1,050,000 x .20)] .................. $ 840,000 Cost of salvaging timber ................................. 700,000 Less: Recovery ($3 x 400,000 bd. ft.).............. 1,200,000 $ 340,000 Loss of land value ........................................... 600,000 Loss of logging roads [($150,000 – (.20 x $150,000)] ........................ 120,000 Logging equipment.......................................... 300,000 Unusual loss due to the eruption of Mt. Leno..................................................... $1,360,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 10.7 Instructors should note the changing depletion base in this problem. 2025 Computation of depletion base for 2025: Timber Cost per acre $1,700 Land cost (800) Timber cost $ 900 x 10,000 acres Road cost Total depletion base
$9,000,000 250,000 $9,250,000*
Estimated depletion for 2025 (Times cost per board foot) Depletion expense for 2025
$9,250,000* x 0.08 (540,000/6,750,000) $ 740,000
Depreciation of removable equipment Cost Salvage value Depreciable base
$ 225,000 (9,000) $ 216,000
Annual depreciation using SL ($216,000/15) $
14,400
Depreciation expense for 2025
$
10,800 (9/12 x $14,400)
2026 Depletion base for 2026 Base for 2025 Less: Depletion for 2025 Plus: Seedling planting costs Depletion base for 2026
$9,250,000 740,000 120,000 $8,630,000
Depletion base for 2026 (Times cost per board foot) Depletion for 2026
$8,630,000 x 0.12 (774,000/6,450,000) $1,035,600
Depreciation expense for 2026
$
14,400
Problem 10.7 (Continued) 2027 Depletion Base for 2027 Base for 2026 Less: Depletion for 2026 Plus: Seedling planting costs Depletion base for 2027
$ 8,630,000 1,035,600 150,000 $ 7,744,400
Depletion base for 2027 (Times cost per board foot) Depletion for 2027
$ 7,744,400 x .10 (650,000/6,500,000) $ 774,440
Depreciation expense for 2027
$
14,400
Note to instructor: Results are the same if using per-unit costs rounded to four decimal points. LO: 1, 3, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 10.8 (a)
The amounts to be recorded on the books of Darby Sporting Goods Inc. as of December 31, 2025, for each of the properties acquired from Encino Athletic Equipment Company are calculated as follows: Cost Allocations to Acquired Properties
Appraisal Value (1) Land (2) Buildings (3) Machinery Totals
Remaining Purchase Price Allocations
Renovations
Capitalized Interest
$100,000
$21,0002
$100,000
$21,000
$290,000 $
77,0001 33,0001
$290,000
$110,000
Total $290,000 198,000 33,000 $521,000
Supporting Calculations 1
Balance of purchase price to be allocated. Total purchase price .......................................................... Less: Land appraisal ......................................................... Balance to be allocated ............................................
Buildings Machinery Totals
Appraisal Values $105,000 45,000 $150,000
Ratios 105/150 = .70 45/150 = .30 1.00
x $110,000 x $110,000
$400,000 290,000 $110,000 Allocated Values $ 77,000 33,000 $110,000
Problem 10.8 (Continued) 2
Capitalizable interest. Expenditures Date Amount 1/1 $ 50,000 4/1 120,000 10/1 140,000 12/31 190,000 $500,000 Weighted-Average Accumulated Expenditures $175,000
Capitalization Period 12/12 9/12 3/12 0/12
x
Interest Rate .12
Weighted-Average Accumulated Expenditures $ 50,000 90,000 35,000 –0– $175,000
=
Capitalized Interest $21,000
Note to instructor: If the interest is allocated between the building and the machinery, $14,700 ($21,000 x 105/150) would be allocated to the building and $6,300 ($21,000 x 45/150) would be allocated to the machinery. (b)
Darby Sporting Goods Inc.’s 2026 depreciation expense, for book purposes, for each of the properties acquired from Encino Athletic Equipment Company is as follows: 1.
Land: No depreciation.
2.
Buildings: Depreciation rate 2026 depreciation expense
3.
Machinery: Depreciation rate = 2.00 x 1/5 = .40 2026 depreciation expense = Cost x Rate x 1/2 = $33,000 x .40 x 1/2 = $6,600
= 1.50 x 1/15 = .10 = Cost x Rate x 1/2 year = $198,000 x .10 x 1/2 = $9,900
Problem 10.8 (Continued) Note to instructor: This could be a good place to discuss arguments for and against interest capitalization. Arguments for the capitalization of interest costs include the following. 1. Diversity of practices among companies and industries called for standardization in practices. 2. Total interest costs should be allocated to enterprise assets and operations, just as material, labor, and overhead costs are allocated. That is, under the concept of historical costs, all costs incurred to bring an asset to the condition and location necessary for its intended use should be reflected as a cost of that asset. Arguments against the capitalization of interest include the following: 1. Interest capitalized in a period would tend to be offset by amortization of interest capitalized in prior periods. 2. Interest cost is a cost of financing, not of construction. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 10.9 (a)
Carrying value of asset: $10,000,000 – $2,500,000* = $7,500,000. *($10,000,000 ÷ 8) x 2 Future cash flows ($6,300,000) < Carrying value ($7,500,000) Impairment entry: Loss on Impairment ............................................... 1,900,000* Accumulated Depreciation—Equipment ..... 1,900,000 *$7,500,000 – $5,600,000
(b)
Depreciation Expense ............................................ 1,400,000** Accumulated Depreciation—Equipment ..... 1,400,000 **($5,600,000 ÷ 4)
(c)
No depreciation is recorded on impaired assets held for disposal. Recovery of impairment losses is recorded. 12/31/25 Loss on Impairment .............................. 1,900,000 Accumulated Depreciation— Equipment .................................. 1,900,000 12/31/26 Accumulated Depreciation— Equipment .......................................... Recovery of Loss from Impairment ($5,900,000 – $5,600,000) ...........
300,000 300,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 10.10 (1)
$80,000
Allocated in proportion to appraised values (1/10 x $800,000) or [($90,000/($90,000 + $810,000)) x $800,000].
(2)
$720,000
Allocated in proportion to appraised values (9/10 x $800,000) or [($810,000/($90,000 + $810,000)) x $800,000].
(3)
Fifty years
Cost less salvage ($720,000 – $40,000) divided by annual depreciation ($13,600).
(4)
$13,600
Same as prior year since it is straight-line depreciation.
(5)
$91,000
[Number of shares (2,500) times fair value ($30)] plus demolition cost of existing building ($16,000).
(6)
None
No depreciation before use.
(7)
$40,000
Fair value.
(8)
$6,000
Cost ($40,000) times percentage (1/10 x 1.50).
(9)
$5,100
Cost ($40,000) less prior year’s depreciation ($6,000) equals $34,000. Multiply $34,000 times (1/10 x 1.50).
(10) $168,000d
Total cost ($182,900) less repairs and maintenance ($14,900).
(11) $36,000
Cost less salvage ($168,000 – $6,000) times 8/36*.
(12) $10,500
Cost less salvage ($168,000 – $6,000) times 7/36 times one-third (4/12) of a year. *
(1 + 2 + 3 + 4 + 5 + 6 + 7 + 8) or [8 x (8+1) / 2]
Problem 10.10 (Continued) (13) $52,000
Annual payment ($6,000) times present value of annuity due at 8% for 11 years (7.710) plus down payment ($5,740). This can be found in an annuity due table (payments are at the beginning of each year). Alternatively, to convert from an ordinary annuity to an annuity due factor, proceed as follows: For eleven payments use the present value of an ordinary annuity for 11 years (7.139) times 1.08. Multiply this factor (7.710) times $6,000 annual payment to obtain $46,260, and then add the $5,740 down payment.
(14) $2,600
Cost ($52,000) divided by estimated life (20 years).
LO: 1, Bloom: AP, Difficulty: Complex, Time: 45-60, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 10.11 (a)
(1)
Straight-line Method:
(2)
Activity Method: Year
(3)
$90,000 – $6,000 100,000 hours
= $.84 per hour
20,000 hrs. x $.84 = 25,000 hrs. x $.84 = 15,000 hrs. x $.84 = 30,000 hrs. x $.84 = 10,000 hrs. x $.84 =
$16,800 21,000 12,600 25,200 8,400
Sum-of-the-Years-Digits: (5 + 4 + 3 + 2 + 1) = 15 or [5 X (5 + 1)/2] Year
(4)
2023 2024 2025 2026 2027
$90,000 – $6,000 = $16,800 per year for all 5 years 5 years
2023 2024 2025 2026 2027
5/15 x ($90,000 – $6,000) 4/15 x ($90,000 – $6,000) 3/15 x ($90,000 – $6,000) 2/15 x ($90,000 – $6,000) 1/15 x ($90,000 – $6,000)
$28,000 22,400 16,800 11,200 5,600
Double-Declining-Balance Method: Each year is 20% (100% ÷ 5) of the asset’s total life. Double the rate to 40%. Year
2023 2024 2025 2026 2027
.40 x $90,000 .40 x ($90,000 – $36,000) .40 x ($90,000 – $57,600) .40 x ($90,000 – $70,560) Amount to reduce to salvage
$36,000 21,600 12,960 7,776 5,664*
*($84,000 - $78,336) (b)
(1)
Straight-line Method: Year
2023 2024 2025 2026 2027 2028
$90,000 – $6,000 x 9/12 = 5 years Full year Full year Full year Full year Full year x 3/12 year
$12,600 16,800 16,800 16,800 16,800 4,200
Problem 10.11 (Continued) (2)
Sum-of-the-Years-Digits Method: 2023
(5/15 x $84,000*) x 9/12
2024
(5/15 X $84,000) x 3/12 (4/15 X $84,000) x 9/12
$ 7,000 16,800
23,800
(4/15 X $84,000) x 3/12 (3/15 X $84,000) x 9/12
5,600 12,600
18,200
(3/15 X $84,000) x 3/12 (2/15 X $84,000) x 9/12
4,200 8,400
12,600
(2/15 X $84,000) x 3/12 (1/15 X $84,000) x 9/12
2,800 4,200
7,000
2025 2026 2027 2028
$21,000
(1/15 X $84,000*) x 3/12
1,400
*Depreciable Base = ($90,000 – $6,000) (3)
Double-Declining-Balance Method:
Year 2023 2024 2025 2026 2027 2028 (1) (2) (3) (4) (5) (6)
Cost $90,000 90,000 90,000 90,000 90,000 90,000
Accum. Depr. at beg. of year — $27,000 52,200 67,320 76,392 81,835
Book Value at beg. of year $90,000 63,000 37,800 22,680 13,608 8,165
Depr. Expense $27,000 (1) 25,200 (2) 15,120 (3) 9,072 (4) 5,443 (5) 2,165 (6)
$90,000 x .40 X 9/12 ($90,000 – $27,000) X .40 ($90,000 – $52,200) x .40 ($90,000 – $67,320) x .40 ($90,000 – $76,392) X .40 Amount to reduce to $6,000 salvage value ($8,165 - $6,000).
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Problem 10.12 (a)
The straight-line method would provide the highest total net income for financial reporting over the three years, as it reports the lowest total depreciation expense. These computations are provided below.
Computations of depreciation expense and accumulated depreciation under various assumptions: (1)
Straight-line: $1,260,000 – $60,000 = $240,000* 5 years Year 2024 2025 2026
Depreciation Expense $240,000* 240,000* 240,000* $720,000
(2)
Double-declining-balance:
(3)
Depreciation Year Expense 2024 $504,000 (.40* x $1,260,000) 2025 302,400 (.40 x $756,000) 2026 181,440 (.40 x $453,600) $987,840 *[(1.0 ÷ 5) X 2] = 40% Sum-of-the-years-digits: Year 2024 2025 2026
Depreciation Expense $400,000 (5/15** x $1,200,000) 320,000 (4/15 x $1,200,000) 240,000 (3/15 x $1,200,000) $960,000 **[5 x (5 + 1) / 2] = 15
Accumulated Depreciation $240,000 $480,000 $720,000
Accumulated Depreciation $504,000 $806,400 $987,840
Accumulated Depreciation $400,000 $720,000 $960,000
*Problem 10.12 (Continued) (4)
Units-of-output: Depreciation Expense $288,000 ($24*** x 12,000) 264,000 ($24 x 11,000) 240,000 ($24 x 10,000) $792,000
Year 2024 2025 2026
Accumulated Depreciation $288,000 $552,000 $792,000
*** $1,200,000 ÷ 50,000 (total units) = $24 per unit (b)
General MACRS method: Total Cost
2024 2025 2026
$1,260,000 x 1,260,000 x 1,260,000 x
MACRS Rates (%)**** 14.29 24.49 17.49
= = =
Annual Depreciation
Accumulated Depreciation
$180,054 308,574 220,374 $709,002
$180,054 $488,628 $709,002
**** Taken from the MACRS rates schedule. Optional straight-line method:
2024 2025 2026
Total Cost $1,260,000 1,260,000 1,260,000
Depreciation Rate x (1/7 x 1/2) = x 1/7 = x 1/7 =
Annual Depreciation $ 90,000 180,000 180,000 $450,000
Accumulated Depreciation $ 90,000 $270,000 $450,000
The general MACRS method would have greater depreciation expense ($709,002) than that of the optional straight-line method ($450,000) for the three-year period ending December 31, 2026. Therefore, the general MACRS method would minimize taxable income for income tax purposes for this period. LO: 1, 5, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
UYJ 10.1 Financial Reporting Problem (a)
P&G classifies its property, plant, and equipment as “Property, Plant, and Equipment, net”, with additional details in the notes.
(b)
P&G’s “depreciation expense is recognized over the assets’ estimated useful lives using the straight-line method.”
(c)
P&G depreciates its assets based on estimated useful lives of 15 years for machinery and equipment, 3 to 5 years for computer equipment and capitalized software, and 3 to 20 years for manufacturing equipment. Buildings are depreciated over an estimated useful life of 40 years.
(d)
P&G’s Statement of Cash Flows reports depreciation and amortization of $3,013 million in 2020, $2,824 million in 2019, and $2,834 million was charged to expense in 2018.
(e)
The Statement of Cash Flows reports the following capital expenditures: 2020, $3,073 million; 2019, $3,347 million; and 2018, $3,717 million.
LO: 1, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 10.2 Comparative Analysis Case (a)
Property, plant, and equipment, net of accumulated depreciation: Coca-Cola at 12/31/20 PepsiCo at 12/31/20
$10,777 million $21,369 million
Percent of total assets: Coca-Cola ($10,777 ÷ $87,296) PepsiCo ($21,369 ÷ $92,918) (b)
Coca-Cola and PepsiCo depreciate property, plant, and equipment principally by the straight-line method over the estimated useful lives of the assets. Depreciation and amortization expense was reported (in the cash flow statement) by Coca-Cola and PepsiCo as follows:
2020 2019 2018 (c)
12.35% 23.00%
(1)
Coca-Cola $1,536 million 1,365 million 1,086 million
Asset turnover: Coca-Cola $33,014 = 0.38 $86,381 + $87,296 2
(2)
PepsiCo $2,548 million 2,432 million 2,399 million
PepsiCo $70,372 = 0.82 $78,547 + $92,918 2
Profit margin on sales: Coca-Cola $7,747 = 23.47% $33,014
PepsiCo $7,120 = 10.12% $70,372
Comparative Analysis Case (Continued) (3)
Return on assets: Coca-Cola $7,747 $86,381 + $87,296 2
PepsiCo = 8.92%
$7,120 = 8.3% $78,547 + $92,918 2
Except for asset turnover, each of Coca-Cola’s ratios is stronger compared to PepsiCo’s. PepsiCo’s lower profit margin is primarily due to its large food business which experiences larger investments in property, plant, and equipment and lower margins compared to the beverage segment. Coca-Cola sales are derived almost entirely from higher-margin beverages. (d)
Coca-Cola’s capital expenditures were $1,177 million in 2020 while PepsiCo’s capital expenditures were $4,240 million in 2020.
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 10.3 Financial Statement Analysis Case (a)
McDonald’s used the straight-line method for depreciating its property and equipment.
(b)
Depreciation and amortization charges do not increase cash flow from operations. In a cash flow statement, these two items are often added back to net income to arrive at cash flow from operations and therefore some incorrectly conclude these expenses increase cash flow. What affects cash flow from operations are cash revenues and cash expenses. Noncash charges have no effect, except for positive tax savings generated by these charges.
(c)
The schedule of cash flow measures indicates that cash provided by operations is expected to cover capital expenditures over the next few years, even as expansion continues to accelerate. It is obvious that McDonald’s believes that cash flow measures are meaningful indicators of growth and financial strength when evaluated in the context of absolute dollars or percentages.
LO: 1, 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 10.4 Accounting, Analysis, and Principles
Accounting (a)
Undiscounted future cash flows = (4 years x $4 million per year) = $16 million Book value = $36 million – $10 million = $26 million $16 million < $26 million; the recoverability test for impairment suggests an impairment charge is necessary. Estimated fair value = ($4 million x PVF-OA4,5%) = ($4 million x 3.54595) = $14,183,800 Impairment charge = $26,000,000 – $14,183,800 = $11,816,200 Post-impairment book value = $14,183,800
(b)
Undiscounted future cash flows = (10 years x $2.72 million per year) = $27.2 million Book value = $36 million – $10 million = $26 million $27.2 million > $26 million; the impairment test suggests no impairment charge is necessary. Book value at fiscal year-end = $26 million.
Analysis If the stores are in the process of being sold, they would likely be considered ‘held for sale’ for financial reporting purposes. If they are held for sale, the impairment test is based on the discounted cash flows, instead of undiscounted. Essentially, it is a lower-of-cost-or-net-realizable-value approach. Estimated fair-value = ($2.72 million x PVF-OA10,6%) = ($2.72 million x 7.36009) = $20,019,445 Therefore, Electroboy will need to write the stores down to $20,019,445 from $26 million. Fixed asset write-downs are a little more likely when management intends to sell the assets.
Accounting, Analysis, and Principles (Continued) Principles Under GAAP, once an asset is written down to an impairment value, it cannot be subsequently written back up. This provision is based in part on conservatism, as well as concerns about the reliability of measurements for the revaluations upward, following impairment. Note that if the assets are held-for-sale, the assets can be written back up (no higher than original historical cost). LO: 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Measurement Anaysis and Interpretation, Reporting, Research, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 10.1 (Time 25–35 minutes) Purpose—to provide the student with an understanding of the basic objective of depreciation accounting. In addition, the case involves a reverse sum-of-the-years’-digits situation and the student is to comment on the propriety of such an approach. Finally, the classic issue of whether depreciation provides funds must be considered. The tax effects of depreciation must be considered when this part of the case is examined. An excellent case for covering the traditional issues involving depreciation accounting. CT 10.2 (Time 20–25 minutes) Purpose—to provide the student with a basic understanding of the difference between the unit and group or composite depreciation methods. The student is required to indicate the arguments for and against these methods and to indicate how retirements are handled. CT 10.3 (Time 25–35 minutes) Purpose—to provide the student with an understanding of a number of unstructured situations involving depreciation accounting. The first situation considers whether depreciation should be recorded during a strike. The second situation involves the propriety of employing the units-of-production method in certain situations. The third situation involves the step-up of depreciation charges because properties are to be replaced due to obsolescence. The case is somewhat ambiguous, so cut-and-dried approaches should be discouraged. CT 10.4 (Time 25–35 minutes) Purpose—to provide the student with an understanding of the objectives of depreciation and the theoretical basis for accelerated depreciation methods. CT 10.5 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to examine the ethical dimensions of the depreciation method choice.
Solutions to Critical Thinking CT 10.1 (a) The purpose of depreciation is to allocate the cost (or book value) of tangible plant assets, less salvage, over their useful lives to expense in a systematic and rational manner. Under generally accepted accounting principles, depreciation accounting is a process of allocation, not of valuation, through which the productive effort (cost) in the alignment of the use of the asset (expense recognition principle) is to be matched with productive accomplishment (revenue) for the period. Depreciation accounting, therefore, is concerned with the timing of the expiration of the cost of tangible plant assets. (b) The proposed depreciation method is, of course, systematic. Whether it is rational in terms of cost allocation depends on the facts of the case. It produces an increasing depreciation charge, which is usually not justifiable in terms of the benefit from the use of the asset because manufacturers typically prefer to use their new equipment as much as possible and their old equipment only as needed to meet production quotas during periods of peak demand. As a general rule, then, the benefit declines with age. Assuming that the actual operations (including equipment usage) of each year are identical, maintenance and repair costs are likely to be higher in the later years of usage than in the earlier years. Hence the proposed method would combine light depreciation and repair charges in the early years. Reported net income in the early years would be much higher than reported net income in the later years of asset life, an unreasonable and undesirable variation during periods of identical operation. On the other hand, if the expected level of operations (including equipment usage) in the early years of asset life is expected to be low as compared to that of later years because of slack demand or production policies, the pattern of the depreciation charges of the proposed method approximately parallels expected benefits (and revenues) and hence is reasonable. Although the units-of-production depreciation method is the usual selection to fit this case, the proposed method also conforms to generally accepted accounting principles in this case provided that proper justification is given. (c) (1)
Depreciation charges neither recover nor create funds. Revenue-producing activities are the sources of funds from operations: if revenues exceed out-of-pocket costs during a fiscal period, funds are available to cover other than out-of-pocket costs; if revenues do not exceed out-ofpocket costs, no funds are made available no matter how much, or little, depreciation is charged.
(2)
Depreciation may affect funds in two ways. First, depreciation charges affect reported income and hence may affect managerial decisions such as those regarding pricing, product selection, and dividends. For example, the proposed method would result initially in higher reported income than would the straight-line method, consequently, stockholders might demand higher dividends in the earlier years than they would otherwise expect. The straight-line method, by causing a lower reported income during the early years of asset life and thereby reducing the amount of possible dividends in early years as compared with the proposed method, could encourage earlier reinvestments in other profit-earning assets to meet increasing demand. Second, depreciation charges affect reported taxable income and hence directly affect the amount of income taxes payable in the year of deduction. Using the proposed method for tax purposes would reduce the total tax bill over the life of the assets (1) if the tax rates were increased in future years or (2) if the business were doing poorly now but were to do significantly better in the future. The first condition is political and speculative, but the second condition may be applicable to Burnitz Manufacturing Company given its recent origin and its rapid expansion program. Consequently, more funds might be
CT 10.1 (Continued) available for reinvestment in plant assets in years of large deductions if one of the above assumptions were true. If Burnitz is not profitable now, it would not benefit from higher deductions now and should consider an increasing charge method for tax purposes, such as the one proposed. If Burnitz is quite profitable now, the president should reconsider his proposal because it will delay the availability of the tax shield provided by depreciation. However, this decision should not affect the decision to use a depreciation method for stockholders’ reporting that is systematic and rational in terms of cost allocation under generally accepted accounting principles as presently understood. LO: 1, Bloom: C, Difficulty: Moderate, Time: 25-35, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 10.2 (a) (1) The unit method of recording depreciation involves the treatment of plant assets or substantial additions thereto as individual items. The method entails maintaining detailed records of the costs of specific assets and the related accumulated depreciation. Computation of depreciation is based on the estimated useful life of the individual asset. The method is distinguished from group and composite-life methods under which the cost and estimated life of the assets are commingled. Depreciation may be recorded by straight-line, accelerated, or other accepted computation methods. (2) Under the group or composite-life methods, assets are aggregated into accounting units. Such grouping might be horizontal, vertical, or geographical. Horizontal grouping combines all assets of similar physical characteristics, such as trucks, presses, returnable containers, etc. A vertical or functional grouping comprises all assets contributing to a common economic function, such as a sugar refinery, a service station, etc. The geographical grouping includes all assets in a district or region, such as telephone poles. Depreciation under these methods requires the development of a weighted-average rate from the assets’ depreciable costs and estimated lives. Separate accounts are established for the total cost of each asset grouping and its related accumulated depreciation. The asset grouping should be composed of a large number of units to obtain a reliable average life. (b) 1.
Arguments for the use of the unit method are: i. The method is simple in that it does not require involved mathematical computations. ii. The gain or loss on the retirement of a particular asset can be computed. iii. For cost purposes, depreciation on idle equipment can be isolated. iv. The method results in a more accurately computed depreciation provision in any given year, as the total depreciation charge represents the best estimate of the depreciation of each asset and is not the result of averaging the cost over a longer period of time. Arguments against the unit method are: i. Considerable additional bookkeeping is necessary to account for each asset and its related depreciation. (Computers reduce the work burden, however.) ii. There is a point of diminishing returns in the accumulation of accounting data under this method. That is, additional accuracy may not justify the additional cost of record-keeping. iii. Under a decentralized financial control system where a measure of the division’s efficiency is the rate of return on the gross book value of the investment, a division manager might scrap fully or nearly fully depreciated equipment to improve the division’s rate of return even though the equipment is still serviceable. iv. There may be reluctance on the part of a division manager to replace equipment not fully depreciated with more efficient equipment because of the effect of the loss on the division’s profits in the year of replacement.
2.
Arguments for the use of the group and composite-life methods are: i. The methods require less detailed bookkeeping.
CT 10.2 (Continued) ii.
The application of depreciation to the whole group tends to average out or offset errors, economic or operating, caused by under-depreciation or over-depreciation.
iii.
Periodic income is not distorted by gains or losses on the disposal of assets.
iv.
A more useful charge to expense is derived from these methods because of their recognition that depreciation estimates are based on averages and that gains and losses on individual assets are of little significance.
Arguments against the use of the group and composite-life methods would include: i. The methods would conceal faulty estimates for a long period of time. ii. When there is an early heavy retirement of assets a debit balance might appear in the Accumulated Depreciation account and present an accounting problem. iii. Information is not available regarding a particular machine for cost-calculation purposes. iv. Under a decentralized financial control system, where a measure of the division’s efficiency is the rate of return on the gross book value of the investment, to improve the division’s financial reports a division manager might scrap idle, but serviceable equipment or equipment that is not earning a satisfactory return on book value. The company would sustain an actual loss in the amount of the value of the equipment scrapped. v. Under the same situation as “iv” above, except that book value is used, where the assets, although serviceable, are fully or almost fully depreciated, the division manager might hesitate to replace them because of the high rate of return on investment. (c) Under the unit method, retirements are recorded by removing from the accounts the cost of the asset and its related accumulated depreciation. The difference between the two accounts, adjusted for salvage and disposal costs, if any, is recognized as gain or loss. Under the group and composite-life methods, the cost of the retired asset is removed from the asset account, and the Accumulated Depreciation—Plant assets account is reduced by the amount of the cost of the retired asset, adjusted for salvage, salvage costs, and removal costs. Accordingly, there is no periodic recognition of gain or loss; the Accumulated Depreciation—Plant assets account serves as a suspense account for the recognition of gain or loss until the final asset retirement. LO: 1, Bloom: C, Difficulty: Simple, Time: 20-25, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 10.3 Situation I. This position relates to the omission of a provision for depreciation during a strike. The same question could be raised with respect to plant shutdowns for many reasons, such as for lack of sales or for seasonal business. The method of depreciation used should be systematic and rational. The annual provision for depreciation should represent a fair estimate of the loss in value arising from wear and usage and also from obsolescence. Each company should analyze its facts and establish the best method under the circumstances. If the company was employing a straight-line depreciation method, for example, it is inappropriate to stop depreciating the plant asset during the strike. If the company employs a units-of-production method, however, it would be appropriate not to depreciate the asset during this period. Even in this latter case, however, if the strike were prolonged, it might be desirable to record some depreciation because of the obsolescence factors related to the passage of time. Situation II. (a) Steady demand for the new blenders suggests the use of the straight-line method or the units-of-production method, both of which will allocate cost evenly over the life of the machine.
CT 10.3 (Continued)
Decreasing demand indicates use of an accelerated method (declining-balance or sum-of-the-years’digits) or the units-of-production method to allocate more of the cost to the earlier years of the machine’s life. Increasing demand indicates the use of the units-of-production method to charge more of the cost to the later years of the machine’s life; an increasing-charge method (annuity or sinking-fund) could be employed, though these methods are seldom used except by utilities. (b) In determining the depreciation method to be used for the machine, the objective should be to allocate the cost of the machine over its useful life in a systematic and rational manner, so that costs will be matched with the benefits expected to be obtained. In addition to demand, consideration should be given to the items discussed below, their interrelationships, the relative importance of each, and the degree of certainty with which each can be predicted: The expected pattern of costs of repairs and maintenance should be considered. Costs that vary with use of the machine may suggest the use of the units-of-production method. Costs that are expected to be equal from period to period suggest the use of the straight-line method. If costs are expected to increase with the age of the machine, an accelerated method may be considered reasonable because it will tend to equalize total expenses from period to period. The operating efficiency of the machine may change with its age. A decrease in operating efficiency may cause increases in such costs as labor and power; if so, an accelerated method is indicated. If operating efficiency is not expected to decline, the straight-line method is indicated. Another consideration is the expiration of the physical life of the machine. If the machine wears out in relation to the passage of time, the straight-line method is indicated. Within this maximum life, if the usage per period varies, the units-of-production method may be appropriate. The machine may become obsolete because of technological innovation; it may someday be more efficient to replace the machine even though it is far from worn out. If the probability is high that such obsolescence will occur in the near future, the shortened economic life should be recognized. Within this shortened life, the depreciation method used would be determined by evaluating such consideration as the anticipated periodic usage. An example of the interrelationship of the items discussed above is the effect of the repairs and maintenance policy on operating efficiency and physical life of the machine. For instance, if only minimal repairs and maintenance are undertaken, efficiency may decrease rapidly and life may be short. It is possible that different considerations may indicate different depreciation methods for the machine. If so, a choice must be made based on the relative importance of the considerations. For instance, physical life may be less important than the strong chance of technological obsolescence, which would result in a shorter economic life. Situation III. Depreciation rates should be adjusted so that the operating sawmills which are to be replaced will be depreciated to their residual value by the time the new facility becomes available. The step-up in the depreciation rates should be considered as a change in estimate and prior years’ financial statements should not be adjusted. The idle mill should be written off immediately as it appears to have no future service potential. LO: 1, Bloom: AN, Difficulty: Simple, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 10.4 To:
Phil Perriman, Supervisor of Canning Room
From:
Your name, Accountant
Date:
January 22, 2025
Subject: Annual depreciation charge to the canning department This memo addresses the questions you asked about the depreciation charge against your department. Admittedly, this charge of $625,000 [(1.0/12 x 2) x ($625,000 X 6)] is very high; however, it is not intended to reflect the wear and tear that the machinery has undergone over the last year. Rather, it is a portion of the machines’ cost, which has been allocated to this period. Depreciation is frequently thought to reflect an asset’s loss in value over time. For financial statement purposes, however, depreciation allocates part of an asset’s cost in a systematic way to each period during its useful life. Although there will always be a decline in an asset’s value over time, the depreciation charge is not supposed to measure that decline; instead, it is a periodic “charge” for using purchased equipment during any given period. When you consider the effect that the alternative would have on your departmental costs—expensing the total cost for all six machines this year—is more equitable. You also mentioned that using straight-line depreciation would result in a smaller charge than the current double-declining-balance method. This is true during the first years of the equipment’s life. Straight-line depreciation expenses even amounts of depreciation for each canning machine’s twelve-year life. Thus, the straight-line charge for this and all subsequent years would be $47,500 [($625,000 - $55,000) /12 years] per machine for total annual depreciation of $285,000 (6 X $47,500). During the earlier years of an asset’s life, the double-declining-balance method results in higher depreciation charges because it doubles the straight-line rate, which would have been made under the straight-line method. However, the same percentage depreciation in the first year is applied annually to the asset’s declining book value. Therefore, the double-declining-balance charge becomes lower than the straight-line charge during the last several years of the asset’s life. For this year, as mentioned above, the charge is $625,000, but in subsequent years, this expense will become lower. By the end of the twelfth year, the same amount of depreciation will have been taken regardless of the method used. The straight-line method would result in fewer charges against your department this year. However, consider this: when the asset is new, additional costs for service and repairs are minimal. Thus, a greater part of the asset’s cost should be allocated to this optimal portion of the asset’s life. After a few years, your department will have to absorb the additional burden of repair and maintenance costs. During that time, wouldn’t you rather have a lower depreciation charge? I hope that this explanation helps clarify any questions that you may have had about depreciation charges to your department. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 10.5 (a)
The stakeholders are Beeler’s employees, including Jerry, current and potential investors and creditors, and upper-level management.
(b)
The ethical issues are honesty and integrity in financial reporting, job security, and the external users’ right to know the financial picture.
CT 10.5 (Continued) (c)
Jerry should review the estimated useful lives and salvage values of the depreciable assets. Since they are estimates, it is possible that some should be changed. Any changes should be based on sound, objective information without concern for the effect on the financial statements (or anyone’s job).
Management may be inclined to consider selling assets that have been depreciated at a fast rate, and which result in gains. Selling assets just to increase income also raises ethical issues. (Note: This case can be used with Chapter 21, Accounting Changes and Error Analysis.) LO: 1, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Ethics, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Ethical Conduct
Codification Exercises CE10.1 (a)
The master glossary provides two entries for amortization: Amortization The process of reducing a recognized liability systematically by recognizing revenues or reducing a recognized asset systematically by recognizing expenses or costs. In pension accounting, amortization is also used to refer to the systematic recognition in net pension cost over several periods of amounts previously recognized in other comprehensive income, that is, prior service costs or credits, gains or losses, and the transition asset or obligation existing at the date of initial application of Subtopic 715-30. Amortization The process of reducing a recognized liability systematically by recognizing revenues or by reducing a recognized asset systematically by recognizing expenses or costs. In accounting for postretirement benefits, amortization also means the systematic recognition in net periodic postretirement benefit cost over several periods of amounts previously recognized in other comprehensive income, that is, gains or losses, prior service cost or credits, and any transition obligation or asset.
(b)
Impairment is the condition that exists when the carrying amount of a long-lived asset (asset group) exceeds its fair value.
(c)
Recoverable amount is the current worth of the net amount of cash expected to be recoverable from the use or sale of an asset.
(d)
According to the glossary, the term activities is to be construed broadly. It encompasses physical construction of the asset. In addition, it includes all the steps required to prepare the asset for its intended use. For example, it includes administrative and technical activities during the preconstruction stage, such as the development of plans or the process of obtaining permits from governmental authorities. It also includes activities undertaken after construction has begun in order to overcome unforeseen obstacles, such as technical problems, labor disputes, or litigation.
LO: 2, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, Technology, AICPA BC: one, AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
CE10.2 According to FASB ASC 360-10-40-4 through 6 (Impairment or Disposal of Long-Lived Assets . . . LongLived Assets to Be Exchanged or to Be Distributed to Owners in a Spinoff): 40-4
For purposes of this Subtopic, a long-lived asset to be disposed of in an exchange measured based on the recorded amount of the nonmonetary asset relinquished or to be distributed to owners in a spinoff is disposed of when it is exchanged or distributed. If the asset (asset group) is tested for recoverability while it is classified as held and used, the estimated future cash flows used in that test shall be based on the use of the asset for its remaining useful life, assuming that the disposal transaction will not occur. In such a case, an undiscounted cash flows recoverability test shall apply prior to the disposal date. In addition to any impairment losses required to be recognized while the asset is classified as held and used, an impairment loss, if any, shall be recognized when the asset is disposed of if the carrying amount of the asset (disposal group) exceeds its fair value. The provisions of this Section apply to nonmonetary exchanges that are not recorded at fair value under the provisions of Topic 845.
CE10.2 (Continued) 40-5
A gain or loss not previously recognized that results from the sale of a long-lived asset (disposal group) shall be recognized at the date of sale.
40-6
See paragraphs 360-10-35-47 through 35-48 for guidance related to the disposition of an asset upon its abandonment.
LO: 2, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
CE10.3 According to FASB ASC 360-10-35-1 through 10 (Subsequent Measurement): 35-1
This Subsection addresses depreciation of property, plant, and equipment, and the acquisition accounting for an interest in the residual value of a leased asset.
35-2
This guidance addresses the concept of depreciation accounting and the various factors to consider in selecting the related periods and methods to be used in such accounting.
35-3
Depreciation expense in financial statements for an asset shall be determined based on the asset’s useful life.
35-4
The cost of a productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles (GAAP) require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation.
35-5
See paragraph 360-10-35-20 for a discussion of depreciation of a new cost basis after recognition of an impairment loss.
35-6
See paragraph 360-10-35-43 for a discussion of cessation of deprecation on long-lived assets classified as held for sale.
35-7
The declining-balance method is an example of one of the methods that meet the requirements of being systematic and rational. If the expected productivity or revenue-earning power of the asset is relatively greater during the earlier years of its life, or maintenance charges tend to increase during later years, the declining-balance method may provide the most satisfactory allocation of cost. That conclusion also applies to other methods, including the sum-of-the-yearsdigits method, that produce substantially similar results.
35-8
In practice, experience regarding loss or damage to depreciable assets is in some cases one of the factors considered in estimating the depreciable lives of a group of depreciable assets, along with such other factors as wear and tear, obsolescence, and maintenance and replacement policies.
CE10.3 (Continued) 35-9
If the number of years specified by the Accelerated Cost Recovery System of the Internal Revenue Service (IRS) for recovery deductions for an asset does not fall within a reasonable range of the asset’s useful life, the recovery deductions shall not be used as depreciation expense for financial reporting.
35-10 Annuity methods of depreciation are not acceptable for entities in general. LO: 1, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
CE10.4 According to FASB ASC 210-10-S99 (Balance Sheet-Overall-SEC Materials) SEC Rules, Regulations, and Interpretations >> Regulation S-X >>> Regulations, S-X Rule 5-02, Balance Sheets S99-1 The following is the text of Regulation S-X Rule 5-02, Balance Sheets. The purpose of this rule is to indicate the various line items and certain additional disclosures which, if applicable, and except as otherwise permitted by the Commission, should appear on the face of the balance sheets or related notes filed for the persons to whom this article pertains (see § 210.4–01(a)). Assets and Other Debits 13.
Property, plant and equipment. – (a) State the basis of determining the amount. – (b) Tangible and intangible utility plant of a public utility company shall be segregated so as to show separately the original cost, plant acquisition adjustments, and plant adjustments, as required by the system of accounts prescribed by the applicable regulatory authorities. This rule shall not be applicable in respect to companies which are not required to make much a classification.
14.
Accumulated depreciation, depletion, and amortization of property, plant and equipment. The amount is to be set forth separately in the balance sheet or in a note thereto.
LO: 4, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology & Tools, AICPA PC: Communication
Codification Research Case (a) According to FASB ASC 360-10-05 (Property, Plant, and Equipment) 05-2
The guidance in the Overall Subtopic is presented in the following two Subsections: a. The General Subsections address the accounting and reporting for property, plant, and equipment, including guidance for accumulated depreciation. b. The Impairment or Disposal of Long-Lived Assets Subsections retain the pervasive guidance for recognizing and measuring the impairment of long-lived assets and for long-lived assets to be disposed of.
05-4
The Impairment of Disposal of Long-Lived Assets Subsections provide guidance for: a. Recognition and measurement or the impairment of longlived assets to be held and used b. Measurement of long-lived assets to be disposed of by sale.
(b) When to Test a Long-Lived Asset for Recoverability is addressed in FASB ASC 360-10-35-21: 35-21
A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. The following are examples of such events or changes in circumstances: a. A significant decrease in the market price of a long-lived asset (asset group) b. A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition c. A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator d. An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group)
Codification Research Case (Continued) e. A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group) f. A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent. (c) According to FASB ASC 360-10-35-36, for long-lived assets (asset groups) that have uncertainties both in timing and amount, an expected present value technique will often be the appropriate technique with which to estimate fair value. According to FASB ASC 820-10-35-37 through 43 (Fair Value Hierarchy): 35-37
To increase consistency and comparability in fair value measurements and related disclosures, this Topic establishes a fair value hierarchy that categorizes into three levels (see paragraphs 820-10-35-40 through 35-41, 820-10-35-41B through 35-41C, 820-10-35-44, 820-10-35-46 through 35-51, and 820-1035-52 through 35-54A) the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).
35-37A In some cases, the inputs used to measure the fair value of an asset or a liability might be categorized within different levels of the fair value hierarchy. In those cases, the fair value measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement. Accessing the significance of a particular input to the entire measurement requires judgment, taking into account factors specific to the asset or liability. Adjustments to arrive at measurements based on fair value, such as costs to sell when measuring fair value less costs to sell, shall not be taken into account when determining the level of the fair value hierarchy within which a fair value measurement is categorized. Codification Research Case (Continued)
35-38
The availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques (see paragraph 820-10-35-24). However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorized within Level 2 to Level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorized.
35-38A If an observable input requires an adjustment using an unobservable input and that adjustment results in a significantly higher or lower fair value measurement, the resulting measurement would be categorized within Level 3 of the fair value hierarchy. For example, if a market participant would take into account the effect of a restriction on the sale of an asset when estimating the price for the asset, a reporting entity would adjust the quoted price to reflect the effect of that restriction. If that quoted price is a Level 2 input and the adjustment is an unobservable input that is significant to the entire measurement, the measurement would be categorized within Level 3 of the fair value hierarchy. 35-39
The remainder of this guidance is organized as follows: a. Level 1 inputs b. Level 2 inputs c. Level 3 inputs d. Inputs based on bid and ask prices. e. Investments in certain entities that calculate net asset value per share (or its equivalent, for example, member units or an ownership interest in partners’ capital to which a proportionate share of net assets is attributed).
Codification Research Case (Continued) 35-36
Valuation techniques used to measure fair value shall maximize the use of relevant observable inputs and minimize the use of unobservable inputs.
35-36A Examples of markets in which inputs might be observable for some assets and liabilities (for example, financial instruments) include exchange markets, dealer markets, brokered markets, and principal-to-principal markets. 35-41
A quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value whenever available, except as specified in paragraph 82-10-35-41C.
35-41A Paragraph superseded by Accounting Standards Update No. 2011-04. 35-41B A Level 1 input will be available for many financial assets and financial liabilities, some of which might be exchanged in multiple active markets (for example, on different exchanges). Therefore, the emphasis within Level 1 is on determining both of the following: a. The principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability b. Whether the reporting entity can enter into a transaction for the asset or liability at the price in that market for the asset or liability at the measurement date. 35-41C A reporting entity shall not make an adjustment to a Level 1 input except in the following circumstances: a. When a reporting entity holds a large number of similar (but not identical) assets or liabilities (for example, debt securities) that are measured at fair value and a quoted price in an active market is available but not readily accessible for each of those assets or liabilities individually (that is, given the large number of similar assets or liabilities held by the reporting entity, it would be difficult to obtain pricing information for each individual asset or liability at the measurement date). In that case, as a
Codification Research Case (Continued) practical expedient, a reporting entity may measure fair value using an alternative pricing method that does not rely exclusively on quoted prices (for example, matrix pricing). However, the use of an alternative pricing method results in a fair value measurement categorized within a lower level of the fair value hierarchy. b. When a quoted price in an active market does not represent fair value at the measurement date. That might be the case if, for example, significant events (such as transactions in a principal-to-principal market, trades in a brokered market, or announcements) take place after the close of a market but before the measurement date. A reporting entity shall establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the adjustment results in a fair value measurement categorized within a lower level of the fair value hierarchy. c. When measuring the fair value of a liability or an instrument classified in a reporting entity’s shareholders’ equity using the quoted price for the identical item traded as an asset in an active market and that price needs to be adjusted for factors specific to the item or the asset (see paragraph 82010-35-16D). If no adjustment to the quoted price of the asset is required, the result is a fair value measurement categorized within Level 1 of the fair value hierarchy. However, any adjustment to the quoted price of the asset results in a fair value measurement categorized within a lower level of the fair value hierarchy. LO: 2, Bloom: K, Difficulty: Simple, Time: 40-50, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, Technology & Tools, AICPA PC: Communication
CHAPTER 11 Intangible Assets Assignment Classification Table (By Topic) Exercises
Critical Problems Thinking
1, 2, 3, 5, 6
1, 2, 3, 5, 6
2
1, 2, 3, 4, 9, 10
4, 5, 6, 7, 8, 9, 10, 12, 16
1, 2, 3, 5, 6
2
15, 16, 17, 18
6, 7, 8
13, 14
5
Goodwill.
12, 13, 14, 18
5, 7, 8
11, 12, 14
1, 4, 5
Research and development costs and similar costs.
19, 20, 21, 22, 23, 24
11, 12, 13
3, 4, 5, 6, 8, 9, 10, 15, 16, 17
1, 2, 3, 5, 6
Topics
Questions
1.
Intangible assets; concepts, definitions; items comprising intangible assets.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14
2.
Patents; franchise; organization costs; trade name.
9, 10, 11, 25
3.
Impairment of intangibles.
4. 5.
Brief Exercises
1, 3, 4
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercise s
Exercises
Problems
Critical Thinking
1. Discuss the characteristics, valuation, and amortization of intangible assets.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 15, 16, 17, 25
1, 2, 3, 4, 6, 9, 10
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 12, 13
1, 2, 3, 5
2
2. Discuss the accounting and financial statement presentation for various types of intangible assets.
11
3, 4, 9, 10
2, 4, 5, 6, 7, 8, 9, 10, 12, 13, 16
1, 2, 3, 5, 6
2
3. Explain the accounting issues for recording goodwill.
12, 13, 14, 18
5, 7, 8
3 11, 12, 14
1, 4, 5
4. Describe the accounting and presentation for research and development and similar costs.
19, 20, 21, 22, 23, 24
11, 12, 13
1, 3, 4, 5, 6, 8, 9, 10, 15, 16, 17
1, 2, 3, 5, 6
1, 3, 4
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E11.1 E11.2 E11.3 E11.4 E11.5 E11.6 E11.7 E11.8 E11.9 E11.10 E11.11 E11.12 E11.13 E11.14 E11.15 E11.16 E11.17
Classification issues—intangibles. Classification issues—intangibles. Classification issues—intangible assets. Intangible amortization. Correct intangible assets account. Recording and amortization of intangibles. Accounting for trade name. Accounting for patents, franchises, and R&D. Accounting for patents. Accounting for patents. Accounting for goodwill. Accounting for goodwill. Copyright impairment. Goodwill impairment. Accounting for organization costs. Accounting for R&D costs. Accounting for R&D costs.
Moderate Simple Moderate Moderate Moderate Simple Simple Moderate Moderate Moderate Moderate Simple Simple Simple Simple Moderate Moderate
15–20 10–15 10–15 15–20 15–20 15–20 10–15 15–20 20–25 15–20 20–25 10–15 15–20 15–20 10–15 15–20 10–15
P11.1 P11.2 P11.3 P11.4 P11.5 P11.6
Correct intangible assets account. Accounting for patents. Accounting for franchise, patents, and trademark. Goodwill, impairment. Comprehensive intangible assets. Accounting for R&D costs.
Moderate Moderate Moderate Complex Moderate Moderate
15–20 20–30 20–30 25–30 30–35 15–20
CT11.1 CT11.2 CT11.3 CT11.4
Accounting for pre-opening costs. Accounting for patents. Accounting for research and development costs. Accounting for research and development costs.
Moderate Moderate Moderate Moderate
20–25 25–30 25–30 20–25
Answers to Questions 1. The two main characteristics of intangible assets are: (a) they lack physical existence. (b) they are not a financial instrument. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
2. If intangibles are acquired for stock, the cost of the intangible is the fair value of the consideration given or the fair value of the consideration received, whichever is more clearly evident. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement, AICPA PC: Communication
3. Limited-life intangibles should be amortized by systematic charges to expense over their useful life. An intangible asset with an indefinite life is not amortized. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measuremen Analysis and Interpretation t, AICPA PC: Communication
4. When intangibles are created internally, it is often difficult to determine the validity of any future service potential. To permit deferral of these types of costs would lead to a great deal of subjecttivity because management could argue that almost any expense could be capitalized on the basis that it will increase future benefits. The cost of purchased intangibles, however, is capitalized because its cost can be objectively verified and reflects its fair value at the date of acquisition. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
5. Companies cannot capitalize self-developed, self-maintained, or self-created goodwill. These expenditures would most likely be reported as selling expenses. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
6. Factors to be considered in determining useful life are: (a) The expected use of the asset by the entity. (b) The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate. (c) Any legal, regulatory, or contractual provisions that may limit useful life. (d) Any legal, regulatory or contractual provisions that enable renewal or extension of the asset’s legal or contractual life without substantial cost. (e) The effects of obsolescence, demand, competition, and other economic factors. (f) The level of maintenance expenditure required to obtain the expected future cash flows from the asset. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
7. The amount of amortization expensed for a limited-life intangible asset should reflect the pattern in which the asset is consumed or used up, if that pattern can be reliably determined. If the pattern of production or consumption cannot be determined, the straight-line method of amortization should be used. Questions Chapter 11 (Continued)
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measuremen Analysis and Interpretation t, AICPA PC: Communication
8. This trademark is an indefinite life intangible and, therefore, should not be amortized. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
9. The $190,000 should be expensed as research and development expense in 2025. The $91,000 is expensed as selling and promotion expense in 2025. The $45,000 of costs to legally obtain the patent should be capitalized and amortized over the useful or legal life of the patent, whichever is shorter. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
10. Amortization Expense ($350,000 ÷ 10) .......................................... Patents (or Accumulated Amortization) ....................................
35,000 35,000
Straight-line amortization is used because the pattern of use cannot be reliably determined. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
11. Artistic-related intangible assets involve ownership rights to plays, pictures, photographs, and video and audiovisual material. These ownership rights are protected by copyrights. Contract-related intangible assets represent the value of rights that arise from contractual arrangements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
12. Varying approaches are used to define goodwill. They are: (a) Goodwill should be measured initially as the excess of the fair value of the acquisition cost over the fair value of the net assets acquired. This definition is a measurement definition but does not conceptually define goodwill. (b) Goodwill is sometimes defined as one or more unidentified intangible assets and identifiable intangible assets that are not reliably measurable. Examples of elements of goodwill include new channels of distribution, synergies of combining sales forces, and a superior management team. (c) Goodwill may also be defined as the intrinsic value that a business has acquired beyond the mere value of its net assets whether due to the personality of those conducting it, the nature of its location, its reputation, or any other circumstance incidental to the business and tending to make it permanent. Another definition is the capitalized value of the excess of estimated future profits of a business over the rate of return on capital considered normal in the industry. A bargain purchase arises when the fair value of the assets purchased is higher than the cost. This situation may develop from a market imperfection. In this case, the seller would have been better off to sell the assets individually than in total. However, situations do occur (e.g., a forced liquidation or distressed sale due to the death of the company founder), in which the purchase price is less than the value of the identifiable net assets. LO: 3, Bloom: K, Difficulty: Moderate, Time: 5-10, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement, Reporting, AICPA PC: Communication
Questions Chapter 11 (Continued) 13. Goodwill is recorded only when it is acquired by purchase of an entire business. Goodwill acquired in a business combination is considered to have an indefinite life and therefore should not be amortized, but should be tested for impairment on at least an annual basis. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
14. Many analysts believe that the value of goodwill is so subjective that it should not be given the same status as other types of assets such as cash, receivables, inventory, etc. The analysts are simply stating that they believe that presentation of goodwill on the balance sheet does not provide any useful information to the users of financial statements. Whether this is true or not is a difficult point to prove, but it should be noted that it appears contradictory to pay for the goodwill and then immediately write it off, denying that it has any value. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
15. Accounting standards require that if events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, then the carrying amount of the asset should be assessed. The assessment or review takes the form of a recoverability test that compares the sum of the expected future cash flows from the asset (undiscounted) to the carrying amount. If the cash flows are less than the carrying amount, the asset has been impaired. The impairment loss is measured as the amount by which the carrying amount exceeds the fair value of the asset. The fair value of assets is measured by their fair value if an active market for them exists. If no market price is available, the present value of the expected future net cash flows from the asset may be used. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
16. No. Under GAAP, impairment losses on intangible assets may not be restored. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
17. Impairment losses are reported as part of income from continuing operations, generally in the “Other expenses and losses” section. Impairment losses (and recovery of losses for assets to be disposed of) are similar to other costs that would flow through operations. Thus, gains (recoveries of losses) on assets to be disposed of should be reported as part of income from continuing operations. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflecting Thinking, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
18. The amount of goodwill impaired is $40,000, computed as follows: Carrying value of net assets ................................. $1,490,000 Fair value of reporting unit .................................... (1,450,000) Impaired goodwill .................................................. $ 40,000 LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, None
19. Research and development costs are incurred to develop new products or processes, to improve present products, or to discover new knowledge. R&D expenditures present problems of (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnitude of the future benefits and the length of time over which such benefits may be realized. R&D activities may incur costs classified as follows: (a) materials, equipment, and facilities, (b) personnel, (c) purchased intangibles, Questions Chapter 11 (Continued) (d) contract services, and (e) indirect costs.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
20. (a) Personnel (labor) type costs incurred in R&D activities should be expensed as incurred. (b) Materials and equipment costs should be expensed immediately unless the items have alternative future uses. If the items have alternative future uses, the materials should be recorded as inventories and allocated as consumed and the equipment should be capitalized and depreciated as used. (c) Indirect costs of R&D activities should be reasonably allocated to R&D (except for general and administrative costs, which must be clearly related to be included) and expensed. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
21. (a) Expense as R&D. (b) Expense as R&D. (c) Capitalize as patent and/or license and amortize. Also, see Illustration 11-10 (page 11-30). LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
22. Each of these items should be charged to current operations. Advertising costs have some minor exceptions to this general rule. Any tangible assets used in Advertising, such as billboards or blimps, are recorded as assets. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
23. $585,000 ($400,000 + $60,000 + $125,000). LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
24. These costs are referred to as start-up costs, or more specifically organizational costs in this case. The accounting for start-up costs is straightforward—expense these costs as incurred. The profession recognizes that these costs are incurred with the expectation that future revenues will occur or increased efficiencies will result. However, to determine the amount and timing of future benefits is so difficult that a conservative approach—expensing these costs as incurred—is required. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
25. The total life, per revised facts, is 40 years (10 + 30). There are 30 (40 – 10) remaining years for $540,000 amortization purposes. Original amortization: = $18,000 per year; $18,000 X 10 years 30 expired = $180,000 accumulated amortization. $540,000 –180,000 $360,000
original cost accumulated amortization remaining cost to amortize
$360,000 ÷ 30 years = $12,000 amortization for 2025 and years thereafter. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 11.1
Patents ......................................................................... Cash ....................................................................
54,000
Amortization Expense ................................................ Patents ($54,000 x 1/10 = $5,400) ......................
5,400
54,000 5,400
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.2 Patents ......................................................................... Cash ....................................................................
24,000
Amortization Expense ................................................ Patents [($43,200 + $24,000) x 1/8 = $8,400]........
8,400
24,000 8,400
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.3 Trade Names ............................................................... Cash ....................................................................
68,000
Amortization Expense ................................................ Trade Names ($68,000 x 1/8 = $8,500) ..............
8,500
68,000 8,500
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.4 Franchises ................................................................... Cash ....................................................................
120,000
Amortization Expense ................................................ Franchises ($120,000 x 1/8 x 9/12 = $11,250) ...
11,250
120,000 11,250
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.5 Purchase price ............................................................ Fair value of assets ..................................................... Less: Fair value of liabilities ............................................................................ Less: Fair value of net assets .................................... Value assigned to goodwill ........................................
$700,000 $800,000 200,000 600,000 $100,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.6 Loss on Impairment .................................................... Patents ($300,000 – $110,000) ...........................
190,000 190,000
Note: An impairment has occurred because expected net future cash flows ($210,000) are less than the carrying amount ($300,000). The loss is measured as the difference between the carrying amount and fair value ($110,000). LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.7 Because the fair value of the division exceeds the carrying amount of the assets, goodwill is not considered to be impaired. No entry is necessary. LO: 3, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
Brief Exercise 11.8 Loss on Impairment ($800,000 – $750,000) ............... Goodwill .............................................................
50,000 50,000
The fair value of the reporting unit ($750,000) is less than the carrying value ($800,000)—an impairment has occurred. The loss is the difference between the recorded net assets of $800,000 and the fair value of $750,000. LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.9 Carrying Amount Patent (1/1/25) $288,000 Legal costs (12/1/25) 85,000 $373,000
Life in Months 96 85
Amortization Per Month $3,000 $1,000
Carrying amount ..................................................... Less: Amortization of patent (12 x $3,000) ........... Legal costs amortization (1 x $1,000) ........ Carrying amount 12/31/25 ......................................
Months Amortization 12 1
$373,000 (36,000) (1,000) $336,000
The $96,000 of Research and Development costs should be expensed in the current year. LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.10 Copyright No. 1 for $9,900 should be expensed and therefore not reported on the balance sheet. Copyright No. 2 for $24,000 should be capitalized. Because the useful life is indefinite, copyright No. 2 should be tested at least annually for impairment using a fair value test. It would be reflected on the December 31, 2025 balance sheet at its cost of $24,000. LO: 1, 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
Brief Exercise 11.11 Organization Expense ................................................ Cash ....................................................................
60,000 60,000
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.12 Research and Development Expense .................... Cash ................................................................
430,000 430,000
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Brief Exercise 11.13 (a) (b) (c) (d)
Capitalize Expense Expense Expense
LO: 4, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 11.1 (15–20 minutes) (a)
10, 13, 15, 16, 17, 19, 23
(b)
1. 2. 3. 4. 5. 6. 7. 8. 9. 11. 12. 14. 18. 20. 21. 22.
Long-term investments in the balance sheet. Property, plant, and equipment in the balance sheet. Research and development expense in the income statement. Current asset (prepaid rent) in the balance sheet. Property, plant, and equipment in the balance sheet. Research and development expense in the income statement. Charge as expense in the income statement. Operating losses in the income statement. Charge as expense in the income statement. Not recorded; any costs related to creating goodwill incurred internally must be expensed. Research and development expense in the income statement. Research and development expense in the income statement. Research and development expense in the income statement. Research and development expense in the income statement. Long-term investments, or other assets, in the balance sheet. Expensed in the income statement.
LO: 1, 4, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 11.2 (10–15 minutes) The following items would be classified as intangible assets: Cable television franchises Film contract rights Music copyrights Customer lists Goodwill Covenants not to compete Internet domain name Brand names Cash, accounts receivable, notes receivable, and prepaid expenses would be classified as current assets on the balance sheet. Property, plant, and equipment, and land would be classified as non-current assets in the property, plant, and equipment section on the balance sheet. (Notes receivable might also be classified as non-current assets on
Exercise 11.2 (Continued) the balance sheet, if the collection period exceeds one year or one operating cycle.) Investments in affiliated companies would be classified as part of the investments section of the balance sheet. Research and development costs would be classified as operating expenses on the income statement. Discount on notes payable is shown as a deduction from the related notes payable in the liabilities section on the balance sheet. Organization costs are start-up costs and should be expensed as incurred and reported in income. LO: 1, 2, Bloom: C, Difficulty: Simple, Time: 10-15, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 11.3 (10–15 minutes) (a)
(b)
Trademarks Excess of cost over fair value of net identifiable assets of acquired subsidiary (goodwill) Total intangible assets Organization costs, $24,000, should be expensed.
$15,000 75,000 $90,000
Discount on bonds payable, $35,000, should be reported as a contra account to bonds payable in the long-term liabilities section on the balance sheet. Deposits with advertising agency for ads to promote goodwill of company, $10,000, should be reported either as an expense or as prepaid advertising in the current assets section of the balance sheet. Advertising costs in general are expensed when incurred or when first used. Cost of equipment acquired for research and development projects, $90,000, should be reported with property, plant, and equipment, on the balance sheet because the equipment has an alternative use.
Exercise 11.3 (Continued) Costs of developing a secret formula for a product that is expected to be marketed for at least 20 years, $80,000, should be classified as research and development expense on the income statement. LO: 1, 3, 4 Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 11.4 (15–20 minutes) 1.
Alatorre should report the patent at $600,000 ($1,000,000 cost net of $400,000 accumulated amortization) on the balance sheet. The computation of accumulated amortization is as follows. Amortization for 2023 and 2024 ($1,000,000/10) x 2 2025 amortization: ($1,000,000 – $200,000) ÷ (6 – 2) Accumulated amortization, 12/31/25
$200,000 200,000 $400,000
2.
Alatorre should amortize the franchise over its estimated useful life. Because it is uncertain that Alatorre will be able to retain the franchise at the end of 2033, it should be amortized over 10 years. The amount of amortization on the franchise for the year ended December 31, 2025, is $40,000: ($400,000/10).
3.
These costs should be expensed as incurred. Therefore $275,000 of organization expense is reported in income for 2025.
4.
Because the license can be easily renewed (at nominal cost), it has an indefinite life. Thus, no amortization will be recorded. The license will be tested for impairment in future periods.
LO: 1, 2, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 11.5 (15–20 minutes) Research and Development Expense ............................ Patents ............................................................................. Rent Expense [(5 ÷ 7) x $91,000] .................................... Prepaid Rent [(2 ÷ 7) x $91,000]...................................... Advertising Expense ....................................................... Retained Earnings........................................................... Discount on Bonds Payable ........................................... Interest Expense ............................................................. Paid in Capital in Excess of Par - Common Stock ....... Intangible Assets......................................................
940,000 75,000 65,000 26,000 207,000 241,000 82,950* 1,050 250,000 1,388,000
*84,000 ÷ 240 months = $350; $350 x 3 = $1,050; $84,000 – $1,050 = $82,950 Amortization Expense [($75,000 ÷ 10) x 1/2] ............. Patents (or Accumulated Amortization)
3,750 3,750
LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 11.6 (15–20 minutes) Patents .................................................................. Goodwill ................................................................ Franchise .............................................................. Copyright .............................................................. Research and Development Expense ................. Intangible Assets ........................................
350,000 360,000 450,000 156,000 215,000
Amortization Expense ......................................... Patents ($350,000/8) .................................... Franchise ($450,000/10 x 6/12) ................... Copyright ($156,000/5 x 5/12) .....................
79,250
1,531,000 43,750 22,500 13,000
Balance of Intangible Assets as of December 31, 2025 Patents = $350,000 – $43,750 = $306,250 Goodwill = $360,000 (no amortization) Franchise = $450,000 – $22,500 = $427,500 Copyright = $156,000 – $13,000 = $143,000 LO: 1, 2, 4, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Exercise 11.7 (10–15 minutes)
(a)
2024 amortization: $16,000 ÷ 10 = $1,600. 12/31/24 book value: $16,000 – $1,600 = $14,400. 2025 amortization: ($14,400 + $7,800) ÷ 9 = $2,467. 12/31/25 book value: ($14,400 + $7,800 – $2,467) = $19,733.
(b)
2025 amortization: ($14,400 + $7,800) ÷ 4 = $5,550. 12/31/25 book value: $14,400 + $7,800 – $5,550 = $16,650.
(c)
Carrying amount ($19,733) > future cash flows ($16,000); thus the trade name fails the recoverability test. The new carrying value is $15,000— the trade name’s fair value. 2026 amortization (after recording impairment loss): $15,000 ÷ 8 = $1,875. 12/31/26 book value: $15,000 – $1,875 = $13,125.
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 11.8 (15–20 minutes) (a)
CARTER COMPANY Intangibles Section of Balance Sheet December 31, 2025
Patent from Ford Company, net of accumulated amortization of $560,000 (Schedule 1) Franchise from Polo Company, net of accumulated amortization of $48,000 (Schedule 2) Total intangibles
$1,440,000 432,000 $1,872,000
Schedule 1 Computation of Patent from Ford Company Cost of patent at date of purchase Amortization of patent for 2024 ($2,000,000 ÷ 10 years) Amortization of patent for 2025 ($1,800,000 ÷ 5 years) Patent balance
$2,000,000 (200,000) 1,800,000 (360,000) $1,440,000
Schedule 2 Computation of Franchise from Polo Company Cost of franchise at date of purchase Amortization of franchise for 2025 ($480,000 ÷ 10) Franchise balance
$ 480,000 (48,000) $ 432,000
(b)
CARTER COMPANY Income Statement Effect For the year ended December 31, 2025
Patent from Ford Company: Amortization of patent for 2025 ($1,800,000 ÷ 5 years) Franchise from Polo Company: Amortization of franchise for 2025 ($480,000 ÷ 10) Payment to Polo Company ($2,500,000 x 5%) Research and development costs Total charged against income
$360,000 $ 48,000 125,000
LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
173,000 433,000 $966,000
Exercise 11.9 (20–25 minutes) (a)
(b)
(c)
2021 Research and Development Expense .... Cash ................................................
170,000
Patents ..................................................... Cash ................................................
18,000
Amortization Expense ............................. Patents [($18,000 ÷ 10) x 3/12] .......
450
2022 Amortization Expense ............................. Patents ($18,000 ÷ 10) ....................
1,800
2023 Patents ......................................................... Cash ....................................................
9,480
Amortization Expense ................................. Patents ($750* + $1,190**) .................. *Jan. 1–June 1: ($18,000 ÷ 10) x 5/12 = $750 **June 1–Dec. 31: ($18,000 – $450 – $1,800 – $750 + $9,480) = $24,480; ($24,480 ÷ 12) x 7/12 = $1,190
1,940
2024 Amortization Expense ................................. Patents ($24,480 ÷ 12) ........................
2,040
2025 and 2026 Amortization Expense ................................. Patents ($21,250 ÷ 2) .......................... ($24,480 – $1,190 – $2,040) = $21,250
170,000 18,000 450 1,800 9,480 1,940
2,040 10,625 10,625
LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, Measurement Analysis and Interpretation, AICPA PC: None
Exercise 11.10 (15–20 minutes) (a)
Patent A Life in years Life in months (12 x 17) Amortization per month ($30,600 ÷ 204) Number of months amortized to date Year Month 2021 10 2022 12 2023 12 2024 12 46
17 204 $150
Carrying amount 12/31/24 $23,700: ($30,600 – [46 x $150]) Patent B Life in years Life in months (12 x 10) Amortization per month ($15,000 ÷ 120) Number of months amortized to date Year Month 2022 6 2023 12 2024 12 30
10 120 $125
Carrying amount 12/31/24 $11,250: ($15,000 – [$125 x 30]) Patent C Life in years Life in months (12 x 4) Amortization per month ($14,400 ÷ 48) Number of months amortized to date Year Month 2023 4 2024 12 16
4 48 $300
Carrying amount 12/31/24 $9,600: ($14,400 – [$300 x 16])
Exercise 11.10 (Continued) At December 31, 2024 Patent A Patent B Patent C Total (b)
$23,700 11,250 9,600 $44,550
Analysis of 2025 transactions 1.
The $245,700 incurred for research and development should be expensed.
2.
The book value of Patent B is $9,750 ($11,250 - $1,500) and its estimated future cash flows are $6,000: (3 x $2,000); therefore Patent B is impaired. The impairment loss is imputed as follows: Book value Less: Present value of future cash flows ($2,000 x 2.57710) Loss recognized
$9,750 5,154 $4,596
Patent B carrying amount (12/31/25) $5,154 At December 31, 2025 Patent A Patent B Patent C Patent D Total
$21,900 5,154 6,000 34,560 $67,614
($23,700 – [12 x $150]) (Present value of future cash flows) ($9,600 – [12 x $300]) ($36,480 – $1,920*)
*Patent D amortization Life in years Life in months Amortization per month ($36,480 ÷ 114) $320 x 6 = $1,920
9 1/2 114 $320
LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Measurement Analysis and Interpretation, AICPA PC: Communication
Exercise 11.11 (20–25 minutes) Net assets of Zweifel as reported ($575,000 – $350,000) Adjustments to fair value Increase in land value Decrease in equipment value Net assets of Zweifel at fair value Selling price Amount of goodwill to be recorded
$225,000 30,000 (5,000)
25,000 250,000 350,000 $100,000
The journal entry to record this transaction is as follows: Cash ............................................................................. Land ............................................................................. Buildings...................................................................... Equipment ................................................................... Copyrights ................................................................... Goodwill ....................................................................... Accounts Payable .............................................. Notes Payable .................................................... Cash ....................................................................
100,000 100,000 200,000 170,000 30,000 100,000 50,000 300,000 350,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Exercise 11.12 (10–15 minutes) (a)
Cash ............................................................................ ............................................................................ Accounts Receivable ......................................... Inventory ............................................................ Land ................................................................... Buildings ............................................................ Equipment .......................................................... Trademark .......................................................... Goodwill ............................................................. Accounts Payable ..................................... Notes Payable ........................................... Cash...........................................................
50,000 90,000 125,000 60,000 75,000 70,000 15,000 65,000*
*$350,000 – [($435,000 - $200,000) + $20,000 + $25,000 + $5,000]
200,000 100,000 250,000
Exercise 11.12 (Continued) Note that the building and equipment would be recorded at the 7/1/25 cost to Brigham; accumulated depreciation accounts would not be recorded. (b)
Amortization Expense ............................................ Trademarks ([$15,000 – $3,000] x 1/4 x 6/12) ...
1,500 1,500
LO: 1, 2, 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Exercise 11.13 (15–20 minutes) (a)
December 31, 2025 Loss on Impairment ......................................... Copyrights............................................... *Carrying amount Less: Fair value Loss on impairment
1,100,000* 1,100,000
$4,300,000 3,200,000 $1,100,000
Note: Asset fails recoverability test because the expected net cash flows of $4,000,000 are less than the carrying value of $4,300,000. (b)
Amortization Expense ..................................... Copyrights............................................... *New carrying amount Useful life Amortization per year
(c)
320,000* 320,000
$3,200,000 ÷ 10 years $ 320,000
No entry is necessary. Restoration of any impairment loss is not permitted..
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Exercise 11.14 (15–20 minutes) (a)
December 31, 2025 Loss on Impairment .............................. 15,000,000* Goodwill ....................................... *$350,000,000 − $335,000,000,
15,000,000
Exercise 11.14 (Continued) The fair value of the reporting unit ($335 million) is below its carrying value ($350 million). Therefore, an impairment has occurred. (b)
No entry necessary. After a goodwill impairment loss is recognized, the adjusted carrying amount of the goodwill is its new accounting basis. Subsequent reversal of previously recognized impairment losses is not permitted under FASB ASC 350-30-35.
Note to instructor: It is important that before conducting the goodwill impairment test that all other long-lived assets are evaluated and adjusted for any impairments. LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 11.15 (10–15 minutes) (a)
Attorney fees in connection with organization of the company Costs of meetings of incorporators to discuss organizational activities State filing fees to incorporate Total organization costs
$15,000 7,000 1,000 $23,000
Drafting and design equipment, $10,000, should be classified as part of plant assets, rather than as organization costs. (b)
Organization Expense ......................................... Cash (Accounts Payable)...........................
23,000 23,000
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
Exercise 11.16 (15–20 minutes) (a)
In accordance with GAAP, the $325,000 is a research and development cost that should be charged to R & D Expense and, if not separately disclosed in the income statement, the total cost of R & D should be separately disclosed in the notes to the financial statements.
Exercise 11.16 (Continued) (b)
(c)
Research and Development Expense ......... Cash, Accts. Payable, etc. ................... (To record research and development costs)
110,000
Patents........................................................... Cash, Accts. Payable, etc. ................... (To record legal and administrative costs incurred to obtain patent #472-1001-84)
16,000
Amortization Expense .................................. Patents ................................................. [To record one year’s amortization expense ($16,000 ÷ 5 = $3,200)]
3,200
Patents.............................................................. Cash, Accts. Payable, etc. ...................... (To record legal cost of successfully defending patent)
47,200
110,000
16,000
3,200
47,200
The cost of defending the patent is capitalized because the defense was successful and because it extended the useful life of the patent. Amortization Expense ..................................... Patents .................................................... (To record one year’s amortization expense: $16,000 – $3,200 = $12,800; $12,800 ÷ 8 = $1,600 $47,200 ÷ 8 = 5,900 Amortization expense for 2026 $7,500 (d)
7,500 7,500
Additional engineering and consulting costs required to advance the design of a product to the manufacturing stage are R & D costs. As indicated in the chapter it is R &D because it translates knowledge into a plan or design for a new product.
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Communication
Exercise 11.17 (10–15 minutes) Depreciation of equipment acquired that will have alternate uses in future research and development projects over the next 5 years ($280,000 ÷ 5) Materials consumed in research and development projects Consulting fees paid to outsiders for research and development projects Personnel costs of persons involved in research and development projects Indirect costs reasonably allocable to research and development projects Total to be expensed for research and development
$ 56,000 59,000 100,000 128,000 50,000 $393,000*
*Materials purchased for future R&D projects should be reported as an asset. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Time and Purpose of Problems Problem 11.1 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to appropriately reclassify amounts charged to a single intangible asset account. Capitalized in the account are amounts representing franchise costs, prepaid rent, organization fees, prior net loss, patents, goodwill, and R&D costs. The student must also be alert to the fact that several transactions require that an adjustment of Retained Earnings be made. The problem provides a good summary of accounting for intangibles. Problem 11.2 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to compute the carrying value of a patent at three balance sheet dates. The student must distinguish between expenditures that are properly included in the patent account and R&D costs which must be expensed as incurred. Computation of amortization is slightly complicated by additions to the account and a change in the estimated useful life of the patents. A good summary of accounting for patents and R&D costs. Problem 11.3 (Time 20–30 minutes) Purpose—the student determines the cost and amortization of a franchise, patent, and trademark and shows how they are disclosed on the balance sheet. The student prepares a schedule of expenses resulting from the intangibles transactions. Problem 11.4 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to determine the amount of goodwill in a business combination and to determine the goodwill impairment. Problem 11.5 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to determine carrying value of intangible assets (limited life, indefinite life, and goodwill) at two balance sheet dates. The problem also requires students to determine impairments, if necessary on the intangible assets. Problem 11.6 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to determine income statement and balance sheet presentation for costs related to research and development of patents. The problem calls on the student to determine whether costs incurred are properly capitalized or expensed. The problem addresses the basic issues involved in accounting for R&D costs and patents.
Solutions to Problems Problem 11.1 Franchises ................................................................... Prepaid Rent................................................................ Retained Earnings (Net loss) ............................................................................ Patents ($84,000 + $12,650) ........................................ Research and Development Expense ($75,000 + $160,000)................................................. Goodwill ...................................................................... Intangible Assets ...............................................
48,000 24,000 16,000 96,650 235,000 278,400 698,050
Amortization Expense ($48,000 ÷ 8) .......................... Retained Earnings ($48,000 ÷ 8 x 6/12)...................... Franchises ..........................................................
6,000 3,000
Rent Expense ($24,000 ÷ 2) ........................................ Retained Earnings ($24,000 ÷ 2 x 3/12)...................... Prepaid Rent.......................................................
12,000 3,000
Amortization Expense ................................................ Patents ($84,000 ÷ 10) + ($12,650 x 7/115) ..................
9,170
9,000
15,000
9,170
Balances at 12/31/26 Prepaid Rent ($24,000 – $15,000) ............................... Franchises ($48,000 – 9,000) ...................................... Patents ($96,650 – 9,170) ............................................ Goodwill ......................................................................
$
9,000 39,000 87,480 278,400
Note: No amortization of goodwill; goodwill should be tested for impairment on at least an annual basis in future periods. LO: 1, 2, 3, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, Measurement Analysis and Interpretation, AICPA PC: None
Problem 11.2 (a)
Costs to obtain patent Jan. 2019 .................. 2019 amortization ($59,500 ÷ 17) .................. Carrying value, 12/31/19 ................................
$59,500 (3,500) $56,000
All costs incurred prior to January 2019 are related to research and development activities and were expensed as incurred in accordance with GAAP. (b)
1/1/20 carrying value of patent..................... 2020 amortization ($59,500 ÷ 17) ................. 2021 amortization ......................................... Legal fees to defend patent 12/21 ................ Carrying value, 12/31/21 ............................... 2022 amortization ($91,000 ÷ 14) ................. 2023 amortization ......................................... Carrying value, 12/31/23 ...............................
$56,000 $3,500 3,500
6,500 6,500
(7,000) 49,000 42,000 91,000 (13,000) $78,000
The costs incurred in 2020 and 2022 are related to research and development activities and are expensed as incurred. (c)
1/1/24 carrying value..................................... 2024 amortization ($78,000 ÷ 5) ................... 2025 amortization ......................................... 2026 amortization ......................................... Carrying value, 12/31/26 ...............................
$78,000 $15,600 15,600 15,600
(46,800) $31,200
The legal costs in 2026 were expensed because the suit was unsuccessful. LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Problem 11.3
(a)
SANDRO CORPORATION Intangible Assets December 31, 2025 Franchise, net of accumulated amortization of $5,870 (Schedule 1) ............................................................................... Patent, net of accumulated amortization of $2,200 (Schedule 2) ............................................................................... Trademark, net of accumulated amortization of $6,600 (Schedule 3) ............................................................................... Total intangible assets........................................................
$ 52,830 15,400 39,600 $107,830
Schedule 1 Franchise Cost of franchise on 1/1/25 ($15,000 + $43,700) ......................... 2025 amortization ($58,700 x 1/10) .............................................. Cost of franchise, net of amortization ...............................
$ 58,700 (5,870) $ 52,830
Schedule 2 Patent Cost of securing patent on 1/2/25 ............................................... 2025 amortization ($17,600 x 1/8) ................................................ Cost of patent, net of amortization ....................................
$ 17,600 (2,200) $ 15,400
Schedule 3 Trademark Cost of trademark on 7/1/22 ......................................................... Amortization, 7/1/22 to 7/1/25 ($36,000 x 3/20)............................ Book value on 7/1/25 .................................................................... Cost of successful legal defense on 7/1/25 ................................ Book value after legal defense .................................................... Amortization, 7/1/25 to 12/31/25 ($40,800 x 1/17 x 6/12) ............. Cost of trademark, net of amortization ..............................
$ 36,000 (5,400) 30,600 10,200 40,800 (1,200) $ 39,600
Problem 11.3 (Continued) (b)
SANDRO CORPORATION Expenses Resulting from Selected Intangible Assets Transactions For the Year Ended December 31, 2025
Interest expense ($43,700 x 14%) ................................................ Franchise amortization (Schedule 1)........................................... Franchise fee ($900,000 x 5%) ..................................................... Patent amortization (Schedule 2) ................................................ Trademark amortization (Schedule 4) ......................................... Total expense ......................................................................
$ 6,118 5,870 45,000 2,200 2,100 $61,288
Note: The $65,000 of research and development costs incurred in developing the patent would have been expensed prior to 2025. Schedule 4 Trademark Amortization Amortization, 1/1/25 to 6/30/25 ($36,000 x 1/20 x 6/12) ................ Amortization, 7/1/25 to 12/31/25 ($40,800 x 1/17 x 6/12) .............. Total trademark amortization ...............................................
$
900 1,200 $ 2,100
LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: None
Problem 11.4
(a)
Goodwill = Excess of the cost of the division over the fair value of the identifiable assets: $3,000,000 – $2,750,000 = $250,000
(b)
No impairment loss is recorded, because the fair value of Conchita ($1,850,000) is greater than carrying value of the net assets ($1,650,000).
(c)
Computation of impairment: Impaired goodwill = Fair value of division less the carrying value of the division (adjusted for fair value changes), including goodwill:
(d)
Fair value of Conchita division .................... Carrying value of division Impairment loss ............................................
$1,600,000 (1,650,000)
Loss on Impairment ..................................... Goodwill .................................................
50,000
($50,000) 50,000
This loss will be reported in income as a separate line item in the continuing operations section. LO: 3, Bloom: AP, Complex, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Measurement, Analysis and Reporting, AICPA PC: None
Problem 11.5 (a)
MONTANA MATT’S GOLF INC. Intangibles Section of Balance Sheet December 31, 2024
Trade name ............................................................... Copyright (net accumulated amortization of $300) (Schedule 1) ........................................................... Goodwill (Schedule 2) .............................................. Total intangibles .......................................................
$ 10,000 23,700 170,000 $203,700
Schedule 1 Computation of Value of Old Master copyright Cost of copyright at date of purchase..................... Amortization of copyright for 2024 [($24,000 ÷ 40) x 1/2 year] .......................................... Carrying value of copyright at December 31 . Schedule 2 Goodwill Measurement Purchase price ........................................................ Fair value of assets ................................................ Fair value of liabilities ............................................ Fair value of net assets................................. Value assigned to goodwill ....................................
$ 24,000 (300) $ 23,700 $770,000
$800,000 (200,000) (600,000) $170,000
Amortization expense for 2024 is $300 (see Schedule 1). There is no amortization for the goodwill or the trade name, both of which are considered indefinite life intangible assets. (b) Amortization Expense ....................................... Copyrights ($24,000 ÷ 40) ...............................
600 600
There is a full year of amortization on the Copyright. There is no amortization for the goodwill or the trade name, which are considered indefinite life intangibles.
Problem 11.5 (Continued) MONTANA MATT’S GOLF INC. Intangibles Section of Balance Sheet December 31, 2025 Trade name ....................................................................... Copyright (net of accumulated amortization, $900) (Schedule 1) ................................................................... Goodwill ............................................................................ Total intangibles ............................................................... Schedule 1 Computation of Value of Old Master Copyright Cost of Copyright at date of purchase ............................ Amortization of Copyright for 2024, 2025 [($24,000 ÷ 40) x 1.5 years] ............................................ Balance of copyright at December 31 ....................
(c)
Loss on Impairment .................................................... 87,000 Goodwill ................................................................... Trade name ($10,000 – $3,000) ................................
$ 10,000 23,100 170,000 $203,100 $ 24,000 (900) $ 23,100
80,000 7,000
*Fair value of Old Master reporting unit .......... $420,000 Net identifiable assets (including goodwill) . (500,000) Goodwill impairment loss ............................... $ 80,000 Goodwill is considered impaired because the fair value of the business unit ($420,000) is less than its carrying value ($500,000). The copyright is not considered impaired because the expected net future cash flows ($30,000) exceed the carrying amount [$22,500 ($23,100 − $600)]. LO: 1, 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 11.6 (a)
Income statement items and amounts for the year ended December 31, 2025: Research and development expenses* ................................................................................. Amortization of patent ($88,000 ÷ 10 years)...................
$288,000 8,800
*The research and development expenses could be listed by the components rather than in one total. The details of the research and development expenses are as follows: Depreciation—building ($320,000 ÷ 20 years) .................................................... Salaries and employee benefits ................................................................................. Other expenses ................................................................ (b)
$ 16,000 195,000 77,000
Balance sheet items and amounts as of December 31, 2025: Land .......................................................................................... .......................................................................................... Building (net of accumulated depreciation of $16,000) ..................................................................... Patent (net of amortization of $15,400)* .........................
$ 60,000
304,000 72,600
*([$88,000 ÷ 10] x 3/4) + ($88,000 ÷ 10) All research and development costs should be charged to expense when incurred. Therefore, all of Wright Tool Company’s costs related to its research and development activities for 2025 would be expensed regardless of the long-term benefits. The patent was acquired for manufacturing rights rather than for use in research and development activities. Consequently, the cost of the patent can be capitalized as an intangible asset and amortized over its useful life. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
UYJ 11.1 Financial Reporting Problem (a)
P&G reports Goodwill of $39,901 million for 2020. P&G also reports (net of amortization) Trademarks and other intangible assets of $23,792 million in 2020.
(b)
P&G spent $1,834 million on research and development in 2020 and $1,861 million in 2019. In 2020, P&G spent 2.58% ($1,834/$70,950) of its sales on research and development costs. As a percent of net income, it spent 14.0% ($1,834/$13,103) of its net income on research and development. For 2019, the figures were 2.75% ($1,861/$67,684) of sales and 46.92% ($1,861/$3,966) of net income.
LO: 3, 4, Bloom: AN, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 11.2 Comparative Analysis Case (a)
(b)
(1)
Coca-Cola reports: Trademarks with indefinite lives, Goodwill and Other Intangible Assets of $28,550M. PepsiCo reports: Amortizable Intangible Assets (net) Goodwill and Other Indefinitelived Intangible Assets of $38,072M.
(2)
Coca-Cola: Intangible assets are 32.70% ($28,550 ÷ $87,296) of total assets. PepsiCo: Intangible assets are 40.97% ($35,072 ÷ $92,918) of total assets.
(3)
At Coca-Cola, intangible assets increased $1,784M. At PepsiCo, intangibles increased $6,528M ($38,072 - $31,544).
(1)
Coca-Cola amortizes intangible assets that are deemed to have definite lives over their useful life primarily on a straight-line basis. PepsiCo amortizes amortizable intangible assets on a straight-line basis over their estimated useful lives.
(2)
Coca-Cola had accumulated amortization of $348M and $400M on December 31, 2020 and 2019, respectively. PepsiCo had accumulated amortization of $1,737M and $1,655M at year-end 2020 and 2019, respectively.
(3)
Coca-Cola identified the composition of its intangible assets as follows: Trademarks with indefinite lives Goodwill Other indefinite-life intangible assets Liited-life intangible assets
$10,395M 17,506 225 424 $28,550M
PepsiCo identified its intangible assets as follows: Amortizable intangible assets Goodwill Other Indefinite-lived intangible assets
$ 1,703M 18,757 17,612 $38,072M
LO: 1, 2, 3, 4, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 11.3 Financial Statement Analysis Case
MERCK AND JOHNSON & JOHNSON (a)
The primary intangible assets of a healthcare products company would probably be patents, goodwill and trademarks. The nature of each of these is quite different; thus, an investor would normally want to know what the composition of intangible assets is if it is material.
(b)
Many corporate executives complain that investors are too concerned about the short-term and don’t reward good long-term planning. As a consequence, they feel that the requirement that research and development expenditures be expensed immediately penalizes those executives who do invest in the future. As a consequence, when net income does not look good, it is always tempting to cut research and development expenditures, since this will cause a direct increase in current year reported profits. Of course, it will also diminish the company’s longterm prospects.
(c)
If a company reports goodwill on its balance sheet, it can only have resulted from one thing—the company must have purchased another company. This is because companies are not allowed to record internally created goodwill. They can only report purchased goodwill. Ironically, if you want to report a large amount of goodwill, all you have to do is overpay when you purchase another company—the more you overpay, the more goodwill you will report. Obviously, reporting a lot of goodwill is not such a good thing.
LO: 1, 2, 3, 4. Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 11.4 Financial Statement Analysis Case (a)
The depressed market (fair) values (less than book value) suggest that market participants are not very optimistic about the future prospects for these companies. Accounting numbers are based in many cases on historical costs, while market prices will reflect new information about the company prospects. This situation does not look very promising.
(b)
Because the market (fair) value of each company is less than its book value of its net assets, it fails the goodwill impairment test; an impairment should be recorded. A
B
C
D
E
G (Columns B–C)
Book Value of Net Assets Fair Value of
(including
Company
goodwill)
of Goodwill
Assets
Sprint Nextel
$36,361
$51,271
$30,718
3.5%
$14,910
Washington Mutual
11,742
23,941
9,062
2.4%
9,062
E* Trade Financial
1,639
4,104
2,035
5.6%
2,035
Company
Carrying Value Return on Goodwill Impairment
$26,007
(c)
As indicated in the expanded spreadsheet above, unless their market values increase dramatically, each of these companies is likely to recognize a goodwill impairment. For Washington Mutual and E-Trade, the impairment will result in a complete write-off of the goodwill asset. Apparently, the prior acquisitions from which the goodwill was recorded did not pan out for these companies. Each of the companies would record its loss by debiting Loss on Impairment and crediting Goodwill.
(d)
Impairment losses are reported in operating income. Thus, the impairments will reduce the numerator in the return on asset ratio. Without recognition of the impairments, these companies’ operating performance is overstated relative to companies in their cohort.
LO: 3, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 11.5 Accounting, Analysis, and Principles Accounting There is a full year of amortization on the copyright. There is no amortization for the trade name, which is considered an indefinite-life intangible. Amortization expense = $15,000/10 = $1,500 Amortization Expense ............................................ Copyrights ......................................................
1,500 1,500
The recoverability test for the copyright indicates that the copyright is not impaired: The expected cash flows (undiscounted) of $20,000 are greater than the carrying value of $13,500 ($15,000 – $1,500). The trade name is tested for impairment using a fair value test. Thus, Raconteur writes it down to the fair value of $5,000, recording an impairment charge of $8,500 – $5,000 = $3,500. Loss on Impairment ................................................ Trade Name ....................................................
3,500 3,500
Analysis Impairment losses are recorded in operating income. Because impairments tend to be nonrecurring items, their recognition can make operating income more volatile from year to year. This volatility effect can be particularly severe for indefinite-life intangibles, such as a trade name or goodwill. The higher carrying values (due to no amortization), combined with the annual fair-value impairment test, can result in impairment losses having a significant impact on operating income. Principles The accounting for impairments provides relevant information about intangible assets by indicating in a timely fashion that intangible assets have declined in value. However, providing this timely information requires significant subjective judgments related to estimating (1) expected cash flows for the cash flow recovery test and (2) fair values in determining the amount of the impairment to be recognized. These estimates may raise concerns about the faithful representation of impairment-loss amounts. LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking
CT 11.1 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to determine the proper classification of certain expenditures related to organizing a business. The student is required to deal with such issues as costs incurred for interest expense during construction, the cost of promotional advertising, and expenditures related to obtaining tenants for a shopping center. Classification of these items is complicated due to a postponement in the starting of business operations. A challenging and interesting case which should provide good background for a discussion of the theoretical support for capitalizing organization costs. CT 11.2 (Time 25–30 minutes) Purpose—to present an opportunity for the student to discuss accounting for patents from a theoretical and a practical viewpoint. The student is required to explain the “discounted value of expected net receipts” method of accounting for patents and to provide support for using cost as the generally accepted valuation method. The student is also required to comment on the theoretical basis of patent amortization. Finally the student must determine proper disclosure in the financial statements for a patent infringement suit which is in progress at the balance sheet date. This case challenges the student to present theoretical support and practical application beyond that presented in the text. CT 11.3 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the theoretical support for and practical applications of the FASB’s position on research and development costs. The student is required to define the terms “research” and “development” as used in the codification to provide theoretical support for the FASB’s position, and to apply the provisions to a situation presented in the case. A good case to thoroughly cover research and development costs. CT 11.4 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to examine the ethical issues related to expensing research and development costs.
Solutions to Critical Thinking CT 11.1 Interest on mortgage bonds. An amount equal to the interest cost incurred in 2024 ($720,000) is a cost which can be associated with the normal construction period and can be regarded as a normal element of the cost of the physical assets of the shopping center because the construction period would have ended at the end of the year if the tornado had not occurred. The decision to use debt capital to finance the shopping center was made with full knowledge that interest would accrue during the construction period and add to the total cost of building the center, bringing it to the point at which it would produce revenue. The future income to be generated by the shopping center must have been estimated to be more than sufficient to recover all of the expected costs of building the center and preparing it for occupancy, including interest during the construction period. In lieu of treating interest during construction as an element of the cost of the physical assets, it can be argued that it represents an element of the general cost of bringing the business to the point of revenue production and should therefore be treated as an organization expense. This view regards interest during construction as just another of the many expenditures that are necessary to acquire and organize the physical assets of a new business but do not attach to any specific assets. Note that interest must be capitalized in this situation (see chapter 10) because the building requires a period of time to get it ready for its intended use. The amount of interest cost for the first nine months of 2025 is the measure of the 2025 loss resulting from the tornado. The extension of the construction period to October 2025 because of the tornado does not warrant its capitalization as construction period interest. It is, in effect, an uninsured loss resulting from the tornado. Had it not been for the tornado, the entire amount would have been a normal operating expense chargeable against the rental revenue that would have been earned during the first nine months of 2025. Cost of obtaining tenants. Both the 2024 and 2025 costs of obtaining tenants should be expensed as incurred. The cost of obtaining tenants is a start-up cost. The accounting for start-up costs is straightforward—expense these costs as incurred. The profession recognizes that these costs are incurred with the expectation that future revenues will occur or increased efficiencies will result. However, to determine the amount and timing of future benefits is so difficult that a conservative approach— expense these costs as incurred—is required. Promotional advertising. The profession has concluded that, except in limited situations, future benefits from advertising are not sufficiently defined or measurable with a degree of reliability that is required to recognize these costs as an asset. As a result, the costs should be expensed as incurred or the first time the advertising takes place. The advertising costs incurred in 2025 might be reported as a loss to indicate that an unusual event caused this additional expense. LO:4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 11.2 (a) A dollar to be received in the future is worth less than a dollar received today because of an interest or discount factor—often referred to as the time value of money. The discounted value of the expected royalty receipts can be thought of either in terms of the present value of an annuity of 1 or in terms of the sum of several present values of 1.
CT 11.2 (Continued) (b) If the royalty receipts are expected to occur at regular intervals and the amounts are to be fairly constant, their discounted value can be calculated by multiplying the value of one such receipt by the present value of an annuity of 1 for the number of periods the receipts are expected. On the other hand, if receipts are expected to be irregular in amount or if they are to occur at irregular intervals, each expected future receipt would have to be multiplied by the present value of 1 for the number of periods of delay expected. In each case some interest rate (discount factor) per period must be assumed and used. As an example, if receipts of $10,000 are expected each six months over the next ten years and an 8% annual interest rate is selected, the present value of the twenty $10,000 payments is equal to $10,000 times the present value of an annuity of 1 for 20 periods at 4%. Twice as many periods as years and half the annual interest rate of 8% are used because the payments are expected at semiannual intervals. Thus the discounted (present) value of these receipts is $135,903 ($10,000 X 13.5903). Because of the interest rate, this discounted value is considerably less than the total expected collection of $200,000. Continuing the example, if instead it is expected that $10,000 will be received six months hence, $20,000 one year from now, and a terminal payment of $15,000 is expected 18 months hence, the calculation is as follows: $10,000 X present value of 1 at 4% for 1 period = $10,000 X .96154 = $9,615. $20,000 X present value of 1 at 4% for 2 periods = $20,000 X .92456 = $18,491. $15,000 X present value of 1 at 4% for 3 periods = $15,000 X .88900 = $13,335. Adding the results of these three calculations yields a total of $41,441 (rounded), considerably less than the $45,000 total collections, again due to the discount factor. (c) The basis of valuation for patents that is generally accepted in accounting is cost. Evidently the cartons were developed and the patents obtained directly by the client corporation. Those costs related to the research and development of the cartons must be expensed in accordance with GAAP. The costs of securing the patent should be capitalized. If the infringement suit is unsuccessful, an evaluation of the value of the patent should be made to ascertain the reasonableness of carrying forward the patent cost. If the suit is successful, the attorney’s fees and other costs of protecting the patent should be capitalized and amortized over its remaining useful or legal life, whichever is shorter. (d) Intangible assets represent rights to future benefits. The ideal measure of the value of intangible assets is the discounted present value of their future benefits. For Ferry Company, this would include the discounted value of expected net receipts from royalties, as suggested by the financial vicepresident, as well as the discounted value of the expected net receipts to be derived from Ferry Company’s production. Other valuation bases that have been suggested are current cash equivalent or fair value. (e) The amortization policy is implied in the definition of intangible assets as rights to future benefits. As the benefits are received by the firm, the cost or other value should be charged to expense or to inventory to provide a proper matching of revenues and expenses. Under the discounted value approach, the periodic amortization would be the decline during the year in the present value of expected net receipts. In practice, generally straight-line amortization is used because it is simple and provides a uniform amortization approach. Another approach would be the units-of-production method.
CT 11.2 (Continued) (f)
The litigation can and should be mentioned in notes to the financial statements. Some indication of the expectations of legal counsel in respect to the outcome can properly accompany the statements. It would be inappropriate to record a contingent asset reflecting the expected damages to be recovered. Costs incurred to September 30, 2025, in connection with the litigation should be carried forward and charged to expense (or to loss if the cases are lost) as royalties (or damages) are collected from the parties against whom the litigation has been instituted; however, the conventional treatment would be to charge these costs as ordinary legal expenses. If the final outcome of the litigation is successful, the costs of prosecuting it should be capitalized. Similarly, if the client were the successful defendant in an infringement suit on these patents, the generally accepted accounting practice would be to add the costs of the legal defense to the Patents account. Developments between the balance sheet date and the date that the financial statements are released would properly be reflected in notes to the statements as post-balance sheet (or subsequent events) disclosure.
LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT 11.3 (a) Research, as defined in GAAP (FASB ASC 730-10-25), is “planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service . . . or a new process or technique . . . or in bringing about a significant improvement to an existing product or process.” Development, as defined in GAAP (FASB ASC 730-10-25), is “the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.” (b) The current accounting and reporting practices for research and development costs were promulgated by the Financial Accounting Standards Board (FASB) in order to reduce the number of alternatives that previously existed and to provide useful financial information about research and development costs. The FASB considered four alternative methods of accounting: (1) charge all costs to expense when incurred, (2) capitalize all costs when incurred, (3) selective capitalization, and (4) accumulate all costs in a special category until the existence of future benefits can be determined. The FASB concluded that all research and development costs should be charged to expense as incurred. (The authoritative guidance for R&D (FASB ASC 730-10-25) does not apply to activities that are unique to enterprises in the extractive industries. Accounting for the costs of research and development activities conducted for others under a contractual arrangement is a part of accounting for contracts in general and is addressed in other literature See FASB ASC 730-205.) In reaching this decision, the FASB considered the three pervasive principles of expense recognition: (1) associating cause and effect, (2) systematic and rational allocation, and (3) immediate recognition. The FASB found little or no evidence of a direct causal relationship between current research and development expenditures and subsequent future benefits. The FASB also stated that the high degree of uncertainty surrounding future benefits, if any, of individual research and development projects make it doubtful that there is any useful purpose to be served by capitalizing the costs and allocating them over future periods. In view of the above, the FASB concluded that the first two principles of expense recognition do not apply, but rather that the “immediate recognition” principle of expense recognition should apply.
CT 11.3 (Continued) The high degree of uncertainty about whether research and development expenditures will provide any future benefits, the lack of objectivity in setting criteria, and the lack of usefulness of the resulting information led the FASB to reject the alternatives of capitalization, selective capitalization, and accumulation of costs in a special category. (c) The following costs attributable only to research and development should be expensed as incurred: Design and engineering studies. Prototype manufacturing costs. Administrative costs related solely to research and development. The cost of equipment produced solely for development of the product ($315,000). The remaining $585,000 of equipment should be capitalized and shown on the balance sheet at cost less accumulated depreciation. The depreciation expense resulting from the current year is a part of research and development expense for the year. The market research direct costs and related administrative expenses are not research and development costs. These costs are treated as period costs and are shown as expense items in the current income statement. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 11.4 (a) Investors and creditors are concerned with corporate profits, dividends, and cash flow. Employees in Czeslaw Corporation’s R&D department are concerned about job security if the company begins to hire outside firms rather than have work done internally. Reid must be concerned with his performance and reputation within the company as well. (b) Ethical issues include long-term versus short-term profits, concern for job security, loyalty to fellow employees, and an efficient operation. (c) Reid should do what is best for Czeslaw Corporation in the long-run. He should choose to have the project done where the work will be done well and at the lowest cost. Whether expenses will appear in the income statement immediately or will be capitalized and allocated over a period of years should NOT be the driving factor in making the decision. He should be able to explain his decision to higherups and illustrate the different required accounting treatments. He also should give some thought to the impact on employee morale if he does not use the company’s own R&D department. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Codification Exercises CE11.1 According to the Master Glossary: (a) Intangible assets are assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.) (b) An asset representing the future economic benefits arising from other assets acquired in a business combination or an acquisition by a not-for-profit entity that are not individually identified and separately recognized. For ease of reference, this term also includes the immediate charge recognized by not-for-profit entities in accordance with paragraph 958-805-25-29. (c) Research and Development: Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service (referred to as product) or a new process or technique (referred to as process) or in bringing about a significant improvement to an existing product or process. Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. LO: 1, 4, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Technology Communication, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE11.2 See FASB ASC 350-30-35. In the discussions related to “Determining the Useful Life of an Intangible Asset” 35-1
The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life shall be amortized; an intangible asset with an indefinite useful life shall not be amortized.
35-2
The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. The useful life is not the period of time that it would take that entity to internally develop an intangible asset that would provide similar benefits. However, a reacquired right recognized as an intangible asset is amortized over the remaining contractual period of the contract in which the right was granted. If an entity subsequently reissues (sells) a reacquired right to a third party, the entity includes the related unamortized asset, if any, in determining the gain or loss on the reissuance.
CE11.2 (Continued) 35-3
The estimate of the useful life of an intangible asset to an entity shall be based on an analysis of all pertinent factors, in particular, all of the following factors with no one factor being more presumptive than the other: a. The expected use of the asset by the entity. b. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate. c. Any legal, regulatory, or contractual provisions that may limit the useful life. The cash flows and useful lives of intangible assets that are based on legal rights are constrained by the duration of those legal rights. Thus, the useful lives of such intangible assets cannot extend beyond the length of their legal rights and may be shorter. d. The entity’s own historical experience in renewing or extending similar arrangements, consistent with the intended use of the asset by the entity, regardless of whether those arrangements have explicit renewal or extension provisions. In the absence of that experience, the entity shall consider the assumptions that market participants would use about renewal or extension consistent with the highest and best use of the asset by market participants, adjusted for entity-specific factors in this paragraph. e. The effects of obsolescence, demand, competition, and other economic factors (such as the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels). f. The level of maintenance expenditures required to obtain the expected future cash flows from the asset (for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life). As in determining the useful life of depreciable tangible assets, regular maintenance may be assumed but enhancements may not. Further, if an income approach is used to measure the fair value of an intangible asset, in determining the useful life of the intangible asset for amortization purposes, an entity shall consider the period of expected cash flows used to measure the fair value of the intangible asset adjusted as appropriate for the entity-specific factors in this paragraph.
35-4
If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an intangible asset to the reporting entity, the useful life of the asset shall be considered to be indefinite. The term indefinite does not mean the same as infinite or indeterminate. The useful life of an intangible asset is indefinite if that life extends beyond the foreseeable horizon—that is, there is no foreseeable limit on the period of time over which it is expected to contribute to the cash flows of the reporting entity. Such intangible assets might be airport route authorities, certain trademarks, and taxicab medallions.
LO: 2, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Technology, Communication, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE11.3 According the FASB ASC 730-10-50: 50-1
Disclosure shall be made in the financial statements of the total research and development costs charged to expense in each period for which an income statement is presented. Such disclosure shall include research and development costs incurred for a computer software product to be sold, leased, or otherwise marketed.
LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Technology Communication, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE11.4 According the FASB ASC 926-720-25, General Overall Deals 25-1
An entity may enter into an overall deal arrangement. An entity shall charge the costs of overall deals that cannot be identified with specific projects to expenses as they are incurred over the related time period. > Exploitation Costs
25-2
An entity shall account for advertising costs in accordance with the provisions of Subtopic 720-35. That is, expense as incurred.
LO: 4, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Technology,, Communication, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a)
FASB ASC 350-10-05. Codification String: Assets > 350 Intangibles – Goodwill and other >10 Overall > 05 Overview and Background
(b)
Codification String: Assets > 350 Intangibles – Goodwill and other > 10 Overall > 20 Glossary Goodwill An asset representing the future economic benefits arising from other assets acquired in a business combination or an acquisition by a notfor-profit entity that are not individually identified and separately recognized. For ease of reference, this term also includes the immediate charge recognized by not-for-profit entities in accordance with paragraph 958-805-25-29.
(c)
Overall Accounting for Goodwill: Codification String; Assets > 350 Intangibles – Goodwill and other > 20 Goodwill > 35 Subsequent Measurement. 35-1
(d)
Goodwill shall not be amortized. Instead, goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit. (Paragraphs 350-20-35-33 through 35-46 provide guidance on determining reporting units.)
Codification String: Assets > 350 Intangibles – Goodwill and other > 20 Goodwill > 35 Subsequent Measurement
Codification Research Case (Continued) Quantitative Impairment Test 350-20-35-4
The quantitative goodwill impairment test, used to identify both the existence of impairment and the amount of impairment loss, compares the fair value of a reporting unit with its carrying amount, including goodwill.
350-20-35-5
The guidance in paragraphs 350-20-35-22 through 3524 shall be considered in determining the fair value of a reporting unit.
350-20-35-6
If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired.
350-20-35-7
In determining the carrying amount of a reporting unit, deferred income taxes shall be included in the carrying amount of the reporting unit, regardless of whether the fair value of the reporting unit will be determined assuming it would be bought or sold in a taxable or nontaxable transaction.
350-20-35-8
If the carrying amount of a reporting unit exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. Additionally, an entity shall consider the income tax effect from any tax-deductible goodwill on the carrying amount of the reporting unit, if applicable, in accordance with paragraph 350-20-35-8B when measuring the goodwill impairment loss.
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Technology, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, Technology and Tools, AICPA PC: Communication
CHAPTER 12 Current Liabilities and Contingencies Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1, 17
1, 2
1
1, 2
1. Concept of liabilities; definition and classification of current liabilities.
1, 2, 3, 4, 5, 28
2. Accounts and notes payable; dividends payable.
6
1, 2, 3
2, 17
3. Deposits and advance payments, gift cards.
11, 12, 13, 14
8, 9, 10, 11
8, 9, 17
4. Collections for third parties.
10
4, 5
5, 6, 7, 17
5. Compensated absences and bonuses.
7, 8, 9,
6, 7
3, 4, 17
6. Contingent liabilities (General).
15, 16, 17, 18, 19
7. Guaranties and warranties.
20, 21
8. Premiums and awards offered to customers.
6 3, 4
13, 17
10, 11, 13
3, 4, 5
14, 15
10, 11, 17
5, 6, 7, 12, 13, 14
4, 5, 6
22, 23
16
12, 14, 17
8, 9, 12, 14
9. Litigation, claims, and assessments.
24, 25
12, 13
10. Presentation and analysis.
26, 27, 28
11. Short-term obligations expected to be refinanced.
29, 30, 31
10, 11, 13 18, 19, 20
17
15, 16
6, 9, 13
1, 2 7
Assignment Classification Table (By Learning Objective) Learning Objectives
Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Describe the nature, valuation, and reporting of current liabilities in the form of payables. Describe the nature, valuation, and reporting of current liabilities in the form of unearned revenues.
1, 2, 3, 4, 5, 6, 7, 8, 9, 103
1, 2, 3, 4, 5, 6, 7
1, 2, 3, 4, 5, 6, 7
1, 2, 3, 4
1, 2
11, 12, 13, 14
8, 9, 10, 11
8, 9
2
1
3.
Explain the accounting for loss and loss contingencies.
15, 16, 17, 18,19, 20, 21, 22, 23, 24, 25
12, 13, 14, 15, 16
10, 11, 12, 13, 14
5, 6, 7, 8, 9, 10, 11, 12, 13, 14
3, 4, 5, 6
4.
Indicate how to present and analyze liabilities and contingencies.
26, 27, 28, 29, 30, 31
17
15, 16, 17, 18, 19, 20
9
7
2.
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E12.1 E12.2 E12.3 E12.4 E12.5 E12.6 E12.7 E12.8 E12.9 E12.10 E12.11 E12.12 E12.13 E12.14 E12.15 E12.16 E12.17 E12.18 E12.19 E12.20
Balance sheet classification of various liabilities. Accounts and notes payable. Compensated absences Compensated absences Adjusting entry for sales tax. Payroll tax entries. Payroll tax entries. Unearned revenues Unearned revenues Warranties. Warranties. Premium entries. Contingencies. Premiums. Refinancing of short-term debt. Refinancing of short-term debt. Financial statement impact of liability transactions. Ratio computations and discussion. Ratio computations and analysis. Ratio computations and effect of transactions.
Simple Moderate Moderate Moderate Simple Simple Moderate Moderate Moderate Simple Moderate Simple Moderate Moderate Moderate Moderate Moderate Simple Simple Moderate
10–15 15–20 25–30 25–30 5–7 10–15 15–20 15–20 15–20 10–15 15–20 15–20 20–30 25–35 10–12 20–25 30–35 15–20 20–25 15–25
P12.1 P12.2 P12.3 P12.4 P12.5 P12.6 P12.7 P12.8 P12.9 P12.10 P12.11 P12.12 P12.13 P12.14
Current liability entries and adjustments. Liability entries and adjustments. Payroll tax entries. Payroll tax entries. Warranties. Extended warranties. Warranties. Premium entries. Premium entries and financial statement presentation. Loss contingencies: entries and essay. Loss contingencies: entries and essays. Warranties and premiums. Liability errors. Warranty and coupon computation.
Simple Simple Moderate Simple Simple Simple Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate
25–30 25–35 20–30 20–25 15–20 10–20 25–35 15–25 30–45 25–30 35–45 20–30 25–35 20–25
CT12.1 CT12.2 CT12.3 CT12.4 CT12.5 CT12.6 CT12.7
Nature of liabilities. Current versus noncurrent classification. Loss contingencies. Loss contingency. Warranties and loss contingencies. Warranties. Refinancing of short-term debt.
Moderate Moderate Moderate Simple Simple Simple Moderate
20–25 15–20 30–40 15–20 15–20 15–20 20–25
Answers to Questions 1. Current liabilities are obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities. Long-term debt consists of all liabilities not properly classified as current liabilities. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
2. A formal definition of liabilities presented in Concepts Statement No. 6 is as follows: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. This more recent definition calls for the disbursement of assets or services in the future and that the present value of all of a person’s or company’s future disbursements of assets constitutes the total liabilities of that person or company. But, accountants quantify or measure only those liabilities or future disbursements which are reasonably determinable at the present time. And, accountants have accepted the completed transaction as providing the objectivity or basis necessary for financial recognition. Therefore, a liability may be viewed as an obligation to convey assets or perform services at some time in the future and is based upon a past or present transaction or event. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
3. As a lender of money, the banker is interested in the priority his/her claim has on the company’s assets relative to other claims. Close examination of the liability section and the related footnotes discloses amounts, maturity dates, collateral, subordinations, and restrictions of existing contractual obligations, all of which are important to potential creditors. The assets and earning power are likewise important to a banker considering a loan. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
4. Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets, or the creation of other current liabilities. Because current liabilities are by definition tied to current assets and current assets by definition are tied to the operating cycle, liabilities are related to the operating cycle. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 12 (Continued) 5. Payables and receivables generally involve an interest element. Recognition of the interest element (the cost of money as a factor of time and risk) results in valuing future payments at their current value. The present value of a liability represents the debt exclusive of the interest factor. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
6. A discount on notes payable represents the difference between the present value and the face value of the note, the face value being greater in amount than the discounted amount. It should be treated as an offset (contra) to the face value of the note and amortized to interest expense over the life of the note. The discount represents interest expense chargeable to future periods. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
7.
Compensated absences are employee absences such as vacation, illness, and holidays for which it is expected that employees will be paid.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
8.
A liability should be accrued for the cost of compensated absences if all of the following conditions are met: (a) The employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered. (b) The obligation relates to the rights that vest or accumulate. (c) Payment of the compensation is probable. (d) The amount can be reasonably estimated. If an employer meets conditions (a), (b), and (c), but does not accrue a liability because of failure to meet condition (d), that fact should be disclosed.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
9.
An employer is required to accrue a liability for “sick pay” that employees are allowed to accumulate and use as compensated time off even if their absence is not due to illness. An employer is permitted, but not required, to accrue a liability for sick pay that employees are allowed to claim only as a result of actual illness.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
10. Employers generally withhold from each employee’s wages amounts to cover income taxes (withholding), the employee’s share of FICA taxes, and other items such as union dues or health insurance. In addition, the employer must set aside amounts to cover the employer’s share of FICA taxes and state and federal unemployment taxes. These latter amounts are recorded as payroll expenses and will lower Battle’s income. In addition, the amount set aside (both the employee and the employer share) will be reported as current liabilities until they are remitted to the appropriate third party. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 12 (Continued) 11. Unearned revenue arises when a company receives cash or other assets as payment from a customer before conveying (or even producing) the goods or performing the services which it has committed to the customer. Unearned revenue is assumed to represent the obligation to the customer to refund the assets received in the case of nonperformance or to perform according to the agreement and thus, earn the unrestricted right to the assets received. While there may be an element of unrealized profit included among the liabilities when unearned revenues are classified as such, it is ignored on the grounds that the amount of unrealized profit is uncertain and usually not material relative to the total obligation. Unearned revenues arise from the following activities: (1) The sale by a transportation company of tickets or tokens that may be exchanged or used to pay for future fares. (2) The sale by a restaurant of meal tickets that may be exchanged or used to pay for future meals. (3) The sale of gift certificates by a retail store. (4) The sale of season tickets to sports or entertainment events. (5) The sale of subscriptions to magazines. LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
12. A gift card is a form of prepayment for goods or services. For example, when Amazon sells a gift card to you, it is receiving a nonrefundable payment for goods and services that you will have the right to receive in the future. As a result, Amazon has a performance obligation. It does not report gift card revenue on the date you buy the card, but rather reports a liability (Unearned Revenue) because it has not satisfied its performance obligation to you (or to the person you give the card). According to the revenue recognition principle, Amazon then recognizes revenue when gift cards are redeemed. LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
13. Breakage is the term used to describe the accounting for gift cards that are not redeemed (they are forfeited). As a result of breakage, the company issuing the gift cards will recognize expense-free revenue. The amount of breakage recognized as revenue is based on an estimate of cards that will not be redeemed in proportion to the total cards expected to be redeemed. LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
14. Unearned revenue is a liability that arises from current sales but for which some services or products are owed to customers in the future. At the time of a sale, customers pay not only for the delivered product, but they also pay for future products or services (e.g., another plane trip, hotel room, or software upgrade). In this case, the company recognizes revenue from the current product and part of the sale proceeds is recorded as a liability (unearned revenue) for the value of future products or services that are “owed” to customers. Market analysts indicate that an increase in the unearned revenue liability, rather than raising a red flag about liquidity often provides a positive signal about sales and profitability. When the sales are growing, its unearned revenue account should grow. Thus, an increase in a liability may be good news about company performance. In contrast, when unearned revenues decline, the company owes less future amounts but this also means that sales of new products may have slowed. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
15. (a) A contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. (b) A contingent liability is a liability incurred as a result of a loss contingency. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 12 (Continued)
16. A contingent liability should be recorded and a charge accrued to expense or loss only if: (a) information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements, and (b) the amount of the loss can be reasonably estimated. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
17. A determinable current liability is susceptible to precise measurement because the date of payment, the payee, and the amount of cash needed to discharge the obligation are reasonably certain. There is nothing uncertain about (1) the fact that the obligation has been incurred and (2) the amount of the obligation. A contingent liability is an obligation that is dependent upon the occurrence or nonoccurrence of one or more future events to confirm the amount payable, the payee, the date payable, or its existence. It is a liability dependent upon a “loss contingency.” Determinable Current liabilities—accounts payable, notes payable, current maturities of long-term debt, dividends payable, returnable deposits, sales and use taxes, payroll taxes, and accrued expenses. Contingent liabilities—obligations related to product warranties and product defects, premiums offered to customers, certain pending or threatened litigation, certain actual and possible claims and assessments, and certain guarantees of indebtedness of others. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
18. The terms probable, reasonably possible, and remote are used in GAAP to denote the chances of a future event occurring, the result of which is a gain or loss to the enterprise. If it is probable that a loss has been incurred at the date of the financial statements, then the liability (if reasonably estimable) should be recorded. If it is reasonably possible that a loss has been incurred at the date of the financial statements, then the liability should be disclosed via a footnote. The footnote should disclose (1) the nature of the contingency and (2) an estimate of the possible loss or range of loss or a statement that an estimate cannot be made. If the incurrence of a loss is remote, then no liability need be recorded or disclosed (except for guarantees of indebtedness of others, which are disclosed even when the loss is remote). LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
19. Under U.S. GAAP, companies may not record provisions for future operating losses. Such provisions do not meet the definition of a liability, since the amount is not the result of a past transaction (the losses have not yet occurred). Therefore the liability has not been incurred. Furthermore, operating losses reflect general business risks for which a reasonable estimate of the loss could not be determined. Note that use of provisions in this way is one of the examples of earnings management discussed in Chapter 4. By reducing income in good years through the use of loss contingencies, companies can smooth out their income from year-to-year. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
20. Companies do not record a separate performance obligation for assurance-type warranties. This type of warranty is nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These types of obligations should be expensed in the period the goods are provided or services performed (in other words, at the point of sale). In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur after sale due to the correction of defects or deficiencies required under the warranty provisions. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 12 (Continued) 21. Companies record a service-type warranty as a separate performance obligation. For example, in the case of the television, the seller recognizes the sale of the television with the assurance-type warranty separately from the sale of the service-type warranty. The sale of the service-type warranty is usually recorded in an Unearned Warranty Revenue account. Companies then recognize revenue on a straight-line basis over the period the service-type warranty is in effect. Companies only defer and amortize costs that vary with and are directly related to the sale of the contracts (mainly commissions). Companies expense employees’ salaries and wages, advertising, and general and administrative expenses because these costs occur even if the company did not sell the service-type warranty. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
22. Southeast Airlines Inc.’s award plan is in essence a discounted ticket sale. Therefore, the full-fare ticket should be recorded as unearned transportation revenue (liability) when sold and recognized as revenue when the transportation is provided. The half-fare ticket should be treated accordingly; that is, record the discounted price as unearned transportation revenue (liability) when it is sold and recognize it as revenue when the transportation is provided. LO: 3, Bloom: AN, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
23. In the case of a free ticket award, a portion of the ticket fares contributing to the accumulation of the 50,000 miles (the free ticket award level) should be deferred as unearned transportation revenue and recognized as revenue when free transportation is provided. The total amount deferred for the free ticket should be based on the revenue value to the airline and the deferral should occur and accumulate as mileage is accumulated. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
24. The absence of insurance does not mean that a liability has been incurred at the date of the financial statements. Until the time that an event (loss contingency) occurs, there can be no diminution in the value of property or incurrence of a liability. If an event has occurred which exposes an enterprise to risks of injury to others and/or damage to the property of others, then a contingency exists. Expected future injury, damage, or loss resulting from lack of insurance need not be recorded or disclosed if no contingency exists. And, a contingency exists only if an uninsurable event which causes probable loss has occurred. Lack of insurance is not in itself a basis for recording a liability or loss. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
25. In determining whether or not to record a liability for pending litigation, the following factors must be considered: (a) The time period in which the underlying cause for action occurred. (b) The probability of an unfavorable outcome. (c) The ability to make a reasonable estimate of the amount of loss. Before recording a liability for threatened litigation, the company must determine: (a) The degree of probability that a suit may be filed, and (b) The probability of an unfavorable outcome. If both are probable, the loss reasonably estimable, and the cause for action dated on or before the date of the financial statements, the liability must be accrued. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 12 (Continued) 26. There are several defensible recommendations for listing current liabilities: (1) in order of maturity, (2) according to amount, (3) in order of liquidation preference. The authors’ recent review of published financial statements disclosed that a significant majority of the published financial statements examined listed “notes payable” first, regardless of relative amount, followed most often by “accounts payable,” and ending the current liability section with “current portion of long-term debt.” LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
27. The acid-test ratio and the current ratio are both measures of the short-term debt-paying ability of the company. The acid-test ratio excludes inventories and prepaid expenses on the basis that these assets are difficult to liquidate in an emergency. The current ratio and the acid-test ratio are similar in that both numerators include cash, short-term investments, and net receivables, and both denominators include current liabilities. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
28. (a) A liability for goods purchased on credit should be recorded when control passes to the purchaser. If the terms of purchase are f.o.b. destination, title passes when the goods purchased arrive; if f.o.b. shipping point, title passes when shipment is made by the vendor. (b) Officers’ salaries should be recorded when they become due at the end of a pay period. Accrual of unpaid amounts should be recorded in preparing financial statements dated other than at the end of a pay period. (c) A special bonus to employees should be recorded when approved by the board of directors or person having authority to approve, if the bonus is for a period of time and that period has ended at the date of approval. If the period for which the bonus is applicable has not ended but only a part of it has expired, it would be appropriate to accrue a pro rata portion of the bonus at the time of approval and make additional accruals of pro rata amounts at the end of each pay period. (d) Dividends should be recorded when they have been declared by the board of directors. (e) Usually it is neither necessary nor proper for the buyer to make any entries to reflect commitments for purchases of goods that have not been shipped by the seller. Ordinary orders, for which the prices are determined at the time of shipment and subject to cancellation by the buyer or seller, do not represent either an asset or a liability to the buyer and need not be reflected in the books or in the financial statements. However, an accrued loss on purchase commitments which results from formal purchase contracts for which a firm price is in excess of the market price at the date of the balance sheet would be shown in the liability section of the balance sheet. (See Chapter 9 on purchase commitments.) LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
29. Liabilities that are due on demand (callable by the creditor) should be classified as current liabilities. Classification of the debt as current is required because it is a reasonable expectation that existing working capital will be used to satisfy the debt. Liabilities often become callable by the creditor when there is a violation of the debt agreement. Only if it can be shown that it is probable that the violation will be cured (satisfied) within the grace period usually given in these agreements can the debt be classified as noncurrent. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
30. A company should exclude a short-term obligation from current liabilities if both of the following conditions are met: (1) It must intend to refinance the obligation on a long-term basis; (2) It must demonstrate an ability to consummate the refinancing. Meeting these criteria supports the assertion that current assets will not be used to pay the debt. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 12 (Continued) 31. The ability to consummate the refinancing may be demonstrated (i) by actually refinancing the shortterm obligation by issuing a long-term obligation or equity securities after the date of the balance sheet but before the balance sheet is issued, or (ii) by entering into a financing agreement that clearly permits the company to refinance the debt on a long-term basis on terms that are readily determinable. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 12.1 July 1 Purchases........................................................ Accounts Payable ..................................
60,000
Freight-In ......................................................... Cash Cash ........................................................
1,200
60,000 1,200
July 3 Accounts Payable ........................................... Purchase Returns and Allowances ......
6,000 6,000
July 10 Accounts Payable ($60,000 - $6,000) ............. Cash ($54,000 - $1,080) Purchase Discounts ($54,000 x .02) .....
54,000 52,920 1,080
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.2 11/1/25 Cash ..................................................................... ..................................................................... Notes Payable....................................
40,000 40,000
12/31/25 Interest Expense......................................... Interest Payable ($40,000 × 9% × 2/12) ......................
600 600
2/1/26 Notes Payable ............................................. Interest Payable .......................................... Interest Expense ($40,000 × .09 × 1/12).....
40,000 600 300
Cash [($40,000 × .09 × 3/12) + $40,000] ..
40,900
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.3 11/1/25 Cash ....................................................................... ....................................................................... Discount on Notes Payable .......................... Notes Payable ......................................
60,000 1,350 61,350
12/31/25 Interest Expense ........................................... Discount on Notes Payable ($1,350 × 2/3) .....................................
900 900
2/1/26 Interest Expense .......................................... Discount on Notes Payable ................ ($1,350 x 1/3)
450
Notes Payable .............................................. Cash .....................................................
61,350
450
61,350
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.4 (a)
(b)
Accounts Receivable .................................................... Sales Revenue ..................................................... Sales Taxes Payable ($30,000 × 6% = $1,800) ....................................
31,800
Cash ....................................................................................... ....................................................................................... Sales Revenue ($20,670 ÷ 1.06) .......................... Sales Taxes Payable ($20,670 − $19,500) ........... (or $19,500 x .06)
20,670
30,000 1,800
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
19,500 1,170
Brief Exercise 12.5 Salaries and Wages Expense ....................................... FICA Taxes Payable ............................................. Withholding Taxes Payable................................. Insurance Premium Payable ............................... Cash ......................................................................
24,000 1,836 3,910 250 18,004
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.6 Salaries and Wages Expense ....................................... Salaries and Wages Payable (30 × 2 × $500) ...................................................
30,000 30,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.7 12/31/25 Salaries and Wages Expense ....................................... Salaries and Wages Payable ...............................
350,000 350,000
2/15/26 Salaries and Wages Payable ........................................ Cash ......................................................................
350,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
350,000
Brief Exercise 12.8 8/1/25 Cash ...................................................................... ...................................................................... Unearned Subscriptions Revenue (12,000 × $18) ...................................
216,000
216,000
12/31/25 Unearned Subscriptions Revenue .............. Subscriptions Revenue ($216,000 × 5/12 = $90,000) .............
90,000 90,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.9 The journal entries to record the gift card transactions are as follows. Cash (200 × $50)........................................... 10,000 Unearned Gift Card Revenue ............. 10,000 (To record sale of 200 gift cards) Unearned Gift Card Revenue ...................... Sales Revenue (100 × $50) ................. (To record redemption of 100 gift cards in November)
5,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
5,000
Brief Exercise 12.10 With 10% estimated breakage, it is expected that 180, not 200 cards will be redeemed. Therefore, when 100 of the gift cards are redeemed, it should recognize 55.55% (100 ÷ 180) of the expected revenue (and expected breakage revenue). The entry to record the transaction is as follows. Unearned Gift Card Revenue ............................. Sales Revenue (100 x $50) ................... Sales Revenue (Breakage) [.5555 × (200 x $50)] ..........................
5,555 5,000 555
While not required in this exercise, Cost of Goods Sold is recorded only for the cards redeemed, not for the breakage revenue. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.11 Cash ($500 × 275) ........................................ Refundable Deposit Liability.............. (To record a deposit)
137,500 137,500
While not required in this exercise, if all apartments are vacated with no repairs needed (good tenants), Brown records return of the deposit with the following entry. Refundable Deposit Lability ........................ Cash .................................................... (To record return of deposit)
137,500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
137,500
Brief Exercise 12.12 (a) (b)
Lawsuit Loss ......................................................... Lawsuit Liability ...........................................
900,000 900,000
No entry is necessary. The loss is not accrued because it is not probable that a liability has been incurred at 12/31/25.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 12.13 Buchanan should record a lawsuit (litigation) accrual on the patent case, since the amount is both estimable and probable. This entry will reduce income by $300,000 and Buchanan will report a lawsuit (litigation) liability of $300,000. The $100,000 self-insurance allowance has no impact on income or liabilities. Lawsuit Loss ............................................ Lawsuit Liability ..........................
300,000 300,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 12.14 During 2025 Warranty Expense ...................................... Inventory....................................................
70,000
Cash ............................................................ Sales Revenue .........................................
1,000,000
70,000 1,000,000
12/31/25 Warranty Expense ...................................... Warranty Liability ($125,000 - $70,000) .(
55,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 12.15
55,000
(a)
(b) (c)
Cash ....................................................................... ....................................................................... Unearned Warranty Revenue (20,000 × $99) ....................................
1,980,000
Warranty Expense ........................................ Inventory ..............................................
180,000
Unearned Warranty Revenue ....................... Warranty Revenue ($1,980,000 ÷ 4) .................................
495,000
1,980,000 180,000
495,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 12.16 Premium Expense ............................................................ Premium Liability .................................................... *UPC codes expected to be sent in (30% × 1,200,000) .. UPC codes already redeemed ........................................ Estimated future redemptions ....................................... Cost of estimated claims outstanding (240,000 ÷ 3) × ($1.10 + $0.60 – $0.50).........................
96,000 96,000* 360,000 120,000 240,000 $ 96,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Brief Exercise 12.17 (a)
$250,000. Since Burr has the contractual right at the balance sheet date to defer payment of $250,000, that amount is classified as a long-term liability. The remaining $250,000 ($500,000 - $250,000) is classified as a current liability, as it will require payment from current assets.
(b)
Because repayment of the note payable required the use of existing 12/31/25 current assets, the entire $500,000 liability must be reported as current. (This assumes Burr had not entered into a long-term agreement prior to issuance.)
LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Solutions to Exercises Exercise 12.1 (10–15 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n)
Current liability. Current liability. Current liability or long-term liability depending on term of warranty. Current liability. Current liability. Current liability. Current or noncurrent liability depending upon the time involved. Current liability. Current liability. Current liability. Current liabilities or long-term liabilities as a deduction from face value of note. Footnote disclosure (assume not probable and/or not reasonably estimable). Current liability. Current liability.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.2 (15–20 minutes) (a)
Sept. 1 Purchases............................................. Accounts Payable .......................
50,000
Oct. 1 Accounts Payable ................................ Notes Payable .............................
50,000
50,000
50,000
Oct. 1 Cash ............................................................... ............................................................... Discount on Notes Payable ................. Notes Payable .............................
50,000 4,000 54,000
Exercise 12.2 (Continued) Dec. 31 (b)
Interest Expense .................................. Interest Payable .......................... ($50,000 × 8% × 3/12)
1,000 1,000
Dec. 31 Interest Expense .................................. Discount on Notes Payable ........ ($4,000 × 3/12) (c)
(1)
Notes payable Interest payable
$50,000 1,000 $51,000
(2)
Notes payable Less discount ($4,000 – $1,000)
$54,000 3,000 $51,000
1,000 1,000
LO: 1, Bloom: AP, Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.3 (25–30 minutes) (a)
2025 To accrue expense and liability for vacations: Salaries and Wages Expense........................ Salaries and Wages Payable ................
7,200 7,200 (1)
To accrue the expense and liability for sick pay: Salaries and Wages Expense........................ Salaries and Wages Payable ................
4,320 (2) 4,320
To record payment for compensated time when used by employees: Salaries and Wages Payable ......................... Cash .......................................................
2,880 (3) 2,880
Exercise 12.3 (Continued) 2026 To accrue the expense and liability for vacations: Salaries and Wages Expense ........................ Salaries and Wages Payable ................
7,920 7,920 (4)
To accrue the expense and liability for sick pay: Salaries and Wages Expense ........................ Salaries and Wages Payable ................
4,752 4,752 (5)
To record vacation time paid: Salaries and Wages Expense ........................ Salaries and Wages Payable ......................... Cash .......................................................
648 6,480 (6) 7,128 (7)
To record sick leave paid: Salaries and Wages Expense ........................ Salaries and Wages Payable ......................... Cash ....................................................... (1) (2) (3) (4) (5) (6) (7) (8)
144 3,816 (8)
9 employees × $10.00/hr. × 8 hrs./day × 10 days 9 employees × $10.00/hr. × 8 hrs./day × 6 days 9 employees × $10.00/hr. × 8 hrs./day × 4 days 9 employees × $11.00/hr. × 8 hrs./day × 10 days 9 employees × $11.00/hr. × 8 hrs./day × 6 days 9 employees × $10.00/hr. × 8 hrs./day × 9 days 9 employees × $11.00/hr. × 8 hrs./day × 9 days 9 employees × $10.00/hr. × 8 hrs./day × (6–4) days = $1,440 9 employees × $11.00/hr. × 8 hrs./day × (5–2) days = $2,376 (9) 9 employees × $11.00/hr. × 8 hrs./day × 5 days
3,960 (9) = $7,200 = $4,320 = $2,880 = $7,920 = $4,752 = $6,480 = $7,128 = $3,816 $3,960
Note: Vacation days and sick days are paid at the employee’s current wage. Also, if employees earn vacation pay at different pay rates, a consistent pattern of recognition (e.g., first-in, first-out) could be employed to determine which liabilities have been paid.
Exercise 12.3 (Continued) (b)
Accrued liability at year-end:
Jan. 1 balance + accrued – paid Dec. 31 balance
2025 Vacation Sick Pay Wages Wages Payable Payable $ 0 $ 0 7,200 4,320 ( 0) (2,880) $7,200(1) $1,440(2)
2026 Vacation Wages Payable $7,200 7,920 (6,480) $8,640(3)
Sick Pay Wages Payable $1,440 4,752 (3,816) $2,376(4)
(1)
9 employees × $10.00/hr. × 8 hrs./day × 10 days =
$7,200
(2)
9 employees × $10.00/hr. × 8 hrs./day × (6–4) days =
$1,440
(3)
9 employees × $10.00/hr. × 8 hrs./day × (10–9) days 9 employees × $11.00/hr. × 8 hrs./day × 10 days =
$ 720 7,920 $8,640
(4)
9 employees × $11.00/hr. × 8 hrs./day × (6 + 6 – 4 – 5) days
$2,376
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-12, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Exercise 12.4 (25–30 minutes) (a)
2025 To accrue the expense and liability for vacations: Salaries and Wages Expense ............. Salaries and Wages Payable .....
7,740 (1) 7,740
To record sick leave paid: Salaries and Wages Expense ............. Cash ............................................
2,880 (2) 2,880
To record vacation time paid: No entry, since no vacation days were used. 2026 To accrue the expense and liability for vacations: Salaries and Wages Expense ............. Salaries and Wages Payable .....
8,352 (3) 8,352
To record sick leave paid: Salaries and Wages Expense ............. Cash ............................................
3,960 (4) 3,960
To record vacation time paid: Salaries and Wage Expense ............... Salaries and Wages Payable .............. Cash ............................................
162 6,966 (5) 7,128 (6)
(1)
9 employees × $10.75/hr. × 8 hrs./day × 10 days = $7,740
(2)
9 employees × $10.00/hr. × 8 hrs./day × 4 days = $2,880
(3)
9 employees × $11.60/hr. × 8 hrs./day × 10 days = $8,352
(4)
9 employees × $11.00/hr. × 8 hrs./day × 5 days = $3,960
Exercise 12.4 (Continued)
(5)
9 employees × $10.75/hr. × 8 hrs./day × 9 days = $6,966
(6)
9 employees × $11.00/hr. × 8 hrs./day × 9 days = $7,128
(b) Accrued liability at year-end: Jan. 1 balance + accrued – paid Dec. 31 balance
2025 $ 0 7,740 ( 0) $7,740(1)
2026 $7,740 8,352 (6,966) $9,126(2)
(1)
9 employees × $10.75/hr. × 8 hrs./day × 10 days =
$7,740
(2)
9 employees × $10.75/hr. × 8 hrs./day × 1 day = 9 employees × $11.60/hr. × 8 hrs./day × 10 days =
$ 774 8,352 $9,126
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Exercise 12.5 (5–7 minutes) June 30 Sales Revenue .............................................................. 21,900 Sales Taxes Payable ............................................ Computation: Sales plus sales tax ($233,200 + $153,700) $386,900 Sales exclusive of tax ($386,900 ÷ 1.06) 365,000 Sales tax $ 21,900 LO: 1, Bloom: AP, Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
21,900
Exercise 12.6 (10–15 minutes) Salaries and Wages Expense ....................................... 480,000 Withholding Taxes Payable ................................. FICA Taxes Payable*............................................ Union Dues Payable............................................. Cash ...................................................................... *[($480,000 – $110,000) × 7.65% = $28,305 $110,000 × 1.45% = $1,595; $28,305 + $1,595 = $29,900 Payroll Tax Expense ..................................................... FICA Taxes Payable ............................................. (See previous computation.) FUTA Taxes Payable ............................................ [($480,000 – $400,000) × .008) SUTA Taxes Payable............................................ [$80,000 × (.035 – .023)]
80,000 29,900 9,000 361,100
31,500 29,900 640 960
LO: 1, Bloom: AP, Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.7 (15–20 minutes) (a)
Computation of taxes Wages Social security taxes (FICA) Federal unemployment taxes State unemployment taxes Total Cost
Factory $120,000 9,180 (.0765 × $120,000) 320 (.008 × $40,000) 1,000 (.025 × $40,000) $130,500
Wages Social security taxes (FICA) Federal unemployment taxes State unemployment taxes Total Cost
Sales $32,000 1,208* 32 (.008 × $4,000) 100 (.025 × $4,000) $33,340
*[($32,000 - $20,000) × .0765] = $918; $20,000 × .0145 = $290; $918 + $290 = $1,208
Exercise 12.7 (continued) Wages Social security taxes (FICA) Federal unemployment taxes State unemployment taxes Total Cost
Administrative $36,000 2,754 (.0765 × $36,000) –0– –0– $38,754
Schedule
Wages FICA Federal U.T. State U.T. Total Cost
Total $188,000 13,142 352 1,100 $202,594
Factory $120,000 9,180 320 1,000 $130,500
Sales $32,000 1,208 32 100 $33,340
(b) Factory Payroll: Salaries and Wages Expense.............................. Withholding Taxes Payable ....................... FICA Taxes Payable .................................... Cash............................................................. Payroll Tax Expense ............................................ FICA Taxes Payable .................................... FUTA Taxes Payable .................................. SUTA Taxes Payable ..................................
Administrative $36,000 2,754 –0– –0– $38,754
120,000 16,000 9,180 94,820 10,500 9,180 320 1,000
Exercise 12.7 (Continued) Sales Payroll: Salaries and Wages Expense .............................. Withholding Taxes Payable ........................ FICA Taxes Payable
32,000 7,000 1,208
Cash ............................................................. Payroll Tax Expense ............................................ FICA Taxes Payable .................................... FUTA Taxes Payable ................................... SUTA Taxes Payable .................................. Administrative Payroll: Salaries and Wages Expense .............................. Withholding Taxes Payable ........................ FICA Taxes Payable .................................... Cash ............................................................. Payroll Tax Expense ............................................ FICA Taxes Payable ....................................
23,792 1,340 1,208 32 100 36,000 6,000 2,754 27,246 2,754 2,754
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.8 (15–20 minutes) (a)
(b)
December 10, 2025 Cash ($275,000 × .15) ........................................... Unearned Revenue ..................................... (To record receipt of customer down-payment) .......................................... April 3, 2026 Cash ..................................................................... Unearned Revenue ..................................... Sales Revenue ............................................ Cost of Goods Sold ............................................. Inventory ...................................................... (To record sale and delivery of the windows)
41,250 41,250
233,750 41,250 275,000 200,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
200,000
Exercise 12.9 (15–20 minutes) (a)
The journal entries to record the gift card transactions during August, 2025 are as follows. Cash (80 × $75) .................................................... Unearned Gift Card Revenue ..................... (To record sale of 80 gift cards).................
6,000 6,000
With estimated breakage of 10 cards, it is expected that 70, not 80 cards will be redeemed. Therefore, when 50 of the gift cards are redeemed, it should recognize 71.43% (50 ÷ 70) of the expected revenue (and expected breakage revenue). The entry to record the transaction is as follows. Unearned Gift Card Revenue ................................ Sales Revenue (.7143 × $75 × 70) ................. Sales Revenue (Breakage) (.7143 × $75 × 10) (To record redemption and breakage of gift cards)
4,286 3,750 536
While not required, Cost of Goods Sold is recorded only for the cards redeemed, not for the breakage revenue. (b)
September Cash ..................................................................... Refundable Deposit Liability ......................
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
300 300
Exercise 12.10 (10–15 minutes) July 10, 2025 Cash (200 × $4,000) ...................................................................... Sales Revenue .............................................
800,000 800,000
During 2025 Warranty Expense................................................. Inventory ......................................................
17,000 17,000
December 31, 2025 Warranty Expense................................................. Warranty Liability [(200 x $330) - $17,000] .
49,000 49,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.11 (15–20 minutes) At Sale (a)
Cash ............................................................................. ............................................................................. Sales Revenue (500 x $6,000) ...................
3,000,000 3,000,000
During 2025 Warranty Expense............................................... Cash, Inventory, Wages Payable ..............
20,000
December 31, 2025 Warranty Expense............................................... Warranty Liability ......................................
35,000
20,000
35,000
At Sale (b)
Cash ............................................................................. ............................................................................. Sales Revenue ........................................... Unearned Warranty Revenue .................... During 2025
3,000,000
2,944,000 56,000
Warranty Expense .............................................. Cash, Supplies, Wages Payable ...............
20,000 20,000
Exercise 12.11 (Continued) Unearned Warranty Revenue ............................. Warranty Revenue ..................................... ($56,000 ÷ 2)
28,000 28,000
Note to Instructor: Under the sales-type warranty (part (b)), revenue must be recognized. Warranty costs are expensed as incurred. LO: 3, Bloom: AP, Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.12 (15–20 minutes) Premium Inventory (8,800 × $.80) .............................. Cash ....................................................................
7,040 7,040
During 2025 Cash (110,000 × $3.30) ................................................ Sales Revenue....................................................
363,000
Premium Expense ....................................................... Premium Inventory [(44,000 ÷ 10) × $.80] .........
3,520
December 31, 2025 Premium Expense ....................................................... Premium Liability ...............................................
363,000 3,520 1,760* 1,760
*[(110,000 × 60%) – 44,000] ÷ 10 × $.80 = 1,760 LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.13 (20–30 minutes) 1.
The FASB requires that, when some amount within the range of expected loss appears at the time to be a better estimate than any other amount within the range, that amount is accrued. When no amount within the range is a better estimate than any other amount, the dollar amount at the low end of the range is accrued and the dollar amount at the high end of the range is disclosed. In this case, therefore, Salt-nPepa Inc. would report a liability of $900,000 at December 31, 2025, and disclose in the notes to the financial statements the $1,400,000.
Exercise 12.13 (Continued) 2.
The loss should be accrued for $5,000,000. The potential insurance recovery is a gain contingency—it is not recorded until received.
3.
This is a gain contingency because the amount to be received will be in excess of the book value of the plant. Gain contingencies are not recorded and are disclosed only when the probabilities are high that a gain contingency will become reality.
LO: 3, Bloom: AP, Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 12.14 (25–35 minutes) 1. Liability for stamp redemptions, 12/31/24 Cost of redemptions redeemed in 2025 Cost of redemptions to be redeemed in 2026 (5,200,000 × 80%) Liability for stamp redemptions, 12/31/25
$13,000,000 (6,000,000) 7,000,000 4,160,000 $11,160,000
2. Total coupons issued Redemption rate To be redeemed Handling charges ($480,000 × .10) Total cost
$800,000 60% 480,000 48,000 $528,000
Total cost Total payments to retailers Liability for unredeemed coupons
$528,000 330,000 $198,000
3. Boxes Redemption rate Total redeemable Coupons to be redeemed (490,000 – 250,000) Cost [($6.00 + $0.50) – $4.00] Liability for unredeemed coupons LO: 3, Bloom: AP, Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
700,000 70% 490,000 240,000 $2.50 $600,000
Exercise 12.15 (10–12 minutes) McDaniel Company Partial Balance Sheet December 31, 2025 Current liabilities: Notes payable (Note 1) Long-term liabilities: Notes payable (Note 1)
$250,000 $950,000
Note 1 Short-term debt refinanced. As of December 31, 2025, the company had notes payable totaling $1,200,000 due on February 2, 2026. These notes were refinanced on their due date to the extent of $950,000 received from the issuance of common stock on January 21, 2026. The balance of $250,000 was liquidated using current assets. Note : Disclosure is provided for the refinancing completed after the balance sheet date but before financial statements are issued. LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.16 (20–25 minutes) HOLMES COMPANY Partial Balance Sheet December 31, 2025 Current liabilities: Notes payable (Note 1) Long-term debt: Notes payable to be refinanced in 2026 (Note 1)
$3,400,000* 3,600,000
Note 1 Under a financing agreement with Gotham State Bank the Company has the contractual right to borrow up to 60% of the gross amount of its accounts receivable at an interest cost of 1% above the prime rate. The Company intends to issue notes maturing in 2030 to replace $3,600,000 of short-term, 15%, notes due periodically in 2026. Because the amount that can be borrowed is expected to range from $3,600,000 to $4,800,000, only $3,600,000 ($7,000,000 - $3,400,000) of the $7,000,000 of currently maturing debt has been reclassified as long-term debt. *[$7,000,000 – ($6,000,000 × 60%)] LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 12.17 (30–35 minutes)
#
Assets
Liabilities
Stockholders’ Equity
Net Income
1
I
I
NE
NE
2
NE
NE
NE
NE
3
NE
I
D
D
4
I
I
NE
NE
5
NE
I
D
D
6
I
I
I
I
7
D
I
D
D
8
NE
I
D
D
9
NE
I
D
D
10
NE
I
D
D
11
I
I
NE
NE
12
NE
I
D
D
13
NE
I
D
D
14
D
D
NE
NE
15
I
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16
D
NE
D
D
17
NE
D
I
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18
NE
I
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D
LO: 4, Bloom: AP, Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Exercise 12.18 (15–20 minutes) (a)
Current Assets Current Liabilities
Current Ratio =
$210,000* $80,000
=
= 2.63
*($40,000 + $75,000 + $95,000)
Current ratio measures the short-term ability of the company to meet its currently maturing obligations. (b)
Acid-test ratio =
Cash + Short-term Investments + Net Receivables $115,000** = Current Liabilities $80,000
= 1.44
**($40,000 = $75,000) Acid-test ratio also measures the short-term ability of the company to meet its currently maturing obligations. However, it eliminates assets that might be slow moving, such as inventories and prepaid expenses. (c)
Debt to assets ratio =
Total Liabilities = Total Assets
($80,000 + $140,000)
$430,000
= 51.16%
This ratio provides the creditors with some idea of the corporation’s ability to withstand losses without impairing the interests of creditors. (d)
Return on assets =
Net Income Average Total Assets
=
$25,000 $430,000
= 5.81%
This ratio measures the return the company is earning on its average total assets and provides one indication related to the profitability of the enterprise. LO: 4, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 12.19 (20–25 minutes) (a)
(1) Current ratio =
$773,000 $240,000
(2) Acid-test ratio =
($52,000 + $198,000 + $80,000) = 1.38 times $240,000
= 3.22 times
Exercise 12.19 (Continued) (3)
Accounts receivable turnover = ($80,000 + $198,000) $1,640,000 ÷ = 11.8 times (or approximately 2 every 31 days)
(4)
Inventory turnover = ($360,000 + $440,000) $800,000 ÷ = 2 times (or approximately 2 every 183 days)
(5)
Return on assets = ($1,400,000 + $1,630,000) $360,000 ÷ 2
(6)
(b)
= 23.76%
Profit margin on sales = $360,000 ÷ $1,640,000 = 21.95%
Financial ratios should be evaluated in terms of industry peculiarities and prevailing business conditions. Although industry and general business conditions are unknown in this case, the company appears to have a relatively strong current position. The main concern from a short-term perspective is the apparently low inventory turnover. The return on assets and profit margin on sales are extremely good and indicate that the company is employing its assets advantageously.
LO: 4, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 12.20 (15–25 minutes) (a)
(1)
Current ratio = $318,000* ÷ $87,000** = 3.66 times
(2)
$820,000 ÷
(3)
$1,400,000 ÷ $95,000 = 14.74 times (25 days) = Accounts receivable t
$200,000 + $170,000 = 4.43 times (82 days) = Inventory 2
*$45,000 + $95,000 + $170,000 + $8,000. **$50,000 + $32,000 + $5,000.
Exercise 12.20 (Continued)
(b)
(4)
$410,000 ÷ (260,000 ÷ $5) = $7.88 = Earnings per share
(5)
$410,000 ÷ $1,400,000 = 29.29% = Profit margin
(6)
$410,000 ÷ $488,000 = 84.02% = Return on assets
(1)
No effect on current ratio, if already included in the allowance for doubtful accounts.
(2)
Weaken current ratio by reducing current assets.
(3)
Improve current ratio by reducing current assets and current liabilities by a like amount.
(4)
No effect on current ratio.
(5)
Weaken current ratio by increasing current liabilities.
(6)
No effect on current ratio.
LO: 4, Bloom: AP, Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Time and Purpose of Problems Problem 12.1 (Time 25–30 minutes) Purpose—to present the student with an opportunity to prepare journal entries for a variety of situations related to liabilities. The situations presented are basic ones including purchases and payments on account, and borrowing funds by giving a zero-interest-bearing note. The student is also required to prepare year-end adjusting entries. Problem 12.2 (Time 25–35 minutes) Purpose—to present the student with the opportunity to prepare journal entries for several different situations related to liabilities. The situations presented include accruals and payments related to sales, use, and asset retirement obligations. Year-end adjusting entries are also required. Problem 12.3 (Time 20–30 minutes) Purpose—to present the student with an opportunity to prepare journal entries for four weekly payrolls. The student must compute income tax to be withheld, FICA tax, and state and federal unemployment compensation taxes. Problem 12.4 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to prepare journal entries for a monthly payroll. The student must compute income tax to be withheld, FICA tax, and state and federal unemployment compensation taxes. The student must be aware that the unemployment taxes do not apply to four employees as their earnings exceed the statutory maximum subject to the taxes. Problem 12.5 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to prepare journal entries and balance sheet presentations for assurance-type warranty costs. Entries in the sales year and one subsequent year are required. Problem 12.6 (Time 10–20 minutes) Purpose—to provide the student with a basic problem covering service-type warranty. The student is required to prepare journal entries in the year of sale and in subsequent years when warranty costs are incurred. Also required are balance sheet presentations for the year of sale and one subsequent year. While the problem is basic in nature it does test the student’s ability to understand and apply accrual concept. Problem 12.7 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare journal entries for assurance-type warranty costs. The student is also required to indicate the proper balance sheet disclosures. Problem 12.8 (Time 15–25 minutes) Purpose—to provide the student with a basic problem in accounting for premium offers. The student is required to prepare journal entries relating to sales, the purchase of the premium inventory, and the redemption of coupons. The student must also prepare the year-end adjusting entry reflecting the estimated liability for premium claims outstanding. A very basic problem.
Time and Purpose of Problems (Continued) Problem 12.9 (Time 30–45 minutes) Purpose—to present the student with a slightly complicated problem related to accounting for premium offers. The problem is more complicated in that coupons redeemed are accompanied by cash payments, and in addition to the cost of the premium item postage costs are also incurred. The student is required to prepare journal entries for various transactions including sales, purchase of the premium inventory, and redemption of coupons for two years. The second year’s entries are more complicated due to the existence of the liability for claims outstanding. Finally the student is required to indicate the amounts related to the premium offer that would be included in the financial statements for each of two years. This very realistic problem challenges the student’s ability to account for all transactions related to premium offers. Problem 12.10 (Time 25–30 minutes) Purpose—to present the student with the problem of determining the proper amount of and disclosure for a contingent loss due to lawsuits. The student is required to prepare a journal entry and a footnote. The student is also required to discuss any liability incurred by a company due to the risk of loss from lack of insurance coverage. A straightforward problem dealing with contingent losses. Problem 12.11 (Time 35–45 minutes) Purpose—to provide the student with a comprehensive problem dealing with contingent losses. The student is required to prepare journal entries for each of three independent situations. For each situation the student must also discuss the appropriate disclosure in the financial statements. The situations presented include a lawsuit, an expropriation, and a self-insurance situation. This problem challenges the student not only to apply the guidelines set forth in GAAP, but also to develop reasoning as to how the guidelines relate to each situation. Problem 12.12 (Time 20–30 minutes) Purpose—to provide the student with a problem to calculate warranty expense, estimated warranty liability, premium expense,premium inventory, and premium liability. Problem 12.13 (Time 25–35 minutes) Purpose—to present the student a comprehensive problem in determining various liabilities and present findings in writing. Issues addressed relate to contingencies, warranties, and litigation. Problem 12.14 (Time 20–25 minutes) Purpose—to present the student with a comprehensive problem in determining the amounts of various liabilities. The student must calculate (for independent situations) the liability for warranties, and an liability for coupons. Journal entries are not required. This problem should challenge the better students.
Solutions to Problems Problem 12.1 (a)
February 2 1. Purchases ($70,000 × .98) ...................................... Accounts Payable .........................................
68,600 68,600
February 26 Accounts Payable ................................................... Purchase Discounts Lost ....................................... Cash ...............................................................
68,600 1,400 70,000
April 1 2. Trucks (or Equipment)............................................ Cash ............................................................... Notes Payable ...............................................
50,000 4,000 46,000
May 1 3. Cash ............................................................................... ............................................................................... Discount on Notes Payable .................................. Notes Payable ............................................ (b)
83,000 9,000 92,000
December 31 1. No adjustment necessary 2. Interest Expense ($46,000 × .12 × 9/12) .......... Interest Payable ..........................................
4,140
3. Interest Expense ($9,000 × 8/12) ..................... Discount on Notes Payable ........................
6,000
4,140
LO: 1, Bloom: AP, Difficulty: Simple, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
6,000
Problem 12.2
1.
2.
3. 4.
Dec. 5
Dec. 1-31
Dec. 10
Cash ............................................................... ............................................................... Refundable Deposits ...................
500
Cash ............................................................... ............................................................... Sales Revenue ($798,000 ÷ 1.05) ....................... Sales Taxes Payable ($760,000 × .05) .........................
798,000
Trucks ($120,000 × 1.05) ....................... Cash..............................................
126,000
500
760,000 38,000 126,000
The journal entries to record the gift card transactions are as follows. Cash (25 × $100) ………………………… Unearned Gift Card Revenue ….. (To record sale of 25 gift cards)
2,500 2,500
With estimated breakage of 3 cards, it is expected that 22, not 25 cards will be redeemed. Therefore, when 20 of the gift cards are redeemed, it should recognize 90.91% (20 ÷ 22) of the expected revenue (and expected breakage revenue). The entry to record the transaction is as follows. Unearned Gift Card Revenue ………… Sales Revenue (.9091×$100x22).. Sales Revenue (Breakage) …….. (.9091 × $100 × 3)
2,273 2,000 273
While not required in this exercise, Cost of Goods Sold is recorded only for the cards redeemed, not for the breakage revenue. LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 12.3
Entries for Payroll 1 Salaries and Wages Expense ..................................... Withholding Taxes Payable (.10 × $1,040) ...... FICA Taxes Payable (.0765 × $1,040) ............... Union Dues Payable (.02 × $1,040) .................. Cash ...................................................................
1,040.00* 104.00 79.56 20.80 835.64
*$200 + $150 + $110 + $250 + $330 = $1,040 Payroll Tax Expense .................................................. FICA Taxes Payable (.0765 × $1,040) ............... FUTA Taxes Payable (.008 × $460*) ................. SUTA Taxes Payable (.025 × $460**) ...............
94.74 79.56 3.68 11.50
**$200 + $150 + $110. Entries for Payroll 2 and 3 Salaries and Wages Payable (Vacation) ................... Salaries and Wages Expense ($200 + $250)............. Withholding Taxes Payable (.10 × $1,040) ...... FICA Taxes Payable (.0765 × $1,040) ............... Union Dues Payable (.02 × $1,040) .................. Cash ...............................................................................
590.00* 450.00 104.00 79.56 20.80 835.64
*($300 + $220 + $660) ÷ 2 Payroll Tax Expense .................................................. FICA Taxes Payable (.0765 × $1,040) ............... FUTA Taxes Payable (.008 × $460) .................. SUTA Taxes Payable (.025 × $460) ..................
94.74 79.56 3.68 11.50
Problem 12.3 (Continued) Entries for Payroll 4 Salaries and Wages Expense .................................... Withholding Taxes Payable (.10 × $1,040)....... FICA Taxes Payable (.0765 × $1,040) ............... Union Dues Payable (.02 × $1,040) .................. Cash ................................................................... Payroll Tax Expense .................................................. FICA Taxes Payable (.0765 × $1,040) ............... FUTA Taxes Payable (.008 × $460)................... SUTA Taxes Payable (.025 × $460) ..................
1,040.00 104.00 79.56 20.80 835.64 94.74
Monthly Payment of Payroll Liabilities Withholding Taxes Payable ($104.00 × 4) ................. 416.00 FICA Taxes Payable ($79.56 × 8) ............................... 636.48 Union Dues Payable ($20.80 × 4) .............................. 83.20 FUTA Taxes Payable ($3.68 × 4)................................ 14.72 SUTA Taxes Payable ($11.50 × 4) ............................. 46.00 Cash ................................................................... LO: 1, Bloom: AP, Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
79.56 3.68 11.50
1,196.40
Problem 12.4 (a) Name B. D. Williams D. Raye K. Baker F. Lopez A. Daniels B. Kingston Total
Earnings to Aug. 31 $
6,800 6,500 7,600 13,600 131,300 136,300 $302,100
September Earnings $
800 700 1,100 1,900 13,000 16,000 $33,500
*($7,000 – $6,800) × .01 = $2.00 **($7,000 – $6,800) × .008 = $1.60 ***($7,000 – $6,500) × .01 = $5.00 ****($7,000 – $6,500) × .008 = $4.00
(b)
(c)
Income Tax Withholding $
80 70 110 190 1,300 1,600 $3,350
FICA
SUTA
FUTA
$ 61.20 53.55 84.15 145.35 901.50a 635.00b $1,880.75
$2.00* 5.00*** – – – – $7.00
$1.60** 4.00**** – – – – $5.60
a
($11,500 × .0765) + ($1,500 × .0145) = $901.50 ($6,500 × 7.65%) + ($9,500 × .0145) = $635.00
b
Salaries and Wages Expense............................. Withholding Taxes Payable ...................... FICA Taxes Payable................................... Cash............................................................
33,500.00
Payroll Tax Expense ........................................... FICA Taxes Payable................................... FUTA Taxes Payable ................................. SUTA Taxes Payable .................................
1,893.35
Withholding Taxes Payable ............................... FICA Taxes Payable ($1,880.75 + $1,880.75) .......... FUTA Taxes Payable .......................................... SUTA Taxes Payable .......................................... Cash............................................................
3,350.00 3,761.50 5.60 7.00
3,350.00 1,880.75 28,269.25 1,880.75 5.60 7.00
LO: 1, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
7,124.10
Problem 12.5
(a)
(b)
Cash (400 × $2,500)............................................ Warranty Expense (400 × [$155 + $185]) .......... Sales Revenue .......................................... Warranty Liability......................................
1,000,000 136,000 1,000,000 136,000
Current Liabilities: Warranty Liability .......................................
$68,000*
Long-term Liabilities: Warranty Liability .......................................
$68,000
*($136,000 ÷ 2) (c)
Warranty Liability ................................................ Inventory .................................................... Salaries and Wages Payable .....................
61,300
LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
21,400 39,900
Problem 12.6 (a)
(b)
Cash .............................................................................. .............................................................................. Sales Revenue (300 × $900) ....................... Unearned Warranty Revenue (270 × $90)....
294,300 270,000 24,300
Current Liabilities: Unearned Warranty Revenue ($24,300/3) .. (Note: Warranty costs assumed to be incurred equally over the threeyear period)
$ 8,100
Long-term Liabilities: Unearned Warranty Revenue ($24,300 × 2/3) .......................................... (c)
(d)
$16,200
Unearned Warranty Revenue .............................. Warranty Revenue ......................................
8,100
Warranty Expense ............................................... Inventory ..................................................... Salaries and Wages Payable......................
6,000
8,100 2,000 4,000
Current Liabilities: Unearned Warranty Revenue .....................
$ 8,100
Long-term Liabilities: Unearned Warranty Revenue .....................
$ 8,100
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 12.7
(a)
(b)
(c)
Cash............................................................. Sales Revenue (600 × $7,400) .............
4,440,000
Warranty Expense ([600 × $390] / 2) .......... Inventory ($170 × 600 × 1/2) ................ Salaries and Wages Payable ($220 × 600 × 1/2) ...............................
117,000
December 31, 2025 Warranty Expense ...................................... Warranty Liability................................ *(600 × $390) − $117,000 Warranty Liability........................................ Inventory………………………………… Salaries and Wages Payable...............
4,440,000
51,000 66,000 117,000 117,000* 117,000 51,000 66,000
(d) As of 12/31/25 the balance sheet would disclose a current liability in the amount of $117,000 for Warranty Liability. LO: 3, Bloom: AP, Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 12.8 Premium Inventory (40,000 x $1.50) ............................. Cash ....................................................................... (To record purchase of 40,000 puppets at $1.50 each)
60,000 60,000
During 2026 Cash ........................................................................................ ........................................................................................ Sales Revenue (480,000 x $3.75) .........................
1,800,000
Premium Expense .......................................................... Premium Inventory .............................................. [To record redemption of 115,000 coupons. Computation: (115,000 ÷ 5) × $1.50 = $34,500]
34,500
December 31, 2026 Premium Expense .......................................................... Premium Liability .................................................. [To record estimated liability for premium claims outstanding at December 31, 2026.]
1,800,000
34,500
23,100 23,100
Computation: Total coupons issued in 2026 ...............
480,000
Total estimated redemptions (40%) .............................. Coupons redeemed in 2026 .......................................... Estimated future redemptions ......................................
192,000 115,000 77,000
Cost of estimated claims outstanding (77,000 ÷ 5) × $1.50 = $23,100 LO: 3, Bloom: AP, Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Problem 12.9
During 2025 (a) Premium Inventory (250,000 x $2.25) ......................... Cash .................................................................... (To record the purchase of 250,000 MP3 downloads at $2.25 each)
562,500 562,500
Cash ...................................................................................... ...................................................................................... Sales Revenue (2,895,400 x $0.30) .................... (To record the sale of 2,895,400 candy bars at 30 cents each)
868,620
Cash [$600,000 – (240,000 × $.50)] ............................. Premium Expense ....................................................... Premium Inventory ........................................... [To record the redemption of 1,200,000 wrappers, the receipt of $600,000 (1,200,000 ÷ 5) = 240,000 × $2.50, and the mailing of 240,000 MP3 downloads]
480,000 60,000
Computation of premium expense: 240,000* Codes @ $2.25 each = .................... Postage—240,000 × $.50 =.............................. Less: Cash received— 240,000 × $2.50 ................................... Premium expense for MP3 downloads issued ($600,000 - $540,000) ......................
868,620
540,000
$540,000 120,000 660,000 600,000 $ 60,000
December 31, 2025 Premium Expense ....................................................... Premium Liability ............................................... (To record the estimated liability for premium claims outstanding at 12/31/25) *(290,000 ÷ 5) × ($2.25 + $.50 – $2.50) = $14,500
14,500* 14,500
Problem 12.9 (Continued) During 2026 Premium Inventory (330,000 x $2.25)......................... Cash .................................................................... (To record the purchase of 330,000 MP3 downloads at $2.25 each)
742,500
Cash ..................................................................................... ..................................................................................... Sales Revenue (2,743,600 x $0.30).................... (To record the sale of 2,743,600 candy bars at 30 cents each)
823,080
Cash ($750,000 – $150,000) ........................................ Premium Liability ........................................................ Premium Expense ....................................................... Premium Inventory ........................................... (To record the redemption of 1,500,000 wrappers, the receipt of $750,000 [(1,500,000 ÷ 5) × $2.50], and the mailing of 300,000 codes.)
600,000 14,500 60,500
Computation of premium expense: 300,000 Codes @ $2.25 =................................ Postage—300,000 @ $.50 = .......................... Less: Cash received— (1,500,000 ÷ 5) = 300,000 × $2.50 ........... Premium expense for Codes issued ................ Less: Outstanding claims at 12/31/25 charged to 2025 but redeemed in 2026 . Premium expense chargeable to 2026 ............. December 31, 2026 Premium Expense ....................................................... Premium Liability ............................................... *(350,000 ÷ 5) × ($2.25 + $.50 – $2.50) = $17,500
742,500
823,080
675,000
$675,000 150,000 825,000 750,000 75,000 14,500 $ 60,500
17,500* 17,500
Problem 12.9 (Continued) (b) Account Premium Inventory Premium Liability Premium Expense
Amount 2025 2026 Classification $22,500* $90,000** Current asset 14,500 17,500 Current liability 74,500*** 78,000**** Selling expense
* $2.25 (250,000 – 240,000) ** $2.25 (10,000 + 330,000 – 300,000) *** $60,000 + $14,500 **** $60,500 + $17,500 Note to Instructor: Students can also post the entries from part a in order to determine the ending balances in the accounts for 2025 and 2026. LO: 3, 4, Bloom: AP, Moderate, Time: 30-45, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Problem 12.10 (a)
Because the cause for litigation occurred before the date of the financial statements and because an unfavorable outcome is probable and reasonably estimable, Windsor Airlines should report a loss and a liability in the December 31, 2025, financial statements. The loss and liability might be recorded as follows: Lawsuit Loss ($9,000,000 × 60%) ........................................... Lawsuit Liability .........................................
5,400,000 5,400,000
Note to the Financial Statements Due to an accident which occurred during 2025, the Company is a defendant in personal injury suits totaling $9,000,000. The Company is charging the year of the casualty with $5,400,000 in estimated losses, which represents the amount that the company legal counsel estimates will finally be awarded. (b)
Windsor Airlines should not establish a liability for risk of loss from lack of insurance coverage itself. GAAP does not require or allow the establishment of a liability for expected future injury to others or damage to the property of others even if the amount of the losses is reasonably estimable. The cause for a loss must occur on or before the balance sheet date for a loss contingency to be recorded. However, the fact that Windsor is self-insured should be disclosed in a note.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 12.11
(a)
1. 2.
(b)
Lawsuit Loss ............................................... Lawsuit Liability .................................
500,000
Loss from Expropriation ............................ Allowance for Expropriation (Plant Assets) [$5,725,000 – (40% × $9,500,000)]...............
1,925,000
500,000
1,925,000
3.
No entry required.
1.
A loss and a liability have been recorded in the first case because (i) information is available prior to the issuance of the financial statements that indicates it is probable that a liability had been incurred at the date of the financial statements and (ii) the amount is reasonably estimable. That is, the occurrence of the uninsured accidents during the year plus the outstanding injury suits and the attorney’s estimate of probable loss required recognition of a loss contingency.
2.
An entry to record a loss and establish an allowance due to threat of expropriation is necessary because the expropriation is imminent as evidenced by the foreign government’s communicated intent to expropriate and the prior settlements for properties already expropriated. That is, enough evidence exists to reasonably estimate the amount of the probable loss resulting from impairment of assets at the balance sheet date. The amount of the loss is measured by the amount that the carrying value (book value) of the assets exceeds the expected compensation. At the time the expropriation occurs, the related assets are written off against the allowance account. In this problem, we established a valuation account because certain specific assets were impaired. A valuation account was established rather than a liability account because the net realizability of the assets affected has decreased. A more appropriate presentation would, therefore, be provided for balance sheet purposes on the realizability of the assets. It does not seem appropriate at this point to write off the assets involved because it may be difficult to determine all the specific assets involved, and because the assets still have not been expropriated.
Problem 12.11 (Continued) 3.
Even though Polska’s chemical product division is uninsurable due to high risk and has sustained repeated losses in the past, as of the balance sheet date no assets have been impaired or liabilities incurred nor is an amount reasonably estimable. Therefore, this situation does not satisfy the criteria for recognition of a loss contingency. Also, unless a casualty has occurred or there is some other evidence to indicate impairment of an asset prior to the issuance of the financial statements, there is no disclosure required relative to a loss contingency. The absence of insurance does not of itself result in the impairment of assets or the incurrence of liabilities. Expected future injuries to others or damage to the property of others, even if the amount is reasonably estimable, does not require recording a loss or a liability. The cause for loss or litigation or claim must have occurred on or prior to the balance sheet date and the amount of the loss must be reasonably estimable in order for a loss contingency to be recorded. Disclosure is required when one or both of the criteria for a loss contingency are not satisfied and there is a reasonable possibility that a liability may have been incurred or an asset impaired, or, it is probable that a claim will be asserted and there is a reasonable possibility of an unfavorable outcome.
LO: 3, Bloom: AN, Moderate, Time: 35-45, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 12.12
(a)
Actual costs incurred for 2025 sales ($94,000 – $44,000) . Accrual at 12/31/25............................................................... *([$5,700,000 × 1%] – $50,000) .................................... Warrant Expense — 12/31/25…………………………………
$50,000 7,000* $ 57,000
(b)
Estimated liability for warranties—1/1/25........................... $ 56,000 2025 warranty expense accrual (from requirement a) ....... 7,000* Subtotal ....................................................................... 63,000 Actual warranty costs during 2025 on pre-2025 sales ...... (44,000) Warranty Liability —12/31/25 .............................................. $ 19,000
(c)
Coupons issued (1 coupon/$1 sale) ................................. 1,500,000 Estimated redemption rate ................................................ .60 Estimated number of coupons to be redeemed .............. 900,000 Exchange rate (200 coupons for a player) ....................... ÷ 200 Estimated number of premium players to be issued ..................................................................... 4,500 Net cost of players ($32 – $20) .......................................... X 12 Premium expense for 2025....................................... $ 54,000**
(d)
Premium Inventory —1/1/25 .............................................. Premium players purchased during 2025 (6,500 × $32) .................................................................... Premium players available ................................................ Premium players exchanged for coupons during 2025 (1,200,000/200 × $32) .................................. Premium Inventory —12/31/25 ..........................................
$
Premium Liability —1/1/25................................................. 2025 premium expense (Requirement c).......................... Subtotal ..................................................................... Actual redemptions during 2025 [1,200,000/200 × ($32 – $20)] .......................................... Premium Liability —12/31/25 .............................................
$
(e)
LO: 3, Bloom: AP, Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
37,600 208,000 245,600
192,000 $ 53,600
$
44,800 54,000** 98,800 72,000 26,800
Problem 12.13 1.
Memo prepared by: Date:
Millay Corporation December 31, 2025 Recognition of Warranty Expense During June of this year, the client began the manufacture and sale of a new line of dishwasher. Sales of 120,000 dishwashers during this period amounted to $60,000,000. These dishwashers were sold under a one-year assurance warranty, and the client estimates warranty costs to be $25 per appliance. As of the balance sheet date, the client paid out $1,000,000 in warranty expenses which was also the amount expensed in its income statement. No recognition of any further liability associated with the warranty had been made. Millay must recognize warranty expense for both actual and expected warranty costs in the year of sale. The client should have made the following journal entries: Cash .................................................................... 60,000,000 Sales Revenue (120,000 × $500)............... 60,000,000 (To record sale of 120,000 dishwashers) Warranty Expense .............................................. Inventory .................................................... (To record warranty costs incurred)
1,000,000
Warranty Expense .............................................. Warranty Liability ...................................... (To accrue for future warranty costs) *(120,000 × $25) – $1,000,000 = $2,000,000
2,000,000
1,000,000
2,000,000*
Problem 12.13 (Continued) 2.
Memo prepared by: Date:
Millay Corporation December 31, 2025 Loss Contingency from Violation Of EPA Regulations I contacted the client’s counsel via a routine attorney letter, asking for information about possible litigation in which the company might be involved. Morgan Sondgeroth, Millay’s attorney, informed me about court action taken against Millay for dumping toxic waste in the Kishwaukee River. Although the litigation is pending, Sondgeroth believes that the suit will probably be lost. A reasonable estimate of clean-up costs and fines is $2,750,000. The client neither disclosed nor accrued this loss in the financial statements. Because this loss is both probable and reasonably estimable, it must be accrued as a contingent liability. I advised the client to record the following entry to accrue this liability. Lawsuit Loss ........................................................ Lawsuit Liability ..........................................
2,750,000 2,750,000
Problem 12.13 (Continued) 3.
Memo prepared by: Date:
Millay Corporation December 31, 2025 Loss Contingency on Patent Infringement Litigation In answer to my attorney letter requesting information about any possible litigation associated with the client, Morgan Sondgeroth informed me that the client is in the middle of a patent infringement suit with Megan Drabek over a hydraulic compressor used in several of Millay’s appliances. The possible loss of this suit is only reasonably possible. Millay did not in any way disclose this information. Because the loss is reasonably possible and can be estimated at $5,000,000, it must be disclosed in the notes to the financial statements. I advised the client to include as a footnote to the financial statements a discussion of this pending litigation along with the attorney’s assessment that the loss is reasonably possible. In addition, I advised the client to disclose the estimated amount of this loss contingency. LO: 3, Bloom: AP, Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 12.14 1.
Estimated warranty costs: On 2024 sales $ 800,000 × .10*.............................. On 2025 sales $1,100,000 × .10*.............................. On 2026 sales $1,200,000 × .10*.............................. Total estimated costs ...................................... Total warranty expenditures ........................... Balance of liability, 12/31/26.............................................
$ 80,000 110,000 120,000 310,000 85,700** $224,300
*(.02 + .03 + .05) **2024—$6,500; 2025—$17,200, and 2026—$62,000. The liability account has a balance of $224,300 at 12/31/26 based on the difference between the estimated warranty costs (totaling $310,000) for the three years’ sales and the actual warranty expenditures (totaling $85,700) during that same period. 2.
Computation of liability for coupons: Unredeemed coupons from 2025 ($9,000 – $8,000) ................................................... 2026 coupons estimated to be redeemed ($30,000 × .40) ....................................................... Total ..................................................................
$ 1,000 12,000 $13,000
LO: 3, Bloom: AP, Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 12.1 Financial Reporting Problem (a)
P&G’s short-term borrowings were $11,183 at June 30, 2020. (in $ millions) DEBT DUE WITHIN ONE YEAR (Per NOTE 10) (In millions) Current portion of long-term debt Commercial paper Other Total short-term debt
2020 $ 2,508 8,545 130 $11,183
The weighted average interest rate is 0.7%. (b)
1.
Working capital = Current assets less current liabilities. ($4,989) = ($27,987 – $32,976)
2.
Acid-test ratio =
0.62 times
3.
=
Current ratio =
0.85 times
=
Cash + short-term investments + net receivables Current liabilities $16,181 + $0 + $4,178 $32,976 Current assets Current liabilities $ 27,987 $ 32,976
While P&G’s current and acid-test ratios are below one, this may not indicate a weak liquidity position. Many large companies carry relatively high levels of accounts payable, which charge no interest. For example, P&G has almost $12,071 of these short-term obligations (Accounts Payable), which can be viewed as very cheap forms of financing. Nonetheless, its debt due within one year (see part (a)) has increased significantly (from $9,697 to $11,183) in 2020, which raises some liquidity/working capital concerns.
Financial Reporting Problem (Continued) (c)
P&G provided the following discussion related to commitments and contingencies: NOTE 13 COMMITMENTS AND CONTINGENCIES Guarantees In conjunction with certain transactions, primarily divestitures, we may provide routine indemnifications (e.g., indemnification for representations and warranties and retention of previously existing environmental, tax and employee liabilities) for which terms range in duration and, in some circumstances, are not explicitly defined. The maximum obligation under some indemnifications is also not explicitly stated and, as a result, the overall amount of these obligations cannot be reasonably estimated. Other than obligations recorded as liabilities at the time of divestiture, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss on any of these matters, the loss would not have a material effect on our financial position, results of operations or cash flows. In certain situations, we guarantee loans for suppliers and customers. The total amount of guarantees issued under such arrangements is not material. Off-Balance Sheet Arrangements We do not have off-balance sheet financing arrangements, including variable interest entities that have a material impact on our financial statements. Purchase Commitments We have purchase commitments for materials, supplies, services and property, plant and equipment as part of the normal course of business. Commitments made under take- or-pay obligations are as follows: Years ending June 30 2021 2022 2023 Purchase obligations $ 782 $ 257 $ 155
2024
2025
Thereafter
$ 92
$ 53
$ 238
Financial Reporting Problem (Continued) Such amounts represent minimum commitments under take- or-pay agreements with suppliers and are in line with expected usage. These amounts include purchase commitments related to service contracts for information technology, human resources management and facilities management activities that have been outsourced to thirdparty suppliers. Due to the proprietary nature of many of our materials and processes, certain supply contracts contain penalty provisions for early termination. We do not expect to incur penalty payments under these provisions that would materially affect our financial position, results of operations or cash flows. Litigation We are subject, from time to time, to certain legal proceedings and claims arising out of our business, which cover a wide range of matters, including antitrust and trade regulation, product liability, advertising, contracts, environmental, patent and trademark matters, labor and employment matters and tax. While considerable uncertainty exists, in the opinion of management and our counsel, the ultimate resolution of the various lawsuits and claims will not materially affect our financial position, results of operations or cash flows. We are also subject to contingencies pursuant to environmental laws and regulations that in the future may require us to take action to correct the effects on the environment of prior manufacturing and waste disposal practices. Based on currently available information, we do not believe the ultimate resolution of environmental remediation will materially affect our financial position, results of operations or cash flows.
UYJ 12.2 Comparative Analysis Case (a)
The working capital position of the two companies is as follows: ($ millions) PepsiCo, Inc. Current assets ...................................... Current liabilities ................................. Working capital ..................................... The Coca-Cola Company Current assets ...................................... Current liabilities .................................. Working capital .....................................
(b)
$
23,001 (23,372) $ (371) $
19,240 (14,601) $ 4,639
The overall liquidity of both companies is good as indicated from the ratio analysis provided below: (all computations in millions) PepsiCo, Inc. Coca-Cola $10,613 $9,844 = 0.48 = 0.47
Current cash debt Coverage ($23,372 + $20,461) 2 Cash debt coverage
$10,613 ($79,366 + $63,679)
($14,601 + $26,973)
2 = 0.15
2 Current ratio Acid-test ratio
($66,012 + $65,283)
= 0.15
2
$23,001 = .98 $23,372
($8,185 + $1,366 + 8,404) $23,372
$9,844
=.77
$19,240 $14,601
= 1.32
($6,795 + $2,348 + $3,144) = 0.84 $14,601
Accounts receivable turnover
$70,392 = 8.67 ($8,404 + 7,822) 2
$33,014 ($3,144 + 3,971)
Inventory turnover
$31,797 = 8.47 ($4,172 + 3,338) 2
$13,433 = 4.04 ($3,266 + 3,379) 2
= 9.28
2
Comparative Analysis Case (Continued) (c) Coca-Cola discusses the following COMMITMENTS AND CONTINGENCIES in Note 11. • • • • •
Guarantees Legal Indemnifications Tax Audits Risk Management Programs
PepsiCo reported the following in MD&A Credit Facilities and Long-Term Contractual Commitments See Note 8 to our consolidated financial statements for a description of our credit facilities. The following table summarizes our long-term contractual commitments by period:
Total
2021
Payments Due by Period(a) 2022 – 2024 – 2026 and 2023 2025 beyond
$ 40,330
$—
$ 6,895
$ 6,298
$ 27,137
1,895
486
663
333
413
One-time mandatory transition tax - TCJ Act (d)
3,239
309
617
1,351
962
Other long-term liabilities (e)
1,277
159
135
140
843
Interest on debt obligations (f) Purchasing commitments (g)
15,988
1,160
2,043
1,771
11,014
2,295
894
1,034
246
121
Marketing commitments (h)
950
355
366
161
68
Other long-term contractual commitments (i)
347
85
167
95
—
$ 66,321
$ 3,448
$ 11,920
$ 10,395
$ 40,558
Recorded Liabilities: Long-term debt obligations (b) Operating leases (c)
Other:
Total contractual commitments
(a) Based on year-end foreign exchange rates. (a) Excludes $3,358 million related to current maturities of debt, $40 million related to the fair value adjustments for debt acquired in acquisitions and interest rate swaps and payments of $260 million related to unamortized net discounts. (b) Primarily reflects building leases. See Note 13 to our consolidated financial statements for further information on operating leases. (c) Reflects our transition tax liability as of December 26, 2020, which must be paid through 2026 under the provisions of the TCJ Act. (d) Reflects contingent consideration related to estimated future tax benefits associated with our acquisition of Rockstar. Also reflects commitments to support socioeconomic programs in South Africa, which are irrevocable conditions of our acquisition of Pioneer Foods. See Note 9 and Note 14 to our consolidated financial statements for further information.
Comparative Analysis Case (Continued) (e) Interest payments on floating-rate debt are estimated using interest rates effective as of December 26, 2020. Includes accrued interest of $352 million as of December 26, 2020. (f) Reflects non-cancelable commitments, primarily for the purchase of commodities and outsourcing services in the normal course of business and does not include purchases that we are likely to make based on our plans but are not obligated to incur. (g) Reflects non-cancelable commitments, primarily for sports marketing in the normal course of business. (h) Reflects our commitment to incur capital expenditures and/or business-related costs associated with our acquisition of Pioneer Foods. See Note 14 to our consolidated financial statements for further information. Reserves for uncertain tax positions are excluded from the table above as we are unable to reasonably predict the ultimate amount or timing of any such settlements. Bottler funding to independent bottlers is not reflected in the table above as it is negotiated on an annual basis. Accrued liabilities for pension and retiree medical plans are not reflected in the table above. See Note 7 to our consolidated financial statements for further information regarding our pension and retiree medical obligations. Off-Balance-Sheet Arrangements We do not have guarantees or other off-balance-sheet financing arrangements, including variable interest entities, that we believe could have a material impact on our financial condition or liquidity. We coordinate, on an aggregate basis, the contract negotiations of raw material requirements, including sweeteners, aluminum cans and plastic bottles and closures for us and certain of our independent bottlers. Once we have negotiated the contracts, the bottlers order and take delivery directly from the supplier and pay the suppliers directly. Consequently, transactions between our independent bottlers and suppliers are not reflected in our consolidated financial statements. As the contracting party, we could be liable to these suppliers in the event of any nonpayment by our independent bottlers, but we consider t his exposure to be remote. Note 2 Commitments and Contingencies We are subject to various claims and contingencies related to lawsuits, certain taxes and environmental matters, as well as commitments under contractual and other commercial obligations. We recognize liabilities for contingencies and commitments when a loss is probable and estimable.
UYJ 12.3 Financial Statement Analysis Case 1 NORTHLAND CRANBERRIES (a)
Working capital is calculated as current assets – current liabilities, while the current ratio is calculated as current assets/current liabilities. For Northland Cranberries these ratios are calculated as follows: Current year
Working capital $6,745,759 – $10,168,685 = $–3,422,926 Current ratio ($6,745,759/$10,168,685) = .66
Prior year $5,598,054 – $4,484,687 = $1,113,367 ($5,598,054/$4,484,687) = 1.25
Historically, it was generally believed that a company should maintain a current ratio of at least 2.0. In recent years, because companies have been able to better maintain their inventory, receivables and cash, many healthy companies have ratios well below 2.0. However, Northland Cranberries has negative working capital in the current year, and current ratios in both years are extremely low. This would be cause for concern and additional investigation. As you will see in the next discussion point, there may well be a reasonable explanation. (b)
This illustrates a potential problem with ratios like the current ratio, that rely on balance sheet numbers that present a company’s finan-cial position at a particular point in time. That point in time may not be representative of the average position of the company during the course of the year, and also, that point in time may not be the most relevant point for evaluating the financial position of the company. If the company does not like the representation that these commonly used measures give of the company’s position, it could change its year end or suggest other measures that it considers to be more relevant for a company in this business. Also, it is possible that by using averages calculated across quarterly data some of this problem might be alleviated. As discussed in Chapter 5, there are also measures that employ cash flows, which addresses at least part of the point-in-time problem of balance sheet ratios.
LO: 4, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 12.4 Financial Statement Analysis Case 2 MOHICAN COMPANY (a)
Under the cash basis, warranty costs are charged to expense as they are paid; in other words, warranty costs are charged in the period in which the seller or manufacturer performs in compliance with the warranty. No liability is recorded for future costs arising from warranties, nor is the period in which the sale is recorded necessarily charged with the costs of making good on outstanding warranties. If it is probable that customers will make claims under warranties relating to goods or services that have been sold, and a reasonable estimate of the costs involved can be made, an accrual for future costs is recorded at year-end.
(b)
When the warranty is sold separately from the product, it is accounted for as a service-type warranty. Revenue on the sale of the extended warranty is deferred and is generally recognized on a straight-line basis over the life of the contract. Revenue is deferred because the seller of the warranty has an obligation to perform services over the life of the contract.
(c)
The general approach is to use the straight-line method to recognize deferred revenue on warranty contracts. If historical evidence indicates that costs incurred do not follow a straight-line approach, then revenue should be recognized over the contract period in proportion to the costs expected to be incurred in performing services under the contract. Only costs that vary with and are directly related to the acquisition of the contracts (mainly commissions) should be deferred and amortized. Costs such as employee’s salaries, advertising, and general and administrative expenses that would have been incurred even if no contract were acquired should be expensed as incurred.
LO: 3, 4, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 12.5 Financial Statement Analysis Case 3 (a)
BOP’s working capital and current ratio have declined in 2025 compared to 2024. While this would appear to be bad news, the acidtest ratio has improved. This is due to BOP carrying relatively more liquid receivables in 2025 (receivable days has increased.) And while working capital has declined, the amount of the operating cycle that must be financed with more costly borrowing has declined. That is, BOP is using relatively inexpensive accounts payable to finance its operating cycle. Note that the overall operating cycle has declined because inventory is being managed at a lower level (inventory days has declined by more than 60 days.
(b)
Answers will vary depending on the companies selected. This activity is a great spreadsheet exercise. As an example, the analysis for Best Buy and Circuit City is presented on the next page (just before Circuit City went out of business). Best Buy reports both a lower current ratio and acid-test ratio. However, much more of Best Buy’s operating cycle in financed with relatively inexpensive accounts payable as indicated by Best Buy’s longer payable days.
Financial Statement Analysis Case 3 (Continued) Note to Instructor: Although the analysis below is for 2005 – 2007, this analysis is particularly useful as Circuit City subsequently filed for bankruptcy. Best Buy (in millions) 2005 2006 Cash $ 470 $748 Accounts Receivable 375 449 Inventory 2,851 3,338 Accounts Payable 2,824 3,234 Purchases 20,496 22,432 Cost of Goods Sold 20,983 23,122 Sales Revenue 30,848
2007 1,205 548 4,028 3,934 31,193 27,165 35,934
Circuit City (in thousands) 2005 2006 2007 879,660 315,970 141,141 230,605 222,869 382,555 1,455,170 1,698,026 1,636,507 635,674 850,359 922,205 7,618,508 8,765,202 11,137,945 7,861,364 8,703,683 9,501,438 10,413,524 11,514,151 12,429,754
Operating Cycle Receivable Days Inventory Days Operating Cycle
5.3 52.7 58.0
5.6 54.1 59.7
7.1 71.2 78.3
11.2 62.9 74.1
Less: Accounts Payable Days
52.62
46.03
35.41
30.22
Days to be Financed
5.38
13.67
42.89
43.88
$1,301 1.40 0.37
$1,847 1.47 0.45
$1,386,506 2.63 0.63
$1,237,998 2.34 0.57
Working Capital Current Ratio Acid-Test Ratio
LO: 4, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 12.6 Accounting, Analysis, and Principles Accounting (1)
(2)
(3)
During 2025 Warranty Expense ................................... Cash ................................................
6,000
12/31/25 Warranty Expense ................................... Warranty Liability ...........................
45,000
2/28/25 Interest Expense ($200,000 x .10 × 2/3) ....... Interest Payable ($200,000 x .10 × 1/3) ......... Cash ($200,000 × 10% × 3/12) ........
3,333 1,667
5/31/25 Interest Expense...................................... Cash ($200,000 × .10 × 3/12) ..........
5,000
8/31/25 Interest Expense...................................... Cash ($200,000 × .10 × 3/12) ..........
5,000
11/30/25 Interest Expense...................................... Cash ($200,000 × .10 × 3/12) ..........
5,000
12/31/25 Interest Expense...................................... Interest Payable ($200,000 x .10 × 1/12) ..
1,667
11/1/25 Cash ...................................................... Unearned Revenue ......................
24,000
March 2026 Cash ($92,000 - $24,000) ...................... Unearned Revenue ............................... Sales Revenue .............................
68,000 24,000
Cost of Goods Sold .............................. Inventory ......................................
6,000
45,000
5,000
5,000
5,000
5,000
1,667
24,000
92,000 55,000 55,000
Accounting, Analysis, and Principles (Continued) Analysis The warranty payable and the interest payable are current liabilities, so all else equal, these will decrease both the current and acid-test ratios. Because of the contractual right granted by First Trust Corp., the $200,000 loan can be classified as a noncurrent liability. Without this letter, YellowCard would likely not be able to classify the obligation as long-term. This would mean the $200,000 loan would have to be classified as a current liability, further depressing YellowCard’s current and acid-test ratios. Principles According to FASB Concepts Statement No. 6, liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. With respect to the new warranty plan, YellowCard would be currently obligated to provide repair service to its customers, arising from the prior sales of its products. So even though customers are making an upfront payment, YellowCard still has an obligation to provide services in the future. Thus the company should record the payments as unearned revenue until it is no longer obligated to make repairs. That is, the current accounting reflects application of the assurance warranty approach. The new plan would be accounted for a service-type warranty, which defers a certain percentage of the original sales price until some future time when the company incurs actual costs or the warranty expires. LO: 2, 3, 4, Bloom: AP, Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Time and Purpose of Critical-Thinking Cases CT 12.1 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to define a liability, to distinguish between current and long-term liabilities, and to explain accrued liabilities. The student must also describe how liabilities are valued, explain why notes payable are usually reported first in the current liabilities section, and to indicate the items that may comprise “compensation to employees.” CT 12.2 (Time 15–20 minutes) Purpose—to provide three situations that require the application of judgment about the current or longterm nature of the items. The student must think about when typical short-term items might not be classified as current. CT 12.3 (Time 30–40 minutes) Purpose— to provide the student with an opportunity to comment on the proper treatment in the financial statements of a contingent loss incurred after the balance sheet date but before issuance of the financial statements. In order to thoroughly answer the case the student will need to understand proper accounting for contingencies.
CT 12.4 (Time 15–20 minutes) Purpose— to provide the student with an opportunity to specify the conditions by which a loss contingency can be recorded in the accounts. The student is also required to indicate the proper disclosure in the financial statements of the situations where the amount of loss cannot be reasonably estimated. CT 12.5 (Time 15–20 minutes) Purpose— to provide the student with an opportunity to discuss how product warranty costs and the fact that a company is being sued should be reported. CT 12.6 (Time 15–20 minutes) Purpose— to provide the student with an opportunity to examine the ethical issues related to estimates for bad debts and warranty obligations CT 12.7 (Time 20–25 minutes) Purpose— to provide the student with a comprehensive case covering refinancing of short-term debt. Four situations are presented in which the student must determine the proper classification and disclosure of the debt in the financial statements. In order to thoroughly resolve the issues presented, the student is expected to research the FASB codification.
Solutions to Concepts for Analysis CT 12.1 (a) A liability is defined as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” In other words, it is an obligation to transfer some type of resource in the future as a result of a past transaction. (b) Current liabilities are “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets or the creation of other current liabilities.” In other words, they are liabilities generally payable within one year or the operating cycle, whichever is longer. (c) Accrued liabilities (sometimes called accrued expenses) arise through accounting recognition of unpaid expenses that come into existence as a result of past contractual commitments or past services received. Examples are salaries and wages payable, interest payable, property taxes payable, income taxes payable, payroll taxes payable, bonuses payable, postretirement benefits payable, and so on. (d) Theoretically, liabilities should be measured by the present value of the future outlay of cash required to liquidate them. But in practice, current liabilities are usually recorded in accounting records and reported in financial statements at their maturity value. Because of the short time periods involved— frequently less than one year—the difference between the present value of a current liability and the maturity value is not large. The slight overstatement of liabilities that results from carrying current liabilities at maturity value is accepted on the grounds it is immaterial. (e) Notes payable are usually listed first in the balance sheet because in liquidation they would probably be paid first. (f)
The item compensation to employees might include: 1. Wages, salaries, or bonuses payable. 2. Compensated absences payable. 3. Postretirement benefits payable.
LO: 1, Bloom: K, Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 12.2 1. Since the notes payable are due in less than one year from the balance sheet date, they would generally be reported as a current liability. The only situation in which this short-term obligation could possibly be excluded from current liabilities is if either (1) the liability is contractually due to be settled more than one year (or operating cycle, if longer) after the balance sheet date or (2) the company has a contractual right to defer settlement of the liability for at least one year (or operating cycle, if longer) after the balance sheet date. If a company - at the balance sheet date - has a liability that will be settled on a long-term basis, this means that the company will not require the use of working capital during the ensuing fiscal year (or operating cycle, if longer). Entering into a financing arrangement that clearly permits the company (a contractual right) to refinance the debt on a long-term basis on terms that are readily determinable before the next balance sheet date is one way to satisfy the second condition.
CT 12.2 (Continued)
IIn addition, the fact that a company has the right to refinance at any time permits the company to classify the liability as non-current. 2.
Generally, deposits from customers would be classified as a current liability. However, the classification of deposits as current or noncurrent depends on the time involved between the date of deposit and the termination of the relationship that required the deposit. In this case, the $6,250,000 would be excluded from current liabilities only if the equipment would not be delivered for more than one year (or one operating cycle, if longer).
3.
Salaries and wages payable is an accrued liability which in almost all circumstances would be reported as a current liability (could not be excluded).
LO: 2, Bloom: AN, Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 12.3 Because the casualty occurred subsequent to the balance sheet date, it does not meet the criteria of a loss contingency; that is, an asset had not been impaired or a liability incurred at the date of the balance sheet. Therefore, a loss contingency should not be accrued by a charge to expense due to the explosion. However, because it had become known before the financial statements were issued that assets were impaired and liabilities were incurred after the balance sheet date, disclosure is necessary to keep the financial statements from being misleading. The financial statements should indicate the nature of and an estimate of the loss to the company’s assets as a result of the explosion and the nature of and an estimate of the loss contingency anticipated from suits that will be filed and claims asserted for injuries and damages. If the loss to assets or the liability incurrence can be reasonably estimated, disclosure may best be made by supplementing the historical financial statements with pro forma financial data giving effect to the loss as if it had occurred at the date of the financial statements. LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 12.4 (a) Two conditions must exist before a loss contingency is recorded: 1. Information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements. 2. The amount of the loss can be reasonably estimated. (b) When some amount within the range appears at the time to be a better estimate than any other amount within the range, that amount is accrued. When no amount within the range is a better estimate than any other amount, the dollar amount at the low end of the range is accrued and the dollar amount at the high end of the range is disclosed. (c) If the amount of the loss is uncertain, the following disclosure in the notes is required: 1. The nature of the contingency. 2. An estimate of the possible loss or range of loss or a statement that an estimate cannot be made. LO: 3, 4, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 12.5 Part 1. For Product Grey, the estimated product warranty costs should be accrued by a charge to expense and a credit to a liability because both of the following conditions were met: 1. It is probable that a liability has been incurred based on past experience. 2. The amount of the loss can be reasonably estimated as 1% of sales. For Product Yellow, the estimated product warranty costs should not be accrued by a charge to income because the amount of loss cannot be reasonably estimated. Since only one condition is satisfied, a disclosure by means of a note should be made. Part 2. The probable judgment ($1,000,000) should be accrued by a charge to expense and a credit to a liability because both of the following conditions were met: 1. It is probable that a liability has been incurred because Constantine’s lawyer states that it is probable that Constantine will lose the suit. 2. The amount of loss can be reasonably estimated because Constantine’s lawyer states that the most probable judgment is $1,000,000. Constantine should disclose in its financial statements or notes the following: The amount of the suit ($4,000,000). The nature of the accrual. The nature of the contingency. The range of possible loss ($400,000 to $2,000,000). LO: 3, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 12.6 (a) No, Hamilton should not follow his owner’s directive if his (Hamilton’s) original estimates are reasonable. (b) Rich Clothing Store benefits in lower rental expense. The Dotson Company is harmed because the misleading financial statement deprives it of its rightful rental fees. In addition, the current stockholders of Rich Clothing Store are harmed because the lower net income reduces the current value of their holdings. (c) Rich is acting unethically to avoid the terms of his rental agreement at the expense of his landlord and his own stockholders. LO: 3, 4, Bloom: AN, Moderate, Time: 20-25, AACSB: Ethics, Reflective Thinking, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 12.7 (This case requires some research of FASB Codification.) (a) No. Management’s intent to refinance the obligation on a long-term basis is not enough to warrant reclassification of the short-term obligation. GAAP indicates that intent and ability to refinance must be present. Ability is demonstrated by refinancing a short-term obligation on a long-term basis – either through the issuance of equity or by replacing it with a long-term obligation after the date of the balance sheet date but before issuance of the balance sheet. Ability is demonstrated a refinancing agreement that clearly permits refinancing of the debt on a long-term basis on terms that are readily determinable.
CT 12.7 (Continued) (b) No. The events described will not have an impact on the financial statements since Dumars Corporation refinanced the long-term debt maturing in March 2026 required use of existing current assets before it obtained funds through the long-term financing. The $10,000,000 should be classified as current at December 31, 2025. (c)
(1)
No. Since Dumars has the contractual right to defer payment beyond 12 months of the balance sheet date, the $10,000,000 should be shown under the caption of either “Long-Term Debt,” “Interim Debt,” “Short-Term Debt to Be Refinanced,” or “Intermediate Debt.” (2)
Yes. GAAP provides that total current liabilities shall be presented in classified balance sheets. If a short-term obligation is excluded from current liabilities pursuant to the provisions of this statement, the notes to the financial statements shall include a general description of the financing agreement and the terms of any new obligation incurred or expected to be incurred or equity securities issued or expected to be issued as a result of a refinancing.
LO: 4, Bloom: AN, Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
Codification Exercises (a) Master Glossary 1.
Current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. See paragraphs 210-10-45-5 through 45-12.
2.
Reasonably possible means the chance of the future event or events occurring is more than remote but less than likely.
3.
A warranty is a guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party. The obligation may be incurred in connection with the sale of goods or services; if so, it may require further performance by the seller after the sale has taken place.
LO: 1, 3, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
Codification Exercises (Continued) (b) According to FASB ASC 450-10-55 (Contingencies —Implementation Guidance and Illustrations): Depreciation 55-2
The fact that estimates are used to allocate the known cost of a depreciable asset over the period of use by an entity does not make depreciation a contingency; the eventual expiration of the utility of the asset is not uncertain. Thus, depreciation of assets is not a contingency, nor are such matters as recurring repairs, maintenance, and overhauls, which interrelate with depreciation. This Topic is not intended to alter depreciation practices as described in Section 360-10-35.
Estimates Used in Accruals 55-3
Amounts owed for services received, such as advertising and utilities, are not contingencies even though the accrued amounts may have been estimated; there is nothing uncertain about the fact that those obligations have been incurred.
Changes in Tax Law 55-4
The possibility of a change in the tax law in some future year is not an uncertainty.
LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
(c) According to FASB ASC 710-10-25-1 (Compensation Recognition—Compensated Absences), an employer must accrue a liability for employees’ compensation for future absences if all of the following conditions are met: 1.
The employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered.
2.
The obligation relates to rights that vest or accumulate. Vested rights are those for which the employer has an obligation to make payment even if an employee terminates; thus, they are not contingent on an employee’s future service. Accumulate means that earned but unused rights to compensated absences may be carried forward to one or more periods subsequent to that in which they are earned, even though there may be a limit to the amount that can be carried forward.
3.
Payment of the compensation is probable.
4.
The amount can be reasonably estimated.
LO: 3, Bloom: K, Difficulty: Simple , Time: 10-15, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
Codification Research Case (a)
FASB ASC 606-20-25-1 addresses how revenue and costs from a separately priced extended warranty or product maintenance contract should be recognized.
(b)
According to FASB ASC 605-20-25 - Some products include warranty obligations that are incurred in connection with the sale of the product, that is, obligations that are not separately priced or sold but are included in the sale of the product. The accounting for these is described in Topic 450. Separately priced contracts for extended warranty and product maintenance contracts provide warranty protection or product services and the contract price of these contracts is not included in the original price of the product covered by the contracts.
(c)
According to FASB ASC 606-10-65-1, a loss shall be recognized on extended warranty or product maintenance contracts if the sum of the expected costs of providing services under the contracts and any asset recognized for the incremental cost of obtaining a contract exceeds the related unearned revenue (contract liability). Extended warranty or product maintenance contracts shall be grouped in a consistent manner to determine if a loss exists. A loss shall be recognized first by charging to expense any recognized asset for the incremental costs of obtaining a contract, determined in accordance with the guidance in paragraphs 340-40-25-1 through 25-4 for contracts within scope of Topic 606 on revenue from contracts with customers. If the loss is greater than the recognized asset for the incremental costs of obtaining a contract, a liability shall be recognized for the excess.
LO: 3, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Measurement, Reporting, Research, Technology, AICPA PC: Communication
CHAPTER 13 Long-Term Liabilities Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises
Critical Thinking Cases
Exercises
Problems
1, 2
10, 11
1, 2
1. Long-term liability; classification; definitions.
1, 14
2. Issuance of bonds; types of bonds.
2, 3, 4, 9, 11
1, 2, 3, 4, 5, 6, 7
3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 4, 5, 6, 7, 10
1, 2, 5
3. Premium and discount; amortization schedules.
5, 6, 7, 8, 10, 11
3, 4, 6, 7, 8, 9
4, 5, 6, 7, 8, 9, 10, 11, 13, 14, 15
1, 2, 3, 4, 5, 6, 7, 10, 11
1, 2, 3
4. Retirement and refunding 12, 13 of debt.
9
12, 13, 14, 15
2, 4, 5, 6, 7, 10
2
5. Long-term notes payable.
14, 15, 16, 17, 18
10, 11, 12, 13
16, 17, 18
8, 9
6. Fair value option.
19, 20
14
19
7. Disclosures of long-term obligations.
13, 21, 22, 23, 24
15
20
10
*8.
25, 26, 27, 28, 29, 30
21, 22, 23, 24, 25, 26, 27
12, 13, 14
Troubled debt restructuring.
*This material is discussed in the Appendix to the Chapter.
1, 3, 4
Assignment Classification Table (By Learning Objective) Learning Objectives
Brief Exercises
Questions
Exercises
Problems
Critical Thinking
1.
Describe the nature 1, 2, 3, 4, 5, 6, of bonds and 7, 8, 9, 10, 11 indicate the accounting for bond issuances.
1, 2, 3, 4, 5, 6, 7, 8
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15
1, 2, 4, 5, 6, 7, 10, 11
1, 2, 3, 5
2.
Describe the accounting for the extinguishment of debt.
12, 13
9
12, 13, 14, 15
2, 4, 5, 6, 7, 10
2, 3
3.
Explain the accounting for long-term notes payable.
14, 15, 16, 17, 18
10, 11, 12, 13,
16, 17, 18
3, 8, 9
4.
Indicate how to present and analyze long-term debt.
13, 19, 20, 21, 22, 23, 24
14, 15
19, 20
4, 10
*5.
Describe the accounting for a debt restructuring.
25, 26, 27, 28, 29, 30
21, 22, 23, 24, 25, 26, 27
12, 13, 14
1, 2, 3, 4, 5
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E13.1 E13.2 E13.3 E13.4 E13.5 E13.6 E13.7 E13.8 E13.9 E13.10 E13.11 E13.12 E13.13 E13.14 E13.15 E13.16 E13.17 E13.18 E13.19 E13.20 *E13.21 *E13.22 *E13.23 *E13.24 *E13.25 *E13.26 *E13.27
Classification of liabilities. Classification. Entries for bond transactions. Entries for bond transactions—straight-line. Entries for bond transactions—effective-interest. Amortization schedule—straight-line. Amortization schedule—effective-interest. Determine proper amounts in account balances. Entries and questions for bond transactions. Entries for bond transactions. Information related to various bond issues. Entry for redemption of bond. Entries for redemption and issuance of bonds. Entries for redemption and issuance of bonds. Entries for redemption and issuance of bonds. Entries for zero-interest-bearing notes. Imputation of interest. Imputation of interest with right. Fair value option. Long-term debt disclosure. Settlement of debt. Term modification without gain—debtor’s entries. Term modification without gain—creditor’s entries. Term modification with gain—debtor’s entries. Term modification with gain—creditor’s entries. Debtor/creditor entries for settlement of troubled debt. Debtor/creditor entries for modification of troubled debt.
Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Simple Simple Complex Moderate Complex Moderate Moderate Moderate Moderate
15–20 15–20 15–20 15–20 15–20 15–20 15–20 15–20 20–30 15–20 20–30 15–20 15–20 12–16 10–15 15–20 15–20 15–20 10–15 10–15 15–20 20–30 25–30 25–30 20–30 15–20 20–25
P13.1 P13.2 P13.3 P13.4
Analysis of amortization schedule and interest entries. Issuance and redemption of bonds. Negative amortization. Issuance and redemption of bonds; income statement presentation. Comprehensive bond problem. Issuance of bonds between interest dates, straight-line, redemption Entries for life cycle of bonds. Entries for zero-interest-bearing note. Entries for zero-interest-bearing note; payable in installments. Comprehensive problem; issuance, classification, reporting. Effective-interest method.
Simple Moderate Moderate Moderate
15–20 25–30 20–30 15–20
Complex Moderate
50–65 20–25
Complex Simple Moderate
20–25 15–25 20–25
Moderate
20–25
Moderate
40–50
P13.5 P13.6 P13.7 P13.8 P13.9 P13.10 P13.11
Assignment Characteristics Table (Continued) Level of Difficulty
Time (minutes)
Debtor/creditor entries for continuation of troubled debt. Restructure of note under different circumstances. Debtor/creditor entries for continuation of troubled debt with new effective interest.
Moderate Complex Complex
15–25 30–45 40–50
Bond theory: balance sheet presentations, interest rate, premium. Bond theory: price, presentation, and redemption. Bond theory: amortization and gain or loss recognition. Off-balance-sheet financing. Bond issue, ethics.
Moderate
25–30
Moderate Moderate Moderate Moderate
15–25 20–25 20–30 23–30
Item
Description
*P13.12 *P13.13 *P13.14
CT13.1 CT13.2 CT13.3 CT13.4 CT13.5
Answers to Questions 1. (a)
Funds might be obtained through long-term debt from the issuance of bonds and from the signing of long-term notes and mortgages.
(b)
A bond indenture is a contractual agreement (signed by the issuer of bonds) between the bond issuer and the bondholders. The bond indenture contains the details of the bonds as well as, covenants or restrictions for the protection of the bondholders.
(c)
A mortgage is a document which describes the security for a loan, indicates the conditions under which the mortgage becomes effective (that is, conditions of default), and describes the rights of the mortgagee under default relative to the security. The mortgage accompanies a formal promissory note and becomes effective only upon default of the note.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
2. If the entire bond matures on a single date, the bonds are referred to as term bonds. Mortgage bonds are secured by real estate. Debenture bonds are unsecured. The interest payments for income bonds depend on the existence of operating income in the issuing company. Callable bonds may be called and retired by the issuer prior to maturity. Registered bonds are issued in the name of the owner and require surrender of the certificate and issuance of a new certificate to complete the sale. A bearer or coupon bond is not recorded in the name of the owner and may be transferred from one investor to another by mere delivery. Convertible bonds can be converted into other securities of the issuing corporation for a specified time after issuance at the option of the bondholder. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity. Deep-discount bonds (also called zero-interest bonds) are sold at a discount which provides the buyer’s total interest payoff at maturity. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
3. (a)
Yield rate—the rate of interest actually earned by the bondholders; it is synonymous with the effective and market rates.
(b)
Nominal rate—the rate set by the party issuing the bonds and expressed as a percentage of the par value; it is synonymous with the stated rate.
(c)
Stated rate—synonymous with nominal rate.
(d)
Effective rate—synonymous with market rate and yield rate.
(e)
Market rate—synonymous with yield rate and effective rate.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
4. (a)
Maturity value—the face value of the bonds; the amount which is payable upon maturity.
(b)
Face value—synonymous with par value and maturity value.
(c)
Market (fair) value—the amount realizable upon sale.
(d)
Par value—synonymous with maturity and face value.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued) 5. A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can alter the effective rate of interest. A premium on bonds payable results from the opposite conditions. That is, when investors are satisfied with a rate of interest lower than the rate stated on the bonds, they are willing to pay more than the face value of the bonds in order to acquire them, thus reducing their effective rate of interest below the stated rate. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
6. Discount (premium) on bonds payable should be reported in the balance sheet as a direct deduction from (addition to) the face amount of the bond. Both are liability valuation accounts and are referred to as a contra (adjunct) account, respectively. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
7. Bond discount and bond premium may be amortized on a straight-line basis or on an effectiveinterest basis. GAAP recommends the effective-interest method but permits the straight-line method when the results obtained are not materially different from the effective-interest method. The straight-line method results in an even or average allocation of the total interest over the life of the notes or bonds. The effective-interest method results in an increasing or decreasing amount of interest each period. This is because interest is based on the carrying amount of the bond issuance at the beginning of each period. The straight-line method results in a constant dollar amount of interest and an increasing or decreasing rate of interest over the life of the bonds. The effective-interest method results in an increasing or decreasing dollar amount of interest and a constant rate of interest over the life of the bonds. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
8. The annual interest expense will decrease each period throughout the life of the bonds. Under the effective-interest method, the interest expense each period is equal to the effective or yield interest rate times the carrying value of the bonds at the beginning of each interest period. When bonds are sold at a premium, their carrying value declines to face value over their life; therefore, the interest expense declines also. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
9. Bond issuance costs should be recorded as a reduction to the issue amount and then amortized into expense (Interest Expense via amortization) over the life of the bond. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
10. Amortization of Discount on Bonds Payable increases interest expense. A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can increase the effective rate of interest. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
11. The call feature of a bond issue grants the issuer the privilege of purchasing, after a certain date at a stated price, outstanding bonds for the purpose of reducing indebtedness or taking advantage of lower interest rates. The call feature does not affect the amortization of bond discount or premium; because early redemption is not a certainty, the life of the bonds should be used for amortization purposes. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued) 12. It is sometimes desirable to reduce bond indebtedness in order to take advantage of lower prevailing interest rates. Also, the company may not want to make a very large cash outlay all at once when the bonds mature. Bond indebtedness may be reduced by either issuing bonds callable after a certain date and then calling some or all of them, or by purchasing bonds on the open market and then retiring them. When a portion of bonds outstanding is going to be retired, any corresponding discount or premium is amortized up to the date of retirement. The gain or loss is computed as the difference between the acquisition or call price and the carrying value of the bonds. When the bonds are extinguished, any gain or loss should be reported in income. LO: 2, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
13. Gains or losses from extinguishment of debt should be aggregated and reported in income. For extinguishment of debt transactions disclosure is required of the following items: (1) A description of the transactions, including the sources of any funds used to extinguish debt if it is practicable to identify the sources. (2) The income tax effect in the period of extinguishment. (3) The per share amount of the aggregate gain or loss net of related tax effect. LO: 2, 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
14. The entire arrangement must be evaluated and an appropriate interest rate imputed. This is done by (1) determining the fair value of the property, goods, or services exchanged or (2) determining the fair value of the note, whichever is more clearly determinable. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
15. If a note is issued for cash, the present value is assumed to be the cash proceeds. If a note is issued for noncash consideration, the present value of the note should be measured by the fair value of the property, goods, or services received or by an amount that reasonably approximates the fair value of the note (whichever is more clearly determinable). LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
16. When a debt instrument is exchanged in a bargained transaction entered into at arm’s length, the stated interest rate is presumed to be fair unless: (1) no interest rate is stated, or (2) the stated interest rate is unreasonable, or (3) the stated face amount of the debt instrument is materially different from the current sales price for the same or similar items or from the current market value of the debt instrument. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
17. Imputed interest is the interest factor (a rate or amount) assumed or assigned which is different from the stated interest factor. It is necessary to impute an interest rate when the stated interest rate is presumed to be unreasonable. The imputed interest rate is used to establish the present value of the debt instrument by discounting, at that imputed rate, all future payments on the debt instrument. In imputing interest, the objective is to approximate the rate which would have resulted if an independent borrower and an independent lender had negotiated a similar transaction under comparable terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount of the purchase which bears the prevailing rate of interest to maturity. In order to accomplish that objective, consideration must be given to (1) the credit standing of the issuer, (2) restrictive covenants, (3) collateral, (4) payment and other items pertaining to the debt, (5) the existing prime interest rate, and (6) the prevailing rates for similar instruments of issuers with similar credit ratings. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued) 18. A fixed-rate mortgage is a note that requires payment of interest by the mortgagor at a rate that does not change during the life of the note. A variable-rate mortgage is a note that features an interest rate that fluctuates with the market rate; the variable rate generally is adjusted periodically as specified in the terms of the note and is usually limited in the amount of each change in the rate up or down and in the total change that can be made in the rate. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
19.
The fair value option is an accounting option where the company can elect to record fair values in their accounts for most financial assets and liabilities, including bonds and notes payable. With bonds at fair value, we assume that the decline in value of the bonds is due to an interest rate increase. If not related to changes in credit risks, these gains and losses are recorded in income. In other situations, the decline may occur because the issuer become more likely to default on the bonds. That is, if the creditworthiness of the issuer declines, the value of its debt also declines. If its creditworthiness declines, its bond investors are receiving a lower rate relative to investors with similar-risk investments. Thus, changes in the fair value of bonds payable for a decline in creditworthiness are included as part of other comprehensive income.
LO: 4, Bloom: C, Difficulty: Moderate, Time: 5-7, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
20.
(a) Unrealized Holding Gain or Loss—Income ................................... Notes Payable ($22,600 – $20,000) ..........................................
2,600
(b) Unrealized Holding Gain or Loss—Equity ..................................... Notes Payable ($22,600 – $20,000) ..........................................
2,600
2,600 2,600
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
21.
The required disclosures at the balance sheet date are future payments for sinking fund requirements and the maturity amounts of long-term debt during each of the next five years.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
22. Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not reported on the balance sheet. Rationales for off-balance-sheet financing are: (1) Many believe removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. (2) Loan covenants are less likely to be violated. (3) The asset side of the balance sheet is understated because fair value is not used for many assets. As a result, not reporting certain debt transactions offsets the nonrecognition of fair values on certain assets. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
23.
Forms of off-balance-sheet financing include (1) investments in non-consolidated subsidiaries for which the parent is liable for the subsidiary debt and (2) use of special purpose entities (SPEs), which are used to borrow money for special projects (resulting in take-or-pay contracts), which when structured carefully give the company benefits without reporting the liability associated with the obligations.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
24. Under GAAP, a parent company does not have to consolidate a subsidiary company that is less than 50 percent owned. In such cases, the parent does not report the assets and liabilities of the subsidiary. All the parent reports on its balance sheet is the investment in the subsidiary. As a result, users of the financial statements may not understand that the subsidiary has considerable debt for which the parent may ultimately be liable if the subsidiary runs into financial difficulty. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued) *25. Two different types of situations result with troubled debt: (1) impairments and (2) restructurings. Restructurings can be further classified into: (a) settlements. (b) modification of terms. When a debtor company runs into financial difficulty, creditors may recognize an impairment on a loan extended to that company. Subsequently, the creditor may modify the terms of the loan or settles it on terms unfavorable to the creditor. In unusual cases, the creditor forces the debtor into bankruptcy in order to ensure the highest possible collection on the loan. LO: 5, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*26. A transfer of noncash assets (real estate, receivables, or other assets) or the issuance of the debtor’s stock can be used to settle a debt obligation in a troubled debt restructuring. In these situations, the noncash assets or equity interest given should be accounted for at fair value. The debtor is required to determine the excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain). Likewise, the creditor is required to determine the excess of the receivable over the fair value of those same assets or equity interests transferred (loss). The debtor recognizes a gain equal to the amount of the excess and the creditor normally would charge the excess (loss) against Allowance for Doubtful Accounts. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the fair value of those assets differs from their carrying amount (book value). LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*27. (a)
(b)
The creditor will grant concessions in a troubled debt situation because it appears to be the more likely way to maximize recovery of the investment. The creditor might grant any one or a combination of the following concessions: 1. Reduce the face amount of the debt. 2. Accept noncash assets or equity interests in lieu of cash in settlement. 3. Reduce the stated interest rate. 4. Extend the maturity date of the face amount of the debt. 5. Reduce or defer any accrued interest.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*28. When a loan is restructured, the creditor should calculate the loss due to restructuring by subtracting the present value of the restructured cash flows (using the historical effective rate) from the carrying value of the loan. Interest revenue is calculated at the original effective rate applied towards the new carrying value. The debtor will record a gain only if the undiscounted restructured cash flows are less than the carrying value of the loan. If a gain is recognized, subsequent payments will be all principal. There is no interest component. If the undiscounted cash flows exceed the carrying amount, no gain is recognized, and a new imputed interest rate must be calculated in order to recognize interest expense in subsequent periods. LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*29. “Accounting symmetry” between the entries recorded by the debtor and the creditor in a troubled debt restructuring means that there is a correspondence or agreement between the entries recorded by each party. Impairments are nonsymmetrical because, while the creditor records a loss, the debtor makes no entry at all. Troubled debt restructurings are nonsymmetrical because creditors calculate their losses using the discounted present value of future cash flows while debtors calculate their gains using the undiscounted cash flows. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 13 (Continued) *30. A transaction would be recorded as a troubled debt restructuring by only the debtor if the amount for which the liability is settled is less than its carrying amount on the debtor’s books, but equal to or greater than the carrying amount on the creditor’s books. In addition to the situation created by the use of discounted versus undiscounted cash flows by creditors and debtors, this situation can occur when a debtor or creditor has been substituted for one of the parties to the original transaction. LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 13.1 Present value of the principal $500,000 x .37689 (PVF20**, 5%***) .................................... Present value of the interest payments $22,500* x 12.46221 (PVF-OA20**, 5%***) .......................... Issue price .............................................................. *($500,000 x .09 x 6/12)
**(10 X 2)
$188,445 280,400 $468,845
***(.10 ÷ 2)
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.2 (a) (b) (c)
Cash .................................................................................. 300,000 Bonds Payable ........................................................
300,000
Interest Expense .............................................................. 15,000 Cash ($300,000 x .10 x 6/12) ...................................
15,000
Interest Expense .............................................................. 15,000 Interest Payable ($300,000 x.10 x 6/12) .................
15,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.3 (a)
(b)
(c)
Cash ($300,000 x .98) ....................................................... 294,000 Discount on Bonds Payable ($300,000 - $294,000) ............6,000 Bonds Payable ........................................................
300,000
Interest Expense ($15,000 + $600) .................................. 15,600 Discount on Bonds Payable ($6,000 x 1/10) ...................................................... Cash ($300,000 x .10 x 6/12) ...................................
600 15,000
Interest Expense ($15,000 + $600) .................................. 15,600 Discount on Bonds Payable ($6,000 x 1/10 = $600) .......................................... Interest Payable ($300,000 x .10 x 6/12) ................
600 15,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.4 (a)
Cash ($300,000 x 1.03) .................................................... 309,000 Bonds Payable ....................................................... 300,000 Premium on Bonds Payable .................................. 9,000
(b)
Interest Expense .............................................................14,100 Premium on Bonds Payable ($9,000 x 1/10 = $900) ................................................... 900 Cash ($300,000 x .10 x 6/12) ..................................
15,000
Interest Expense .............................................................14,100 Premium on Bonds Payable ($9,000 x 1/10)............................................................... 900 Interest Payable ($300,000 x .10 x 6/12)................
15,000
(c)
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.5 (a)
Cash ................................................................................. 408,000 Bonds Payable ....................................................... 400,000 Interest Expense ($400,000 x .06 x 4/12) .............. 8,000
(b)
Interest Expense .............................................................12,000 Cash ($400,000 x .06 x 6/12) ..................................
12,000
Interest Expense .............................................................12,000 Interest Payable ($400,000 x .06 x 6/12)................
12,000
(c)
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.6 (a)
Cash ................................................................................. 559,224 Discount on Bonds Payable ...........................................40,776 Bonds Payable ....................................................... 600,000
(b)
Interest Expense ($559,224 x .08 x 6/12) .......................22,369 Cash ($600,000 x.07 x 6/12) ................................... Discount on Bonds Payable ........................................
21,000 1,369
Brief Exercise 13.6 (Continued) (c)
Interest Expense ($560,593* x .08 x 6/12) ....................... 22,424 Interest Payable ($600,000 x .07 x 6/12)...................... Discount on Bonds Payable ..................................................
21,000 1,424
*($559,224 + $1,369) LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.7 (a)
Cash .................................................................................. 644,636 Bonds Payable ........................................................ Premium on Bonds Payable ..................................
600,000 44,636
(b)
(c)
Interest Expense ($644,636 x .06 x 6/12) ........................ 19,339 Premium on Bonds Payable............................................1,661 Cash ($600,000 x .07 x 6/12) ...................................
21,000
Interest Expense ($642,975* x .06 x 6/12) ....................... 19,289 Premium on Bonds Payable............................................1,711 Interest Payable ($600,000 x .07 x 6/12) ................
21,000
*($644,636 – $1,661) LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.8 Interest Expense ($644,636 x .06 x 2/12) ........................ Premium on Bonds Payable ........................................... Interest Payable ($600,000 x .07 x 2/12) ................
6,446 554
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
7,000
Brief Exercise 13.9 Bonds Payable ....................................................................... 500,000 Premium on Bonds Payable ................................................. 15,000 Gain on Redemption of Bonds .................................... 20,000* Cash ($500,000 x .99) ................................................... 495,000 *[($500,000 + $15,000) - $495,000] LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.10 (a)
Cash .................................................................................100,000 Notes Payable ........................................................ 100,000
(b)
Interest Expense ............................................................. 10,000 Cash ($100,000 x .10) .............................................
10,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.11 (a)
(b)
Cash ................................................................................. 47,664 Discount on Notes Payable ............................................ 27,336 Notes Payable ........................................................
75,000
Interest Expense ............................................................. 5,720 Discount on Notes Payable ($47,664 x .12) ..........
5,720
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.12 (a)
(b)
Equipment ........................................................................ 31,495 Discount on Notes Payable .............................................8,505 Notes Payable .........................................................
40,000
Interest Expense ($31,495 x .12) .....................................3,779 Cash ($40,000 x .05) ................................................ Discount on Notes Payable ....................................
2,000 1,779
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.13 Cash ................................................................................. Discount on Notes Payable ............................................ Notes Payable......................................................... Unearned Sales Revenue [$60,000 – ($60,000 x .63552 (PVF4, 12%)] .............
60,000 21,869 60,000 21,869
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.14 (a) Fair Value – Book Value = $17,500 – $16,000 = $1,500 unrealized holding loss. (b) Unrealized Holding Gain or Loss—Equity ...................... 1,500 Notes Payable .........................................................
1,500
Note: If the fair value change was due to non-credit risk factor (market interest rates), any gain or loss is recorded in income. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 13.15 Current liabilities Interest Payable...................................................... Long-term liabilities Bonds Payable, due January 1, 2034 .................... Less: Discount on Bonds Payable ....................... LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$
80,000
$2,000,000 88,000 $1,912,000
Solutions to Exercises Exercise 13.1 (15–20 minutes) (a)
(b) (c) (d) (e)
(f) (g)
(h) (i)
Valuation account relating to the long-term liability, bonds payable (sometimes referred to as an adjunct account). The $3,000 would continue to be reported as long-term. Current liability if current assets are used to satisfy the debt. Current liability, $200,000; long-term liability, $800,000 ($1,000,000 $200,000). Current liability. Probably noncurrent, although if operating cycle is greater than one year and current assets are used, this item would be classified as current. Current liability. Current liability unless (a) a fund for liquidation has been accumulated which is not classified as a current asset or (b) arrangements have been made for refinancing. Current liability. Current liability.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 15-20, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.2 (15–20 minutes) (a)
Discount on bonds payable—Contra account to bonds payable in long-term liabilities on balance sheet.
(b)
Interest expense (credit balance)—Reclassify to interest payable on balance sheet.
(c)
Unamortized bond issue costs—Classified as part of long-term liabilities on balance sheet.
(d)
Gain on repurchase of debt—Classify as part of other gains and losses on the income statement.
(e)
Mortgage payable—Classify one-third as current liability and the remainder as long-term liability on balance sheet.
Exercise 13.2 (Continued) (f)
Debenture bonds—Classify as long-term liability on balance sheet.
(g)
Notes payable—Classify as long-term liability on balance sheet.
(h)
Premium on bonds payable—Classify as adjunct account to Bonds payable in long-term liabilities on balance sheet.
(i)
Bonds payable—Classify as long-term liability on balance sheet.
LO: 1, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Knowledge, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.3 (15–20 minutes) 1.
Simon Company:
(a)
(b)
(c)
2.
1/1/25 Cash ................................................................................. 200,000 Bonds Payable ....................................................... 200,000 7/1/25 Interest Expense ............................................................. 4,500 ($200,000 x .09 x 3/12) Cash ........................................................................ 4,500 12/31/25 Interest Expense ($200,000 x .09 x 3/12) .................................. 4,500 Interest Payable ..................................................... 4,500
Garfunkel Company:
(a)
6/1/25 Cash ................................................................................. 105,000 Bonds Payable ....................................................... 100,000 Interest Expense .................................................... 5,000 ($100,000 x .12 x 5/12)
Exercise 13.3 (Continued) (b)
(c)
7/1/25 Interest Expense ............................................................. 6,000 Cash ........................................................................ 6,000 ($100,000 x .12 x 6/12) 12/31/25 Interest Expense ............................................................. 6,000 Interest Payable ..................................................... 6,000
Note to instructor: Some students may credit Interest Payable on 6/1/25. If they do so, the entry on 7/1/25 will have a debit to Interest Payable for $5,000 and a debit to Interest Expense for $1,000. LO: 1, Bloom: AP, Difficulty: Moderate, Time: Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.4 (15–20 minutes)
(a)
(b)
(c)
1/1/25 Cash ($600,000 x 1.02) .................................................... 612,000 Bonds Payable .......................................................600,000 Premium on Bonds Payable ................................................................ 12,000 7/1/25 Interest Expense ............................................................. 29,700 Premium on Bonds Payable ........................................... 300 ($12,000 ÷ 40*) Cash ........................................................................ 30,000 ($600,000 x .10 x 6/12) 12/31/25 Interest Expense ............................................................. 29,700 Premium on Bonds Payable ........................................... 300 ($12,000 ÷ 40*) Interest Payable ..................................................... 30,000 ($600,000 x .10 x 6/12) *(20 x 2)
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.5 (15–20 minutes)
(a)
(b)
(c)
1/1/25 Cash ($600,000 x 1.02) .................................................... 612,000 Bonds Payable ....................................................... 600,000 Premium on Bonds Payable 12,000
7/1/25 Interest Expense ............................................................. ($612,000 x .097705 x 1/2) 29,898 *Premium on Bonds Payable ......................................... 102 Cash ........................................................................ ($600,000 x .10 x 6/12) 30,000 12/31/25 Interest Expense .............................................................. ($611,898** x .097705 x 1/2) 29,893 Premium on Bonds Payable ............................................ 107 Interest Payable ...................................................... 30,000 Carrying amount of bonds at July 1, 2025: Carrying amount of bonds at January 1, 2025 $612,000 *Amortization of bond premium ($30,000 – $29,898) (102) Carrying amount of bonds at July 1, 2025 $611,898**
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.6 (15–20 minutes) Schedule of Discount Amortization Straight-Line Method
Year Jan. 1, 2025 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027 Dec. 31, 2028 Dec. 31, 2029
Cash Paid (10%)
Interest Expense
Discount Amortized
(1)
(1) + (2)
(2)
$200,000* 200,000 200,000 200,000 200,000
$228,836.80*** 228,836.80 228,836.80 228,836.80 228,836.80
$28,836.80** 28,836.80 28,836.80 28,836.80 28,836.80
Carrying Value of Bonds $1,855,816.00 1,884,652.80 1,913,489.60 1,942,326.40 1,971,163.20 2,000,000.00
*$2,000,000 x 10% **$28,836.80 = ($2,000,000 – $1,855,816) ÷ 5. ***$200,000 + $28,836.80 LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.7 (15–20 minutes) The effective-interest or yield rate is 12%. It is determined through trial and error using Table 5-2 for the discounted value of the principal ($1,134,860)* and Table 5-4 for the discounted value of the interest ($720,956)**; $1,134,860 plus $720,956 equals the proceeds of $1,855,816. (A financial calculator may be used to determine the rate of 12%.) *$2,000,000 x .56743 (PVF5,12%) = $1,134,860 **($2,000,000 x 10%) x 3.60478 (PVF-OA5,12%) = $720,956
Exercise 13.7 (Continued) Schedule of Discount Amortization Effective-Interest Method (12%)
Year
Jan. 1, 2025 Dec. 31, 2025 Dec. 31, 2026 Dec. 31, 2027 Dec. 31, 2028 Dec. 31, 2029
Cash Paid (10%)
Interest Expense (12%)
Discount Amortized
(1)
(2)
(2) – (1)
$200,000*** 200,000 200,000 200,000 200,000
$222,697.92* 225,421.67 228,472.27 231,888.94 235,703.20**
*$222,697.92 = $1,855,816 x .12. **Rounded.
$22,697.92 25,421.67 28,472.27 31,888.94 35,703.20
Carrying Value of Bonds
$1,855,816.00 1,878,513.92 1,903,935.59 1,932,407.86 1,964,296.80 2,000,000.00
***$2,000,000 x 10%
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 13.8 (15–20 minutes) (a)
(b)
Interest paid for the period from January 1 to June 30 and paid from July 1 to December 31, 2025; $2,000,000 x .10 x 6/12 Less: Premium amortization for the period from January 1 to June 30 and July 1 to December 31, 2025 [($2,000,000 x 1.04) – $2,000,000] ÷ 10 X 6/12 Interest expense to be recorded on July 1 and December 31, 2025
Carrying value of bonds on June 30, 2025 Effective-interest rate for the period from June 30 to October 31, 2025 (.10 x 4/12) Interest expense to be recorded on October 31, 2025
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$100,000
4,000 $ 96,000
$562,500 x.033333 $ 18,750
Exercise 13.9 (20–30 minutes)
(a)
1.
June 30, 2025 Cash ................................................................................. 4,300,920.00 Bonds Payable ....................................................... 4,000,000.00 Premium on Bonds Payable .................................. 300,920.00
2.
December 31, 2025 Interest Expense.............................................................. 258,055.20 ($4,300,920.00 x.12 x 6/12) Premium on Bonds Payable ........................................... 1,944.80 Cash ........................................................................ 260,000.00 ($4,000,000 x .13 x 6/12)
3.
June 30, 2026 Interest Expense.............................................................. 257,938.51 [($4,300,920.00 – $1,944.80) x .12 x 6/12] Premium on Bonds Payable ........................................... 2,061.49 Cash ........................................................................ 260,000.00 ($4,000,000 x .13 x 6/12)
4.
December 31, 2026 Interest Expense.............................................................. 257,814.82 [($4,300,920.00 – $1,944.80 – $2,061.49) x .12 x 6/12] Premium on Bonds Payable ........................................... 2,185.18 Cash ....................................................................... 260,000.00 ($4,000,000 x .13 x 6/12)
Exercise 13.9 (Continued) (b)
Long-term Liabilities: Bonds payable, 13% (due on June 30, 2045) Premium on bonds payable* Book value of bonds payable
$4,000,000.00 294,728.53* $4,294,728.53
*$300,920.00 – ($1,944.80 + $2,061.49 + $2,185.18) = $294,728.53
(c)
1.
Interest expense for the period from January 1 to June 30, 2026 from (a) 3. Interest expense for the period from July 1 to December 31, 2026 from (a) 4. Amount of interest expense reported for 2026
$257,938.51 257,814.82 $515,753.33
2.
The amount of bond interest expense reported in 2026 using the effective-interest method will be greater than the amount that would be reported if the straight-line method of amortization were used. Under the straight-line method, the annual amortization of bond premium is $15,046 ($300,920/20). Bond interest expense for 2026 is the difference between the amortized premium, $15,046, and the actual interest paid, $520,000 ($4,000,000 x .13). Thus, the amount of annual bond interest expense is $504,954 ($520,000 – $15,046), which is smaller than the bond interest expense under the effective-interest method.
3.
Total interest to be paid for the bond ($4,000,000 x .13 x 20) Principal due in 2045 Total cash outlays for the bond Cash received at issuance of the bond Total cost of borrowing over the life of the bond
4.
$10,400,000 4,000,000 14,400,000 (4,300,920) $10,099,080
They will be the same.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 13.10 (15–20 minutes) (a)
(b)
January 1, 2025 Cash ................................................................................. 537,907.37 Premium on Bonds Payable .................................. Bonds Payable .......................................................
37,907.37 500,000.00
Schedule of Interest Expense and Bond Premium Amortization Effective-Interest Method 12% Bonds Sold to Yield 10% Cash Paid
Interest Expense
(12%)
(10%)
(1) – $60,000.00* 60,000.00 60,000.00
(2) – $53,790.74 53,169.81 52,486.79
Date
1/1/25 12/31/25 12/31/26 12/31/27
Carrying Value of Bonds
Premium Amortized (1) – (2) $6,209.26 6,830.19 7,513.21
$537,907.37 531,698.11 524,867.92 517,354.71
*$500,000 X .12 (c)
(d)
December 31, 2025 (see schedule in b) Interest Expense ............................................................. 53,790.74 Premium on Bonds Payable ........................................... 6,209.26 Cash ........................................................................
60,000.00
December 31, 2027 (see schedule in b) Interest Expense ............................................................. 52,486.79 Premium on Bonds Payable ........................................... 7,513.21 Cash ........................................................................
60,000.00
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.11 (20–30 minutes) Unsecured Bonds (1)
Maturity value
(2)
Number of interest periods
(3)
Stated rate per period
(4)
Effective rate per period
(5)
Payment amount per period
(6)
Present value
(a)
$10,000,000
$25,000,000
$20,000,000
40 (10 x 4)
10
10
0
10%
12%
12%
$375,000(a)
0
$2,000,000(b)
$11,733,639(c)
$8,049,250(d)
$17,739,840(e)
3.75% (
15% 4
)
3% (
12% 4
)
$20,000,000 x .10 = $2,000,000
Present value of an annuity of $375,000 discounted at 3% per period for 40 periods ($375,000 x 23.11477) = Present value of $10,000,000 discounted at 3% per period for 40 periods ($10,000,000 x .30656) =
(d)
(e)
Mortgage Bonds
$10,000,000 x .15 x 1/4 = $375,000
(b) (c)
Zero-Coupon Bonds
Present value of $25,000,000 discounted at 12% for 10 periods [$25,000,000 x .32197 (PVF12%,10)] =
Present value of an annuity of $2,000,000 discounted at 12% for 10 periods [$2,000,000 x 5.65022 (PVF-OA10,12%)] = Present value of $20,000,000 discounted at 12% for 10 years [$20,000,000 x .32197 (PVF10,12%)]
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$ 8,668,039 3,065,600 $11,733,639
$ 8,049,250
$11,300,440 6,439,400 $17,739,840
Exercise 13.12 (15–20 minutes) Reacquisition price ($900,000 x 1.01) Less: Net carrying amount of bonds redeemed: Par value Unamortized discount
$909,000c $900,000 (13,500)
Loss on redemption
886,500 $ 22,500
Calculation of unamortized discount— Original amount of discount: $900,000 x (1.00 - .97) = $27,000 $27,000/10 = $2,700 amortization per year; 5 x $2,700 = $13,500. January 2, 2025 Bonds Payable ................................................................. 900,000 Loss on Redemption of Bonds .......................................22,500 Discount on Bonds Payable .................................. Cash ........................................................................
13,500 909,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.13 (15–20 minutes) Cash ($9,000,000 x .98) ................................................... 8,820,000 Discount on Bonds Payable (.02 x $9,000,000) ............. 180,000 Bonds Payable........................................................ (To record issuance of 10% bonds)
9,000,000
Exercise 13.13 (Continued) Bonds Payable ................................................................ 6,000,000 Loss on Redemption of Bonds.......................................240,000 Cash ($6,000,000 x 1.02) ........................................ Discount on Bonds Payable .................................. (To record retirement of 11% bonds) Reacquisition price ......................................................... Less: Net carrying amount of bonds redeemed: Par value ................................................................. $6,000,000 Unamortized bond discount .................................. (120,000) Loss on redemption ........................................................
6,120,000 120,000 $6,120,000
5,880,000 $ 240,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.14 (12–16 minutes) (a)
(b)
June 30, 2026 Bonds Payable ................................................................ 800,000 Loss on Redemption of Bonds ...................................... 40,800* Discount on Bonds Payable .................................. Cash ........................................................................
8,800 832,000
Reacquisition price ($800,000 x 104%) .......................... Less: Net carrying value of bonds redeemed: Par value ................................................................. $800,000 Unamortized discount ........................................... (8,800) [.02 x $800,000 X (20 – 9)/20] Loss on redemption ........................................................
$ 40,800*
Cash ($1,000,000 x 1.02) ................................................. 1,020,000 Premium on Bonds Payable .................................. Bonds Payable .......................................................
20,000 1,000,000
December 31, 2026 Interest Expense ............................................................. 49,500 Premium on Bonds Payable (1/40 x $20,000) ............................................................. 500 Cash (.10 x $1,000,000 x 6/12) ...............................
50,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 12-16, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$832,000
791,200
Exercise 13.15 (10–15 minutes) Reacquisition price ($300,000 x 1.04) ............................ Less: Net carrying value of bonds redeemed: Par value ................................................................ $300,000 Unamortized discount ..........................................(10,000) Loss on redemption ........................................................
$312,000
290,000 $ 22,000
Bonds Payable .................................................................300,000 Loss on Redemption of Bonds ....................................... 22,000 Discount on Bonds Payable .................................. Cash ........................................................................ (To record redemption of bonds payable)
10,000 312,000
Cash ($300,000 x 1.03) ....................................................309,000 Premium on Bonds Payable (.03 x $300,000) ............. Bonds Payable........................................................ (To record issuance of new bonds)
9,000 300,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.16 (15–20 minutes) (a)
1.
2.
January 1, 2025 Land ................................................................................. 200,000.00 Discount on Notes Payable……………. 137,012.00 Notes Payable ......................................................... (The $200,000 capitalized land cost represents the present value of the note discounted for five years at 11%.) Equipment ........................................................................ 185,674.30 Discount on Notes Payable ............................................ 64,325.70* Notes Payable .........................................................
337,012.00
250,000.00
Exercise 13.16 (Continued) *Computation of the discount on notes payable: Maturity value Present value of $250,000 due in 8 years at 11%—$250,000 x .43393 (PVF8,11%) $108,482.50 Present value of $15,000 payable annually for 8 years at 11% annually—$15,000 x 5.14612 (PVF-OA8,11%) 77,191.80 Present value of the note Discount (b)
1.
2.
Interest Expense ............................................................. 22,000.00 Discount on Notes Payable ................................... ($200,000 x .11) Interest Expense ............................................................. 20,424.17 ($185,674.30 X .11) Discount on Notes Payable ................................... Cash ($250,000 x .06) .............................................
$250,000.00
(185,674.30) $ 64,325.70
22,000.00
5,424.17 15,000.00
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Exercise 13.17 (15–20 minutes) (a)
(b)
Face value of the zero-interest-bearing note Discount factor (12% for 3 periods) Amount to be recorded for the land at January 1, 2025
$550,000 x .71178 $391,479
Carrying value of the note at January 1, 2025 Applicable interest rate (12%) Interest expense to be reported in 2025
$391,479 x .12 $ 46,977
January 1, 2025 Cash ................................................................................. 5,000,000 Discount on Notes Payable ............................................ 1,584,950 Notes Payable ........................................................ Unearned Sales Revenue ......................................
5,000,000 1,584,950*
*$5,000,000 – [$5,000,000 x .68301(PVF4,10%)] = $1,584,950
Exercise 13.17 (Continued) Carrying value of the note at January 1, 2025 Applicable interest rate (10%) Interest expense to be reported for 2025
$3,415,050* x .10 $ 341,505
*$5,000,000 – $1,584,950 = $3,415,050 LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.18 (15–20 minutes) (a)
Cash ................................................................................. 400,000 Discount on Notes Payable ............................................ 82,468 Notes Payable......................................................... Unearned Sales Revenue ...................................... ($400,000 – $317,532) Face value Present value of 1 at 8% for 3 years Present value
(b)
400,000 82,468
$400,000 x .79383 $317,532
Interest Expense ($317,532 x 8%) .................................. 25,403 Discount on Notes Payable ...................................
25,403
Unearned Sales Revenue ($82,468 ÷ 3) 27,489 Sales Revenue ........................................................
27,489
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 13.19 (10–15 minutes)
Year Ending 2025 2026 2027 (a)
Carrying Value $54,000 44,000 36,000
Fair Value $54,000 42,500 38,000
Unrealized Holding Gain or (Loss) $ 0 1,500 (2,000)
2025 No Entry (Carrying value = Fair Value) 2026 Notes Payable ................................................................. 1,500 Unrealized Holding Gain or Loss— Income ...............................................................
1,500
2027 Unrealized Holding Gain or Loss—Income ................... 2,000 Notes Payable ........................................... Income
2,000
(b)
The fair value of $42,500.
(c)
Unrealized holding loss of $2,000.
(d)
Fallen’s creditworthiness has improved during 2027 because bond investors are receiving a higher rate relative to investors in similarrisk investments. Any gain and losses arising from changes in fallen credit risk should be recorded in other comprehensive income.
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Exercise 13.20 (10–15 minutes) At December 31, 2025, disclosures would be as follows: Maturities and sinking fund requirements on long-term debt are as follows: 2026 2027 2028 2029 2030
$ 0 2,500,000 4,500,000 8,500,000 2,500,000
($2,000,000 + $2,500,000) ($6,000,000 + $2,500,000)
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 13.21 (15–20 minutes) (a)
Transfer of property on December 31, 2025: Strickland Company (Debtor): Notes Payable......................................................... 200,000 Interest Payable...................................................... 18,000 Accumulated Depreciation—Machinery ............... 221,000 Machinery ....................................................... Gain on Disposal of Machinery ..................... Gain on Restructuring of Debt ...................... a
390,000 11,000a 38,000b
$180,000 – ($390,000 – $221,000) = $11,000 ($200,000 + $18,000) – $180,000 = $38,000
b
Moran State Bank (Creditor): Machinery ............................................................... 180,000 Allowance for Doubtful Accounts ......................... 38,000 Notes Receivable............................................ Interest Receivable......................................... (b)
200,000 18,000
“Gain on Disposal of Machinery” and the “Gain on Restructuring of Debt” should be reported in the income statement.
*Exercise 13.21 (Continued) (c)
Granting of equity interest on December 31, 2025: Strickland Company (Debtor): Notes Payable ........................................................ 200,000 Interest Payable ..................................................... 18,000 Common Stock (15,000 x $10) ....................... Paid-in Capital in Excess of ParCommon Stock ($180,000 - $150,000) ............. Gain on Restructuring of Debt ...................... Moran State Bank (Creditor): Equity Investments ................................................ 180,000 Allowance for Doubtful Accounts ......................... 38,000 Notes Receivable ........................................... Interest Receivable ........................................
150,000 30,000 38,000
200,000 18,000
LO: 5, Bloom: AP, Difficulty: Complex, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 13.22 (20–30 minutes) (a)
No. The gain recorded by Barkley is not equal to the loss recorded by American Bank under the debt restructuring agreement. (You will see why this happens in the following four parts to this exercise.) In response to this “accounting asymmetry” treatment, GAAP did not address debtor accounting because the FASB was concerned that expansion of the scope of its pronouncement would delay issuance of GAAP for the creditor.
(b)
No. There is no gain under the modified terms because the total future cash flows after restructuring exceed the total pre-restructuring carrying amount of the note (principal): Total future cash flows after restructuring are: Principal ................................................................. Interest ($2,400,000 x .10 x 3) ................................
Total pre-restructuring carrying amount of note (principal): ....................................................................
$2,400,000 720,000 $3,120,000
$3,000,000
*Exercise 13.22 (Continued) (c)
The interest payment schedule is prepared as follows: BARKLEY COMPANY Interest Payment Schedule After Debt Restructuring Effective-Interest Rate 1.4276% Cash Interest Reduction Carrying Paid Expense of Carrying Value of Date (10%) (1.4276%) Value Note (1) (2) (1)- (2) 12/31/25 $3,000,000 a b c 12/31/26 $240,000 $ 42,828 $197,172 2,802,828 12/31/27 240,000 40,013 199,987 2,602,841 d 12/31/28 240,000 37,159 202,841 2,400,000 Total $720,000 $120,000 $600,000 a
$2,400,000 x .10 = $240,000. $3,000,000 x .014276 = $42,828. c $240,000 – $42,828 = $197,172. d Adjusted $1 due to rounding. b
(d)
Interest payment entry for Barkley Company is: December 31, 2027 Notes Payable.................................................................. 199,987 Interest Expense ............................................................. 40,013 Cash ........................................................................
(e)
240,000
The payment entry at maturity is: January 1, 2029 Notes Payable.................................................................. 2,400,000 Cash ........................................................................
2,400,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*Exercise 13.23 (25–30 minutes) (a)
American Bank should use the historical interest rate of 12% to calculate the loss.
(b)
The loss is computed as follows: Pre-restructuring carrying amount of note Less: Present value of restructured future cash flows: Present value of principal $2,400,000 due in 3 years at 12% $1,708,272a Present value of interest $240,000 paid annually for 3 years at 12% 576,439b Loss on restructuring of debt a
$3,000,000
2,284,711 $ 715,289
$2,400,000 x .71178 = $1,708,272. $240,000 x 2.40183 = $576,439.
b
December 31, 2025 Bad Debt Expense........................................................... 715,289 Allowance for Doubtful Accounts ......................... (c)
715,289
The interest receipt schedule is prepared as follows: AMERICAN BANK Interest Receipt Schedule After Debt Restructuring Effective-Interest Rate 12% Cash Interest Increase Carrying Received Revenue in Carrying Value of Date (10%) (12%) Value Note (1) (2) (2) – (1) 12/31/25 $2,284,711 a b c 12/31/26 $240,000 $274,165 $ 34,165 2,318,876 12/31/27 240,000 278,265 38,265 2,357,141 12/31/28 240,000 282,859* 42,859 2,400,000 Total $720,000 $835,289 $115,289 a
$2,400,000 x .10 = $240,000. $2,284,711 x .12 = $274,165. c $274,165 – $240,000 = $34,165. *Rounded $2 b
*Exercise 13.23 (Continued) (d)
Interest receipt entry for American Bank is: December 31, 2027 Cash ................................................................................. 240,000 Allowance for Doubtful Accounts .................................. 38,265 Interest Revenue ....................................................
(e)
278,265
The receipt entry at maturity is: January 1, 2029 Cash ................................................................................. 2,400,000 Allowance for Doubtful Accounts .................................. 600,000 Notes Receivable ...................................................
3,000,000
LO: 5, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 13.24 (25–30 minutes) (a)
Yes. Barkley Company can record a gain under this term modification. The gain is calculated as follows: Total future cash flows after restructuring are: Principal .................................................................. Interest ($1,900,000 x .10 x 3) ....................... Total pre-restructuring carrying value of note (principal):...........................................................
$1,900,000 570,000 $2,470,000 $3,000,000
Therefore, the gain = $3,000,000 – $2,470,000 = $530,000. (b)
(c)
The entry to record the gain on December 31, 2025: Notes Payable......................................................... 530,000 Gain on Restructuring of Debt ......................
530,000
Because the new carrying value of the note ($3,000,000 – $530,000 = $2,470,000) equals the sum of the undiscounted future cash flows ($1,900,000 principal + $570,000 interest = $2,470,000), the imputed interest rate is 0%. Consequently, all the future cash flows reduce the principal balance and no interest expense is recognized.
*Exercise 13.24 (Continued) (d)
The interest payment schedule is prepared as follows: BARKLEY COMPANY Interest Payment Schedule After Debt Restructuring Effective-Interest Rate 0% Cash Interest Reduction Carrying Paid Expense of Carrying Value of Date (10%) (0%) Value Note (1) (2) (1) – (2) 12/31/25 $2,470,000 a 12/31/26 $190,000 $0 $190,000 2,280,000b 12/31/27 190,000 0 190,000 2,090,000 12/31/28 190,000 0 190,000 1,900,000 Total $570,000 $0 $570,000 a
$1,900,000 x .10 = $190,000. $2,470,000 – $190,000 = $2,280,000.
b
(e)
Cash interest payment entries for Barkley Company are: December 31, 2026, 2027, and 2028 (see schedule) Notes Payable ................................................................. 190,000 Cash ........................................................................
(f)
190,000
The payment entry at maturity is: January 1, 2029 Notes Payable ................................................................. 1,900,000 Cash ........................................................................
1,900,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*Exercise 13.25 (20–30 minutes) (a)
The loss can be calculated as follows: Pre-restructuring carrying value of note ....................... Less: Present value of restructured future cash flows: Present value of principal $1,900,000 due in 3 years at 12%........................................ $1,352,382a Present value of interest $190,000 paid annually for 3 years at 12% ...................... 456,348b Loss on restructuring of debt ........................................ a
$3,000,000
1,808,730 $1,191,270
$1,900,000 x .71178 (PVF3,12%) = $1,352,382 $190,000 x 2.40183 (PVF-OA3,12%) = $456,348
b
December 31, 2025 Bad Debt Expense ........................................................... 1,191,270 Allowance for Doubtful Accounts ......................... (b)
1,191,270
The interest receipt schedule is prepared as follows: AMERICAN BANK Interest Receipt Schedule After Debt Restructuring Effective-Interest Rate 12% Cash Interest Increase Carrying Received Revenue in Carrying Value of Date (10%) (12%) Value Note (1) (2) (2) – (1) 12/31/25 $1,808,730 a b c 12/31/26 $190,000 $217,048 $27,048 1,835,778 12/31/27 190,000 220,293 30,293 1,866,071 12/31/28 190,000 223,929 33,929 1,900,000 Total $570,000 $661,270 $91,270 a
$1,900,000 x .10 = $190,000. $1,808,730 x .12 = $217,048. c $217,048 – $190,000 = $27,048. b
*Exercise 13.25 (Continued) (c)
(d)
Interest receipt entries for American Bank are: (see schedule) December 31, 2026 Cash ................................................................................. 190,000 Allowance for Doubtful Accounts .................................. 27,048 Interest Revenue ....................................................
217,048
December 31, 2027 Cash ................................................................................. 190,000 Allowance for Doubtful Accounts .................................. 30,293 Interest Revenue ....................................................
220,293
December 31, 2028 Cash ................................................................................. 190,000 Allowance for Doubtful Accounts .................................. 33,929 Interest Revenue ....................................................
223,929
The receipt entry at maturity is: January 1, 2029 Cash ................................................................................. 1,900,000 Allowance for Doubtful Accounts .................................. 1,100,000 Notes Receivable ...................................................
3,000,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
*Exercise 13.26 (15–20 minutes) (a)
Gottlieb Co.’s entry: Notes Payable ................................................................. 199,800 Land ........................................................................ Gain on Disposal of Land ($140,000 – $90,000) ........................................... Gain on Restructuring of Debt ..............................
90,000 50,000 59,800*
*$199,800 – $140,000 (b)
Ceballos Inc. entry: Land ................................................................................. 140,000 Allowance for Doubtful Accounts .................................. 59,800 Notes Receivable ...................................................
LO: 5, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
199,800
*Exercise 13.27 (20–25 minutes) Because the carrying amount of the debt, $270,000 exceeds the total future cash flows $242,000 [$220,000 + ($11,000 x 2)], a gain and a loss are recognized and no interest is recorded by the debtor. (a)
(b)
Vargo Corp.’s entries: 2025 Notes Payable ($270,000 - $242,000)..................... 28,000 Gain on Restructuring of Debt ......................
28,000
2026 Notes Payable......................................................... 11,000 Cash (.05 x $220,000) .....................................
11,000
2027 Notes Payable......................................................... 231,000 Cash [$220,000 + (.05 x $220,000)] .......................
231,000
First Trust’s entry on December 31, 2025: Bad Debt Expense ........................................................... 76,027 Allowance for Doubtful Accounts .........................
76,027
Pre-restructure carrying amount Present value of restructured cash flows: Present value of $220,000 due in 2 years at 12%, interest payable annually (Table 5-2); ($220,000 x .79719) .......................... $175,382 Present value of $11,000 interest payable annually for 2 years at 12% (Table 5-4); ($11,000 x 1.69005) .............................................. 18,591 Creditor’s loss on restructuring of debt ........................
Date 12/31/25 12/31/26 12/31/27 a
Cash Interest
EffectiveInterest
Increase in Carrying Value
$11,000a 11,000
$23,277b 24,750
$12,277c 13,750
$11,000 = $220,000 x .05 $23,227 = $193,973 x 12% c $12,277 = $23,277 – $11,000 *Exercise 13.27 (Continued) b
$270,000
193,973 $ (76,027) Carrying Value of Note $193,973 206,250 220,000
December 31, 2026 (see schedule) Cash ................................................................................. 11,000 Allowance for Doubtful Accounts .................................. 12,277 Interest Revenue ....................................................
23,277
December 31, 2027 (see schedule) Cash ................................................................................. 11,000 Allowance for Doubtful Accounts .................................. 13,750 Interest Revenue ....................................................
24,750
Cash ................................................................................. 220,000 Allowance for Doubtful Accounts .................................. 50,000 Notes Receivable ...................................................
270,000
LO: 5, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Time and Purpose of Problems PROBLEM 13.1 (Time 15–20 minutes) Purpose—to provide the student with the opportunity to interpret a bond amortization schedule. This problem requires both an understanding of the function of such a schedule and the relevance of each of the individual numbers. The student is to prepare journal entries to reflect the information given in the bond amortization schedule. PROBLEM 13.2 (Time 25–30 minutes) Purpose—to provide the student with an understanding of how to make the journal entry to record the issuance of bonds. In addition, a portion of the bonds are retired and therefore a bond amortization schedule has to be prepared. PROBLEM 13.3 (Time 20–30 minutes) Purpose—to provide the student with an understanding of how interest rates can be used to deceive a customer. The problem is challenging because for the first year of this transaction, negative amortization results. PROBLEM 13.4 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the relevant journal entries which are necessitated when there is a bond issuance and bond retirement. This problem also provides an opportunity for the student to learn the income statement treatment of the loss from retirement and the footnote disclosure required. PROBLEM 13.5 (Time 50–65 minutes) Purpose—to provide the student with an understanding of the relevant journal entries which are necessitated for a bond issuance. This problem involves two independent bond issuances with the assumption that one is sold at a discount and the other at a premium, both utilizing the effective-interest method. This comprehensive problem requires preparing journal entries for the issuance of bonds, related interest payments and amortization (with the construction of amortization tables where applicable), and the retirement of part of the bonds. PROBLEM 13.6 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the relevant journal entries which are necessitated when there is a bond issuance and bond retirement. This problem requires preparing journal entries, assuming the straight-line method, for the issuance of bonds, related interest payments and amortization, and the retirement of part of the bonds. PROBLEM 13.7 (Time 20–25 minutes) Purpose—to provide the student with a series of transactions from bond issuance, payment of bond interest, accrual of bond interest, amortization of bond discount, and bond retirement. Journal entries are required for each of these transactions. PROBLEM 13.8 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to become familiar with the application of GAAP, involving the exchange of notes for cash or property, goods, or services. This problem requires the preparation of the necessary journal entries concerning the exchange of a zero-interest-bearing longterm note for a computer, and the necessary adjusting entries relative to depreciation and amortization. The student should construct the relevant Schedule of Note Discount Amortization to support the respective entries.
Time and Purpose of Problems (Continued) PROBLEM 13.9 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to become familiar with the application of GAAP, involving the exchange of a note, which is payable in equal installments, for machinery. This problem requires the preparation of the necessary journal entries concerning the exchange and the annual payments and interest. A Schedule of Note Discount Amortization should be constructed to support the respective entries. PROBLEM 13.10 (Time 20–25 minutes) Purpose—to provide the student with an understanding of a number of areas related to bonds. Specifically, the classification of bonds, determination of cash received and accrued interest, and disclosure requirements. PROBLEM 13.11 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to explain what the effective-interest method is, why it is preferable, and how it is computed. As one part of the problem, an amortization schedule must be prepared. *PROBLEM 13.12 (Time 15–25 minutes) Purpose—to provide the student with a troubled debt situation that requires computation of the creditor’s loss on restructure, entries to recognize the loss, and discussion of GAAP relating to this situation. *PROBLEM 13.13 (Time 30–45 minutes) Purpose—to provide the student with four independent and different restructured debt situations where losses or gains must be computed and journal entries recorded on the books of the creditor. *PROBLEM 13.14 (Time 40–50 minutes) Purpose—to provide the student with a complex troubled debt situation that requires two amortization schedules, computation of loss on restructure, and entries at different times on both the creditor’s and debtor’s books.
Solutions to Problems Problem 13.1
(a)
The bonds were sold at a discount of $5,651 ($100,000 − $94,349). Evidence of the discount is the January 1, 2019 book value of $94,349, which is less than the maturity value of $100,000 in 2028.
(b)
The interest allocation and bond discount amortization are based upon the effective-interest method; this is evident from the increasing interest charge. Under the straight-line method the amount of interest would have been $11,565.10 [$11,000 + ($5,651 ÷ 10)] for each year of the life of the bonds.
(c)
The stated rate is 11% ($11,000 ÷ $100,000). The effective rate is 12% ($11,322 ÷ $94,349).
(d)
January 1, 2019 Cash ................................................................................. 94,349 Discount on Bonds Payable ...........................................5,651 Bonds Payable .......................................................
100,000
December 31, 2019 Interest Expense ............................................................. 11,322 Discount on Bonds Payable .................................. Interest Payable......................................................
322 11,000
January 1, 2026 (Interest Payment) Interest Payable ............................................................... 11,000 Cash ........................................................................
11,000
December 31, 2026 Interest Expense ............................................................. 11,712 Discount on Bonds Payable .................................. Interest Payable......................................................
712 11,000
(e)
(f)
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 13.2
(a)
Present value of the principal $2,000,000 x .38554 (PVF10, 10%) ........................ Present value of the interest payments $210,000* x 6.14457 (PVF-OA10, 10%) ................. Present value (selling price of the bonds) ........
$ 771,080 1,290,360 $2,061,440
*$2,000,000 x .105 = $210,000 Cash ................................................................................. 2,061,440 Bonds Payable ....................................................... Premium Bonds Payable ....................................... ($2,061,440 - $2,000,000) (b) Date
1/1/24 1/1/25 1/1/26 1/1/27 1/1/28 (c)
Cash Paid (10.5%) (1) $210,000 210,000 210,000 210,000
Interest Expense (10%) (2) $206,144 205,758 205,334 204,868
Premium Amortization
2,000,000 61,440 Carrying Value of Bonds
(1) – (2) $3,856 4,242 4,666 5,132
$2,061,440 2,057,584 2,053,342 2,048,676 2,043,544
Carrying value as of 1/1/27 ................................... Less: Amortization of bond premium (5,132 ÷ 2) ................................................... Carrying amount as of 7/1/27 ...............................
$2,048,676
Reacquisition price ............................................... Carrying value as of 7/1/27 ($2,046,110 ÷ 2)................................................... Loss on redemption of bonds ..............................
$1,065,000
2,566 $2,046,110
(1,023,055) $ 41,945
Problem 13.2 (Continued) Entry for accrued interest Interest Expense ............................................................. 51,217 Premium on Bonds Payable ($5,132 x 1/2 x 6/12) ...................................................... 1,283 Cash ($210,000 x 1/2 x 6/12) ..................................
52,500
Entry for reacquisition Bonds Payable ($2,000,000 x ½).................................... 1,000,000 Premium on Bonds Payable ........................................... 23,055* Loss on Redemption of Bonds ...................................... 41,945 Cash ........................................................................ 1,065,000 *Premium as of 7/1/27 to be written off ($2,046,110 – $2,000,000) x 1/2 = $23,055 The loss is reported in Other gains and losses on the income statement. LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 13.3 (a)
Date 1/1/25 4/1/25 7/1/25 10/1/25 1/1/26
Cash Paid (1) $400 400 400 400
Interest Expense (2) $640* 645 650 655
Discount Amortized (2) – (1) $240 245 250 255
Carrying Value of Note $32,000** 32,240 32,485 32,735 32,990
*($32,000 x .08 x 3/12) ** ($33,000 – $1,000) = $32,000 (b)
At this point, we see that the customer owes $32,990, or $990 more than at the beginning of the year.
(c)
To earn 8% over the next two years the quarterly payments must be $4,503 computed as follows: $32,990 ÷ 7.32548 (PVF-OA8, 2%) = $4,503
(d) Date
Cash Paid (1)
1/1/26 4/1/26 7/1/26 10/1/26 1/1/27 4/1/27 7/1/27 10/1/27 1/1/28
$4,503 4,503 4,503 4,503 4,503 4,503 4,503 4,503
*rounded by $5
Interest Expense (2%e) (2) $660 583 505 425 343 260 175 83*
Discount Amortized
Carrying Value of Note
(1) - (2) $3,843 3,920 3,998 4,078 4,160 4,243 4,328 4,420
$32,990 29,147 25,227 21,229 17,151 12,991 8,748 4,420 0
Problem 13.3 (Continued) (e)
The new sales gimmick may bring people into the showroom the first time but will drive them away once they learn of the amount of their year 2 and year 3 payments. Many will not have budgeted for these increases, and will be in a bind because they owe more on their car than it’s worth. One should question the ethics of a dealer using this tactic.
LO: 1, 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Problem 13.4 (a)
Entry to record the issuance of the 11% bonds on December 18, 2025: Cash ($4,000,000 x 1.02) ................................................. 4,080,000 Bonds Payable ....................................................... Premium on Bonds Payable ..................................
4,000,000 80,000
Entry to record the retirement of the 9% bonds on January 2, 2026: Bonds Payable ................................................................ 3,000,000 Loss on Redemption of Bonds ...................................... 180,000 Discount on Bonds Payable ($150,000 x 10/25)……………………... Cash ($3,000,000 x 104%) ...................................... [The loss represents the excess of the cash paid ($3,120,000) over the carrying value of the bonds ($3,000,000 - $60,000 = $2,940,000).]
60,000 3,120,000
(b) The loss is reported as an ordinary loss. Note 1. Loss on Bond Redemption The loss represents a loss of $180,000 from the redemption and retirement of $3,000,000 of the Company’s outstanding bond issue due in 2036. The funds used to purchase the mortgage bonds represent a portion of the proceeds from the sale of $4,000,000 of 11% debenture bonds issued December 18, 2025 and due in 2045. LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 13.5 1. Sanford Co. Schedule of Bond Discount Amortization Effective-Interest Method 10% Bonds Sold to Yield 12%
Date
3/1/25 9/1/25 3/1/26 9/1/26 3/1/27 9/1/27 3/1/28 9/1/28
Cash Paid (10%) (1) $25,000* 25,000 25,000 25,000 25,000 25,000 25,000
*($500,000 x .10 x 1/2)
Interest Expense (12%) (2) $28,325 28,525 28,736 28,961 29,198 29,450 29,715**
Discount Amortized
Carrying Value of Bonds
(2) – (1) $3,325 3,525 3,736 3,961 4,198 4,450 4,715
$472,090 475,415 478,940 482,676 486,637 490,835 495,285 500,000
**Rounded $2 ($472,090 x .12 x ½)
3/1/25 Cash ................................................................................. 472,090 Discount on Bonds Payable ........................................... 27,910* Bonds Payable........................................................ *Maturity value of bonds payable ................................... Present value of $500,000 due in 7 periods at 6%*** [$500,000 x .66506 (PVF7,6%)] ....................................... $332,530 Present value of interest payable semiannually [$25,000 x 5.58238 (PVF-OA7,6%)] ................................ 139,560 Proceeds from sale of bonds ........................................ Discount on bonds payable ...........................................
500,000 $500,000
(472,090) $ 27,910
***.12 ÷ 2 = 6%
9/1/25 (see schedule) Interest Expense ............................................................. 28,325 Discount on Bonds Payable .................................. Cash ........................................................................
3,325 25,000
Problem 13.5 (Continued) 12/31/25 (see schedule) Interest Expense ($28,525 x 4/6) ..................................... 19,017 Discount on Bonds Payable ($3,525 x 4/6) ........................................................ Interest Payable ($25,000 x 4/6) .............................
2,350 16,667
3/1/26 (see schedule) Interest Expense ($28,525 x 2/6) ..................................... 9,508 Interest Payable .............................................................. 16,667 Discount on Bonds Payable ($3,525 X 2/6) ........................................................ Cash .........................................................................
1,175 25,000
9/1/26 (see schedule) Interest Expense .............................................................. 28,736 Discount on Bonds Payable................................... Cash .........................................................................
3,736 25,000
12/31/26 (see schedule) Interest Expense ($28,961 x 4/6) ..................................... 19,308 Discount on Bonds Payable ($3,961 x 4/6) ........................................................ Interest Payable ($25,000 x 4/6) .............................
2,641 16,667
Problem 13.5 (Continued) 2. Titania Co. Schedule of Bond Discount Amortization Effective-Interest Method 12% Bonds Sold to Yield 10%
Date
6/1/25 12/1/25 6/1/26 12/1/26 6/1/27 12/1/27 6/1/28 12/1/28 6/1/29
Cash Paid (12%) (1) $24,000* 24,000 24,000 24,000 24,000 24,000 24,000 24,000
Interest Expense (10%) (2)
Premium Amortized
$21,293 21,157 21,015 20,866 20,709 20,545 20,372 20,190**
Carrying Value of Bonds
(1) – (2) $2,707 2,843 2,985 3,134 3,291 3,455 3,628 3,810
$425,853 423,146 420,303 417,318 414,184 410,893 407,438 403,810 400,000
*($400,000 x .12 x 1/2) ($425,853 x .10 x ½) **$.50 adjustment due to rounding. 6/1/25 Cash ................................................................................. 425,853 Premium on Bonds Payable .................................. Bonds Payable........................................................ Maturity value of bonds payable .................................... Present value of $400,000 due in 8 periods at 5%*** [$400,000 x .67684 (PVF8,5%)] ........................................ $270,736 Present value of interest payable semiannually [$24,000 x 6.46321 (PVF-OA8,5%) .................................. 155,117 Proceeds from sale of bonds ......................................... Premium on bonds payable ............................................ ***(.10 ÷ 2)
25,853 400,000 $400,000
(425,853) $ 25,853
Problem 13.5 (Continued)
12/1/25 (see schedule) Interest Expense .............................................................. 21,293 Premium on Bonds Payable ............................................ 2,707 Cash ($400,000 x .12 x 6/12) ...................................
24,000
12/31/25 (see schedule) Interest Expense ($21,157 x 1/6) ..................................... 3,526 Premium on Bonds Payable ($2,843 x 1/6) ................................................................. 474 Interest Payable ($24,000 x 1/6) .............................
4,000
6/1/26 (see schedule) Interest Expense ($21,157 x 5/6) ..................................... 17,631 Interest Payable ............................................................... 4,000 Premium on Bonds Payable ($2,843 x 5/6) ................................................................. 2,369 Cash .........................................................................
24,000
10/1/26 (see schedule) Interest Expense ($21,015 x .3* x 4/6) ....................................................... 4,203 Premium on Bonds Payable ($2,985 X .3 x 4/6) .......................................................... 597 Cash ($24,000 x .3* x 4/6) .......................................
4,800
*$120,000 ÷ $400,000 = .3
Problem 13.5 (Continued) 10/1/26 Bonds Payable ................................................................ 120,000 Premium on Bonds Payable ........................................... 5,494 Gain on Redemption of Bonds .............................. Cash ........................................................................ *Reacquisition price $126,000 – ($120,000 x .12 x 4/12) Net carrying value of bonds redeemed: Par value Unamortized premium [.3 x ($25,853 – $2,707 – $2,843)] – $597 Gain on redemption
4,294* 121,200 $121,200
$120,000 5,494
(125,494) $ (4,294)
12/1/26 (see schedule) Interest Expense ($21,015 x .7*) ..................................... 14,711 Premium on Bonds Payable ($2,985 x .7)................................................................... 2,089 Cash ($24,000 X .7) ................................................ ($400,000 – $120,000) ÷ $400,000 = .7
16,800
12/31/26 Interest Expense ($20,866 x .7 x 1/6) ............................. 2,434 Premium on Bonds Payable ($3,134 x .7 x 1/6) .......................................................... 366 Interest Payable ($24,000 x .7 X 1/6) ..............................................
2,800
6/1/27 Interest Expense ($20,866 x .7 x 5/6) ............................. 12,172 Interest Payable .............................................................. 2,800 Premium on Bonds Payable ($3,134 x .7 x 5/6) .......................................................... 1,828 Cash ($24,000 x .7) .................................................
16,800
Problem 13.5 (Continued) 12/1/27 (see schedule) Interest Expense ($20,709 x .7) ....................................... 14,496 Premium on Bonds Payable ($3,291 x .7) ................................................................... 2,304 Cash ($24,000 x .7) ..................................................
16,800
LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 50-65, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 13.6 May 1, 2025 Cash ($900,000 x 106%) + ($900,000 x .12 x 4/12) ................ 990,000.00 Bonds Payable........................................................ 900,000.00 Premium on Bonds Payable .................................. 54,000.00 Interest Expense ($900,000 x .12 x 4/12) ............... 36,000.00 December 31, 2025 Interest Expense ($900,000 x.12) .................................... 108,000.00 Interest Payable ...................................................... 108,000.00 Premium on Bonds Payable ........................................... 3,724.14 Interest Expense ($54,000 x 8/116* = $3,724.14) .............................
3,724.14
*(12 x 10) – 4 = 116 January 1, 2026 Interest Payable ............................................................... 108,000.00 Cash ........................................................................ 108,000.00 April 1, 2026 Bonds Payable ................................................................. 360,000.00 Premium on Bonds Payable ...........................................19,551.72* Interest Expense ($360,000 x .12 x 3/12) ........................10,800.00 Cash ($367,200 + $10,800) ..................................... 378,000.00 Gain on Redemption of Bonds .............................. 12,351.72** *[($360,000 ÷ $900,000) x $54,000 x 105/116 = $19,551.72] **Reacquisition price (including accrued interest) ($360,000 x 102%) + ($360,000 x .12 x 3/12) ................ $378,000.00 Net carrying value of bonds redeemed: Par value .......................................................................... $360,000.00 Unamortized premium [$54,000 x ($360,000 ÷ $900,000) X 105/116] ...............19,551.72 (379,551.72) Accrued interest ($360,000 x .12 x 3/12) ........................ (10,800.00) Gain on redemption of bonds ......................................... $ (12,351.72)
Problem 13.6 (Continued) December 31, 2026 Interest Expense ($540,000 x .12)...................................64,800.00 Interest Payable......................................................
64,800.00
Premium on Bonds Payable ........................................... 3,910.34 Interest Expense ....................................................
3,910.34
Amortization per year on $540,000 ($54,000 x 12/116 x .60*) ............................................... Amortization on $360,000 for 3 months ($54,000 x 3/116 x .40**) ............................................... Total premium amortization ...........................................
$3,351.72 558.62 $3,910.34
*($900,000 – $360,000) ÷ $900,000 = .6 **$360,000 ÷ $900,000 = .4 LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 13.7 4/1/25 (a)
Cash (15,000 x $1,000 x 97%)........................................... 14,550,000 Discount on Bonds Payable ............................................ 450,000 Bonds Payable ....................................................... 15,000,000 10/1/25
(b)
Interest Expense ............................................................... 840,000 Cash ........................................................................ 825,000* Discount on Bonds Payable .................................. 15,000** *$15,000,000 x .11 x 6/12 = $825,000 **$450,000 ÷ 180 months = $2,500/mo.; $2,500/mo. x 6 months = $15,000 12/31/25
(c)
Interest Expense ............................................................... 420,000 Interest Payable ($825,000 x 3/6) .................................................... 412,500 Discount on Bonds Payable ($2,500 x 3 months) ............................................. 7,500 3/1/26
(d)
Interest Payable ($412,500 x 6/15) ............................................................ 165,000 Interest Expense ............................................................... 112,000 ($275,000 + $2,000 - $165,000) Cash ........................................................................ 275,000* Discount on Bonds Payable .................................. 2,000** *Cash paid to retiring bondholders: $6,000,000 x .11 x 5/12 = $275,000 **$2,500/mo. x 2 months x 6 /15 of the bonds = $2,000
Problem 13.7 (Continued) At March 1, 2026 the carrying amount of the retired bonds is: Bonds payable........................................................................ $6,000,000 Less: Unamortized discount ................................................ 169,000* $5,831,000 6 *$2,500/mo. x 169 months x /15 of the bonds = $169,000 (180 – 11) = 169 The reacquisition price: 200,000 shares x $31 = $6,200,000. The loss on redemption of bonds is: Reacquisition price ....................................................... Less: Carrying value.................................................... Loss on redemption of bonds ...................................... The entry to record extinguishment of the bonds is: Bonds Payable ....................................................... 6,000,000 Loss on Redemption of Bonds ............................. 369,000 Discount on Bonds Payable .......................... Common Stock (200,000 x $10) ..................... Paid-in Capital in Excess of Par— Common Stock [($31 - $10) x 200,000] ............................. LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$6,200,000 5,831,000 $ 369,000
169,000 2,000,000 4,200,000
Problem 13.8 (a)
(b)
December 31, 2025 Equipment........................................................................ 409,806.00 Discount on Notes Payable ............................................ 190,194.00 Notes Payable......................................................... [Computer capitalized at the present value of the note—$600,000 x .68301 (PVF4,10%)]
600,000.00
December 31, 2026 Depreciation Expense ..................................................... 67,961.20 Accumulated Depreciation—Equipment [($409,806 – $70,000) ÷ 5]....................................
67,961.20
Interest Expense ............................................................. 40,980.60 Discount on Notes Payable ...................................
40,980.60
Date 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29
Schedule of Note Discount Amortization Debit Interest Expense / Credit Carrying Value Discount on Notes Payable of Note (10%) $409,806.00 $40,980.60 450,786.60 45,078.66 495,865.26 49,586.53 545,451.79 54,548.21* 600,000.00
*3.03 adjustment due to rounding. (c)
December 31, 2027 Depreciation Expense ..................................................... 67,961.20 Accumulated Depreciation—Equipment ..............
67,961.20
Interest Expense ............................................................. 45,078.66 Discount on Notes Payable ...................................
45,078.66
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 13.9 12/31/24 (a)
Machinery ........................................................................ 182,485.20 Discount on Notes Payable ............................................ 27,514.80 Cash ........................................................................50,000.00 Notes Payable ......................................................... 160,000.00 [To record machinery at the present value of the note plus the immediate cash payment: PV of $40,000 annuity @ 8% for 4 years ($40,000 x 3.31213) PVF-OA4,8%] ........................................... $132,485.20 Down payment ........................................................50,000.00 Capitalized value of Machinery ............................................................ $182,485.20 12/31/25
(b)
Notes Payable ................................................................. 40,000.00 Cash ........................................................................ 40,000.00 Interest Expense ............................................................. 10,598.82 Discount on Notes Payable ................................... 10,598.82
Date 12/31/24 12/31/25 12/31/26 12/31/27 12/31/28
Schedule of Note Discount Amortization Interest Cash Paid Expense Amortization (1) (2) (1) - (2) $40,000.00 40,000.00 40,000.00 40,000.00
$10,598.82* 8,246.72 5,706.46 2,962.80***
*$132,485.20 x .08 **$103,084.02 = $132,485.20 – $29,401.18. ***$0.18 adjustment due to rounding.
$29,401.18 31,753.28 34,293.54 37,037.20
Carrying Value of Note $132,485.20 103,084.02** 71,330.74 37,037.20 —
Problem 13.9 (Continued) 12/31/26 (see schedule) (c)
Notes Payable.................................................................. 40,000.00 Cash ........................................................................ 40,000.00 Interest Expense ............................................................. 8,246.72 Discount on Notes Payable ................................... 8,246.72 12/31/27 (see schedule)
(d)
Notes Payable.................................................................. 40,000.00 Cash ........................................................................ 40,000.00 Interest Expense ............................................................. 5,706.46 Discount on Notes Payable ................................... 5,706.46 12/31/28 (see schedule)
(e)
Notes Payable.................................................................. 40,000.00 Cash ........................................................................ 40,000.00 Interest Expense ............................................................. 2,962.80 Discount on Notes Payable ................................... 2,962.80
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 13.10 (a)
(b)
Wilke Co. Selling price of the bonds ($4,000,000 x 1.03) ........ Accrued interest from January 1 to February 28, 2026 ($4,000,000 x .09 x 2/12) .......................... Total cash received from issuance of the bonds.... Less: Bond issuance costs ...................................... Net amount of cash received ................................... Langley Co. Carrying amount of the bonds on 1/1/25 ................. Effective-interest rate (10%) ..................................... Interest expense to be reported for 2025 ................
$4,120,000 60,000 4,180,000 27,000 $4,153,000
$656,992 x 0.10 $ 65,699
(c)
Tweedie Building Co. Maturities and sinking fund requirements on long-term debt for the next five year are as follows: 2026 $400,000 2029 $200,000 2027 350,000 2030 350,000 2028 200,000 Thereafter 300,000
(d)
Beckford Inc. Since the three bonds reported by Beckford Inc. are secured by either real estate, securities of other corporations, or plant equipment, none of the bonds are classified as debenture bonds.
LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
Problem 13.11 Dear Samantha, When a bond is issued at face value, the annual interest expense and the interest payout equals the face value of the bond times the interest rate stated on its face. However, if the bond is issued to yield a higher or lower interest rate than what is stated on its face, the interest expense recorded by the issuer and the actual interest payout will differ. Labeled as a discount or premium respectively, this difference in interest must be systematically associated with the interest periods which occur over the bond’s life through a process called amortization. One method of amortization is the straight-line method, whereby the amount of the premium or discount is divided by the number of interest periods in the bond’s life. The result is an even amount of amortization for every period. However, a better way of recording interest expense in the period during which it is incurred is the effective-interest method. Assume a premium: the theory behind this method is that, as time passes, the difference between the face value of the bond and its carrying value becomes smaller, resulting in a lower interest expense every period. (The carrying value equals the face value of the bond plus any unamortized portion of the premium.) Because the carrying value of the bond becomes smaller over time, the effective-interest expense also does. Since the stated interest rate remains constant, the resulting difference between the actual interest payout and the interest expense recognized must be reflected when interest expense is recorded for the period. To amortize the premium applying this method to the data provided, you must know the bond’s face value, its stated rate of interest, its effective rate of interest, and its premium. 1.
Multiply the stated rate times the face value. This is the cash interest payout.
2.
Calculate the carrying value by adding the premium to the bond’s face value. Now multiply this carrying value by the effective rate, which gives you the actual interest expense.
Problem 13.11 (Continued) 3.
Subtract the amount calculated in #2 from that found in #1. This is the amount to be amortized for the period.
4.
Subtract the difference computed in #3 from the carrying value. The process begins all over when you apply the effective rate to this new carrying value for the following period.
The schedule below illustrates this calculation. The face value ($2,000,000) is multiplied by the stated rate of 11 percent, while the carrying value ($2,171,600) is multiplied by the effective rate of 10 percent. Because this bond pays interest semiannually, you must also multiply these amounts by 6/12. The result is the stated interest of $110,000 and effective- interest of $108,580. The difference ($1,420) is amortized, lowering the carrying value of the bond to $2,170,180. For the next period, this new carrying value will be multiplied by the effective rate times 6/12 and subtracted from the constant $110,000. Obviously, this time the effective-interest will be lower than it was last period, resulting in a greater amount of amortization in the next period. Follow these steps, and you should have no trouble amortizing premiums and discounts over the life of a bond. Sincerely, Attachment to letter
Date 6/30/25 12/31/25 6/30/26 12/31/26 6/30/27
HOBART COMPANY Interest and Discount Amortization Schedule 11% Bond Issued to Yield 10% Cash Interest Carrying Paid Expense Premium Value of (11%) (10%) Amortized Bond $2,171,600 $110,000 $108,580 $1,420 2,170,180 110,000 108,509 1,491 2,168,689 110,000 108,434 1,566 2,167,123 110,000 108,356 1,644 2,165,479
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 40-50, AACSB: Communication, AICPA BC: Professional Behavior, AICPA AC: Reporting, AICPA PC: Communication
*Problem 13.12
(a)
It is a troubled debt restructuring.
(b)
1.
No entry.
2.
Bad Debt Expense.................................................. 237,311* Allowance for Doubtful Accounts .................
237,311
*Calculation of loss. Pre-restructure carrying value Present value of restructured cash flows: Present value of $600,000 due in 10 years at 12%, interest payable annually ($600,000 x .32197) ........................................................ $193,182 Present value of $30,000 interest payable annually for 10 years at 12% ($30,000** x 5.65022) ..................................................... 169,507 Creditor’s loss on restructuring of debt ........................
$600,000
(362,689) $237,311
**($600,000 x .05) (c)
Losses are calculated based upon the discounted present value of future cash flows. However, the debtor’s gain is calculated using the undiscounted cash flows. This does not fairly state the economic benefits derived by the debtor as a result of the restructuring.
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
*Problem 13.13 (a)
On the books of Halvor Corporation: Notes Payable ................................................................. 5,000,000 Common Stock ...................................................... Paid-in Capital in Excess of Par— Common Stock.................................................. Gain on Restructuring of Debt ..............................
1,700,000 2,000,000 1,300,000
Fair value of equity ............................................. $3,700,000 Carrying value of debt ........................................ (5,000,000) Gain on restructuring of debt ............................................................... ($1,300,000)
(b)
On the books of Frontenac National Bank: Equity Investments ......................................................... 3,700,000 Allowance for Doubtful Accounts .................................. 1,300,000 Notes Receivable ...................................................
5,000,000
On the books of Halvor: Notes Payable ................................................................. 5,000,000 Land ........................................................................ Gain on Disposal of Plant Assets ......................... Gain on Restructuring of Debt ..............................
3,250,000 750,000 1,000,000
Fair value of land ................................................ $4,000,000 Book value of land .............................................. (3,250,000) Gain on disposal of plant assets ...................................................... $ 750,000 Note payable (carrying amount)................................................................ $5,000,000 Fair value of land ................................................... (4,000,000) Gain on restructuring of debt .................................................................. $1,000,000 On the books of Frontenac National Bank: Land ................................................................................. 4,000,000 Allowance for Doubtful Accounts .................................. 1,000,000 Notes Receivable ...................................................
5,000,000
*Problem 13.13 (Continued) (c)
On the books of Halvor: No entry is needed because aggregate cash flows equal the carrying value. Aggregate cash flows—principal .......................... Carrying value ........................................................
$5,000,000 $5,000,000
On the books of Frontenac National Bank: Bad Debt Expense ........................................................... 1,243,400* Allowance for Doubtful Accounts .........................
1,243,400
*Calculation of loss: Pre-restructure carrying value Less: Present value of restructured cash flows: Present value of $5,000,000 due in 3 years at 10% (Table 5-2); ($5,000,000 x 0.75132) ..................................... Creditor’s loss on restructuring of debt ........................ (d)
On the books of Halvor: No entry is needed because aggregate cash flows equal the carrying value. Principal .................................................................. Interest ($4,166,667 x .10 x 2) ................................ Aggregate cash flows Carrying amount On the books of Frontenac National Bank: Bad Debt Expense ........................................................... 1,212,100* Allowance for Doubtful Accounts .........................
$5,000,000
3,756,600 $1,243,400
$4,166,667 833,333 $5,000,000 $5,000,000
1,212,100
*Problem 13.13 (Continued) *Calculation of loss: Pre-restructure carrying value ..................................... Present value of restructured cash flows: Present value of $4,166,667 due in 3 years at 10%, interest payable annually (Table 5-2); ($4,166,667 x .75132) ................................................................. $3,130,500 Present value of $416,667 interest payable annually for 3 years at 10%, (Table 5-4); ($416,667 x 2.48685) ........................ 1,036,188 Less first-year payment: Present value of $416,667 interest due in 1 year at 10% (Table 5-2); ($416,667 x .90909).............................................. 378,788 Creditor’s loss on restructuring of debt…...
$5,000,000
3,787,900 $1,212,100
LO: 5, Bloom: AP, Difficulty: Complex, Time: 15-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
*Problem 13.14 Carrying value of the debt at date of restructure, $330,000 + $33,000 = $363,000. Total future cash flow, $300,000 + ($300,000 x .10 x 3) = $390,000. Because the future cash flow exceeds the carrying value of the debt, no gain is recognized at the date of restructure. (a)
The effective-interest rate subsequent to restructure is computed by trial and error using the assumed partial present value tables based on the present value of $300,000 (new principal) plus $30,000 (interest per year) for three years to equal $363,000. Try 2 1/2% ($300,000)(.92859) = ($30,000)(2.85602) = PV =
$278,577 85,681 $364,258
Try 2 5/8% ($300,000)(.92521) = ($30,000)(2.84913) = PV =
$277,563 85,474 $363,037
Try 2 3/4% ($300,000)(.92184) = ($30,000)(2.84226) = PV =
$276,552 85,268 $361,820
Therefore, the approximate effective rate is 2 5/8%. Note to instructor = The solution using Excel is as follows: Compute the new effective-interest rate for Crocker Corp. following restructure. (Hunt: Find the interest rate that approximates $363,000 as the present value of the total future cash flows) Present Value Future Value Payment Term Rate
363,000 -300,000 -30,000 3 2.63%
Using the Rate function, we can use Excel to calculate what effective rate will give us a present value of $363,000 based on a 3-year term, future value of $300,000 and annuity (interest) payment of $30,000. =RATE [PV, FV, PMT, per, rate]
*Problem 13.14 (Continued) (b)
SCHEDULE OF DEBT REDUCTION AND INTEREST EXPENSE AMORTIZATION
Date 12/31/25 12/31/26 12/31/27 12/31/28 12/31/28
Cash Paid
Interest Expense
Premium Amortized
$ 30,000 30,000 30,000 300,000
$9,529* 8,991 8,480**
$ 20,471 21,009 21,520 300,000
*$9,529 = $363,000 x .02625 **Adjusted $40 due to rounding.
Carrying Value of Note $363,000 342,529 321,520 300,000 –0–
*Problem 13.14 (Continued) (c)
Calculation of loss: Pre-restructure carrying value ....................................... Present value of restructured cash flows: Present value of $300,000 due in 3 years at 10%, interest payable annually (Table 5-2); ($300,000 x .75132) .......................... $225,396 Present value of $30,000 interest payable annually for 3 years at 10% (Table 5-4); ($30,000 x 2.48685) .............................................. 74,605 Creditor’s loss on restructuring of debt ........................
$363,000
(300,000*) $ 63,000
*Although the sum of the present value amounts is $300,001, the true present value of a 10% note discounted at 10% is face value, or $300,000. The $1 difference is due to rounding.
Date 12/31/25 12/31/26 12/31/27 12/31/28 12/31/28
Cash Received
Interest Revenue
$ 30,000a 30,000 30,000 300,000
$30,000b 30,000 30,000 0
Change in Carrying Amount $
0 0 0 300,000
Carrying Amount of Note $300,000 300,000c 300,000 300,000 0
a
$30,000 = $300,000 x .10. $30,000 = $300,000 x .10. c $300,000 = $300,000 – $0. b
(d)
Crocker Corp. entries: December 31, 2025 Interest Payable............................................................... 33,000 Notes Payable ........................................................
33,000
December 31, 2026 (see schedule) Interest Expense ............................................................. 9,529 Notes Payable ................................................................. 20,471 Cash ........................................................................
30,000
*Problem 13.14 (Continued) December 31, 2027 Interest Expense ............................................................. 8,991 Notes Payable ................................................................. 21,009 Cash ........................................................................
30,000
(e) Yaeger Corp. entries: December 31, 2025 Bad Debt Expense .......................................................... 63,000 Allowance for Doubtful Accounts.........................
63,000
December 31, 2026 and 2027 Cash ................................................................................. 30,000 Interest Revenue ....................................................
30,000
LO: 5, Bloom: AP, Difficulty: Complex, Time: 30-45, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Financial Reporting Problem UYJ13.1 (a)
According to the Short-Term and Long-Term Debt note (Note 10), Long-term debt maturities during the next five fiscal years are: 2021, $2,508 million; 2022, $2,830 million; 2023, $2,425 million; 2024 $2,481 million; and 2025 $2743 million.
(b)
(Amounts in $ millions) 1. Working capital = Current assets less current liabilities. ($4,989) = $27,987 – $32,976 2.
Cash + investments + net receivables Current liabilities
Acid-test ratio =
($16,181 + $0 + $4,178) $32,976
0.62 times = 3.
Current ratio = 0.85 times =
(.51 in 2019)
Current assets Current liabilities $27,987 (.75 in 2019) $32,976
It appears P&G has a fairly weak liquidity position. The current ratio is below 1. The acid-test ratio is significantly below 1, possibly due to a slowing economy. However, P&G’s high current liabilities could reflect a cheap form of financing. The other ratio analysis below provides P&G’s additional insight into financial position in 2020. Receivables turnover = =
Net sales Average receivables $70,950 $4,178 + $4,951 2
= 15.54 times (14.05 times in 2019)
UYJ13.1 Financial Reporting Problem (Continued) Inventory turnover = =
= Current cash debt coverage = =
= Cash debt coverage
Cost of goods sold Average inventory $35,250 $5,498 + $5,017 2 6.71 times (7.13 in 2019)
Net cash provided by operating activities Average current liabilities $17,403 $32,976 + $30,011 2 0.55 times (0.52 in 2019) = Net cash provided by operating activities Average total liabilities $17,403 = $73,822 + $67,516 2 = 0.25 times (.23 times in 2019)
Debt to assets ratio =
$73,822 = 0.61 (.59 in 2019) $120,700
Time interest earned = Income before income taxes and interest expense Interest expense = $16,299 + $465 $465 = 36.05 times (13.92 times in 2019) Similar to P&G’s liquidity position, the company’s solvency also appears weak. It has low coverage of its current and long-term liabilities. However, its interest coverage appears adequate. Industry and yearto-year comparisons should also be employed. In general, and with comparison to 2019, P&G has an improving liquidity and solvency position. LO: 4, Bloom: AN, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Comparative Analysis Case UYJ13.2 (a)
Debt to assets ratio: Coca-Cola PepsiCo
$66,012/$87,296 = 75.6% $79,366/$92,918 = 85.4%
Times interest earned ratio: Coca-Cola ($7,768 + $1,981 + $1,437)/$1,437 = 7.78 times PepsiCo ($7,175 + $1894 + $1,128)/$1,128 = 9.04 times The debt to assets ratio around 78-85% for both Coca-Cola and PepsiCo show both companies to be highly leveraged, PepsiCo more so than Coca-Cola. The times interest earned ratios are adequate for both firms; (b) Coca-Cola (Note 16) PepsiCo (Note 9)
Carrying Value $40,610* 40,370
Fair Value $43,218 50,000
*Includes current portion of long-term debt.
The fair value will vary from the historical cost carrying value due to changes in interest rates. (c)
1.
Lower interest rates may be available in foreign countries.
2.
Credit may be more readily available in foreign countries.
Using foreign debt to finance operations is subject to the risk of foreign currency exchange rate fluctuations. Both PepsiCo and Coca-Cola enter into interest rate and foreign currency swaps to effectively change the interest rate and currency of specific debt issuances. These swaps are generally entered into concurrently with the issuance of the debt they are intended to modify. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Financial Statement Analysis Case UYJ13.3 (a)
Due to the markdown from 99.803 to 99.25, Commonwealth Edison would record a slightly larger discount and, of course, receive and record less cash. Amortization of the larger discount will result in a larger interest expense charge in each year the bonds are outstanding. As a result of the additional $5.50 markdown, the effective-interest rate increased from 9.3% to 9.45%.
(b)
In the same Wall Street Journal article, the following explanation was provided for Commonwealth Edison’s bond markdown and slow sale: “Commonwealth had the misfortune to begin its giant offering only hours before investor sentiment was soured by the report last Thursday of a record increase in the nation’s money supply. The monetary surge, plus a recent rebound in industrial productivity reported Friday, halted the market rally triggered in early May by signs of an economic slowdown and a peaking of interest rates.” Other economic events that can and do affect the price of securities issued are: 1.
A change in the Federal Reserve’s lending rate.
2.
A change in the bank prime rate.
3.
A flood of other similar securities issues.
4.
A good or poor earnings report for the issuer.
5.
A change in the issuer’s credit rating.
6.
The issuance of a favorable or unfavorable broker’s or other financial analysis.
UYJ13.3 Financial Statement Analysis Case (Continued) Of course, noneconomic, political, or other world events can also affect the day-to-day sale of securities. The “recent rebound in industrial productivity” mentioned in the article would normally not be a depressant on a securities issue; but because the financial community was anticipating, even hoping for, a recession to “cool off the economy” and, thus, lower the then existing high-interest rates, the rebound represented a delay in the recession and the lowering of interest rates. LO: 4, Bloom: AN, Difficulty: Complex, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Accounting, Analysis, and Principles UYJ13.4 Accounting BUGANT, INC. Income Statement For the year Ended December 31, 2026 Sales revenue Expenses: Cost of goods sold (1) Salaries and wages expense Depreciation expense (2) Interest expense (3) Net income (1) (2) (3)
$3,500 $1,900 700 80 172
$1,800 + $2,000 – $1,900 = $1,900 $2,000 / 25 years = $80 1/1 – 6/30: $1,426 x .12 x 6/12 = $86 7/1 – 12/31: ($1,426 + [$86 – $75]) x .12 x 6/12 = $86 Interest expense = $86 + $86 = $172 1/1 – 6/30: $1,500 x .10 x 6/12 = $75 7/1 – 12/31: $1,500 x .10 x 6/12 = $75 Interest paid = $75 + $75 = $150
2,852 $ 648
UYJ13.4 Accounting, Analysis, and Principles (Continued) BUGANT, INC. Balance Sheet December 31, 2026 ASSETS Cash (1) .................................................................... Inventory .................................................................. Total current assets ................................................ Plant and equipment ............................................... Accumulated depreciation (2) ................................ Total assets..............................................................
$1,000 1,900 $2,900 2,000 (240)
LIABILITIES Bonds payable (3).................................................... STOCKHOLDERS’ EQUITY Common stock ........................................................ Retained earnings (4) .............................................. Total liabilities and stockholders’ equity ............... (1) (2) (3) (4)
1,760 $4,660 $1,448
$1,500 1,712
$450 + $3,500 – $2,000 – $700 – $100 – $150 = $1,000 $(160) + $(80) = $(240) $1,426 + ($86 – $75) + ($86 – $75) = $1,448 $1,164 + $648 – $100 = $1,712
3,212 $4,660
UYJ13.4 Accounting, Analysis, and Principles (Continued) Analysis 2026
2025
Debt to Assets Ratio
$1,448 $4,660 = 0.31
$1,426 $4,090 = 0.35
Times Interest Earned
$648 + $172 = 4.77 $172
$550 + $169 = 4.25 $169
Less than one-third of Bugant’s financing comes from debt, which is good. Earnings before interest are also more than 4.5 times interest expense. Both ratios also improved during the year. Note that the company’s interest expense is larger than its yearly cash interest payments. Cash payments for interest are $150 per year. Thus, one might argue times interest earned ‘understates’ a little the company’s ability to make interest payments. Essentially, the company is delaying the payment of some of the interest each year until the bond’s maturity date. With the company’s current cash balance and low income, one would have to question the company’s ability to meet its obligation on the maturity date when it arrives. Principles One could argue that this represents a classic trade-off between relevance and faithful representation. Many people think that the fair values of assets and liabilities are relevant to making investing and financing decisions. However, the determination of fair value is the responsibility of management. Management may have incentives to bias reported fair value numbers one direction or the other. For example, in this case, changes in the fair value of debt would be part of the period’s net income. Thus, management may have an incentive to bias their estimate of the fair values of their debt. On the other hand, one might argue that fair values of debt are not really relevant if the company will not pay off the debt early. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 13.1 (Time 25–30 minutes) Purpose—to provide the student with some familiarity with the economic theory which relates to the accounting for a bond issue. The student is required to discuss the conceptual merits for each of the three different balance sheet presentations for the same bond issue, and the merits for utilizing the nominal rate versus the effective rate at date of issue in the computation of the carrying value of the obligations arising from a bond issue. CT 13.2 (Time 15–25 minutes) Purpose—this case includes discussions of the determination of the selling price of bonds, presentation of items related to bonds on the balance sheet and the income statement, whether discount amortization increases or decreases, and how an early retirement of bonds should be reported on the income statement. CT 13.3 (Time 20–25 minutes) Part I—Purpose—to provide the student with an understanding of the significance of the difference between the effective-interest method of amortization and the straight-line method of amortization. Part II—Purpose—to provide the student with some familiarity with the various methods of accounting for gains and losses from the early extinguishment of debt, and the justifications for each of the different methods. CT 13.4 (Time 20–30 minutes) Purpose—the student is asked to explain project financing arrangements, off-balance-sheet financing, and the conditions for which a contractual obligation is to be disclosed as an unconditional purchase obligation. The case also requires the student to determine accounting treatment for a project financing arrangement. CT 13.5 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to examine the ethical issues related to the issue of bonds.
Solutions to Critical Thinking CT 13.1 (a) 1. This is a common balance sheet presentation and has the advantage of being familiar to users of financial statements. The face or maturity value of $1,000,000 is shown in an obvious manner. The total of $1,085,800 is the objectively determined exchange price at which the bonds were issued. It represents the fair value of the bond obligations given. Thus, this is in keeping with the generally accepted accounting practice of using exchange prices as a primary source of data. 2. This presentation indicates the dual nature of the bond obligations. There is an obligation to make periodic payments of $55,000 and an obligation to pay the $1,000,000 at maturity. The amounts presented on the balance sheet are the present values of each of the future obligations discounted at the initial effective rate of interest. The proper emphasis is placed upon the accrual concept, that is, that interest accrues through the passage of time. The emphasis upon premiums and discounts is eliminated. 3. This presentation shows the total liability which is incurred in a bond issue, but it ignores the time value of money. This would be a fair presentation of the bond obligations only if the effective-interest rate were zero. (b) When an entity issues interest-bearing bonds, it normally accepts two types of obligations: (1) to pay interest at regular intervals and (2) to pay the principal at maturity. The investors who purchase Nichols Company bonds expect to receive $55,000 each January 1 and July 1 through January 1, 2045 plus $1,000,000 principal on January 1, 2045. Since this ($55,000) is more than the 10% per annum ($50,000 semiannually) that the investors would be willing to accept on an investment of $1,000,000 in these bonds, they are willing to bid up the price—to pay a premium for them. The amount that the investors should be willing to pay for these future cash flows depends upon the interest rate that they are willing to accept on their investment(s) in this security. The amount that the investors are willing to pay (and the issuer is willing to accept), $1,085,800, is the present value of the future cash flows discounted at the rate of interest that they will accept. Another way of viewing this is that the $1,085,800 is the amount which, if invested at an annual interest rate of 10% compounded semiannually, would allow withdrawals of $55,000 every six months from July 1, 2025 through January 1, 2045 and $1,000,000 on January 1, 2045. When bonds are issued at their maturity value, the price paid coincides with the maturity value because the coupon rate is equal to the effective rate. If the bonds had been issued at their maturity value, the $1,000,000 would be the present value of future interest and principal payments discounted at an annual rate of 11% compounded semiannually. Here the effective rate of interest is less than the coupon rate, so the price of the bonds is greater than the maturity value. If the effective rate of interest was greater than the coupon rate, the bonds would sell for less than the maturity value. (c) 1. The use of the coupon rate for discounting bond obligations would give the face value of the bond at January 1, 2025, and at any interest-payment due thereafter. Although the coupon rate is readily available while the effective rate must be computed, the coupon rate may be set arbitrarily at the discretion of management so that there would be little or no support for accepting it as the appropriate discount rate.
CT 13.1 (Continued) 2. The effective-interest rate at January 1, 2025 is the market rate to Nichols Company for longterm borrowing. This rate gives a discounted value for the bond obligations, which is the amount that could be invested at January 1, 2025 at the market rate of interest. This investment would provide the sums needed to pay the recurring interest obligation plus the principal at maturity. Thus, the effective-interest rate is objectively determined and verifiable. The market or yield rate of interest at the date of issue should be used throughout the life of the bond because it reflects the interest obligation which the issuer accepted at the time of issue. The resulting value at the date of issue was the current value at that time and is similar to historical cost. Also, this yield rate is objectively determined in an exchange transaction. The continued use of the issue-date yield rate results in a failure to reflect whether the burden is too high or too low in terms of the changes which may have taken place in the interest rate. (d) Using a current yield rate produces a current value, that is, the amount which could currently be invested to produce the desired payments. When the current yield rate is lower than the rate at the issue date (or than at the previous valuation date), the liabilities for principal and interest would increase. When the current yield is higher than the rate at the issue date (or at the previous valuation date), the liabilities would decrease. Thus, holding gains and losses could be determined. If the debt is held until maturity, the total of the interest expense and the holding gains and losses under this method would equal the total interest expense using the yield rate at issue date. LO: 1, 4 Bloom: C, Difficulty: Moderate, Time: 25-30, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 13.2 (a) 1. The selling price of the bonds would be the present value of all of the expected net future cash outflows discounted at the effective annual interest rate (yield) of 11 percent. The present value is the sum of the present value of its maturity amount (face value) plus the present value of the series of future semiannual interest payments. 2. Immediately after the bond issue is sold, the current asset, cash, would be increased by the proceeds from the sale of the bond issue, adjusted for any bond issue costs. A noncurrent liability, bonds payable, would be presented in the balance sheet at the face value of the bonds less the discount. (b) Interest expense would be included for ten months (March 1, 2025, to December 31, 2025) at an effective-interest rate (yield) of 11 percent. This is composed of the nominal interest of 9 percent adjusted for the amortization of the related bond discount. Bond discount should be amortized using the effective-interest method over the period the bonds will be outstanding, that is, the period from the date of sale (March 1, 2025) to the maturity date (March 1, 2030). (c) The amount of bond discount amortization would be lower in the second year of the life of the bond issue than in the third year. The effective-interest method of amortization uses a uniform interest rate based upon a changing carrying value which results in increasing amortization each year when there is a bond discount. (d) The retirement of the bonds would result in a loss from extinguishment of debt that should be included in the determination of net income and classified in other expenses and losses. LO: 1, 2, 4 Bloom: C, Difficulty: Moderate, Time: 15-25, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 13.3 Part I. (a) The effective-interest method of amortization of bond discount or premium applies a constant interest rate to the carrying value of the debt. The straight-line method applies a constant dollar amount over the life of the debt resulting in a changing effective-interest rate incurred based on the carrying value of the debt. Either method, however, computes the total premium or discount to be amortized as the difference between the par value of the debt and the proceeds from the issuance. (b) Before the effective-interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the principal value due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the effective interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value adjusted for unamortized premium or discount). The amount of amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by the nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument. This is due to the decreasing carrying value of the bond instrument multiplied by the constant effective-interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond. This is due to the increasing carrying value of the bond instrument multiplied by the constant effective-interest rate from which is subtracted the amount of cash interest paid. The varying amounts of amortization occur because of the changing carrying value of the bond over the life of the instrument. In contrast, the straight-line method of amortization yields a constant dollar amount of amortization based upon the life of the instrument regardless of effective yield rates demanded in the marketplace. Part II. (a) 1. Gain or loss to be amortized over the remaining life of old debt. The basic argument supporting this method is that if refunding is done to obtain debt at a lower cash outlay (interest cost), then the gain or loss is truly a cost of obtaining the reduction in cash outlay. As such, the new rate of interest alone does not reflect the cost of the new debt, but a portion of the gain or loss on the extinguishment of the old instrument must be matched with the nominal interest to reflect the true cost of obtaining the new debt instrument. This argument states that this matching must continue for the unexpired life of the old debt in order to reflect the true nature of the transaction and cost of obtaining the new debt instrument. 2. Gain or loss to be amortized over the life of the new debt instrument. This argument states that the gain or loss from early extinguishment of debt actually affects the cost of obtaining a new debt instrument. However, this method asserts that the effect should be matched with the interest expense of the new debt for the entire life of the new debt instrument. This argument is based on the assumption that the debt was refunded to take advantage of new lower interest rates or to avoid projected high interest rates in the future and that any gain or loss on early extinguishment should be reflected as an element of this decision and total interest cost over the life of the new instrument should be stated to reflect this decision.
CT 13.3 (Continued) 3. Gain or loss recognized in the period of extinguishment. Proponents of this method state that the early extinguishment of debt to be refunded actually does not differ from other types of extinguishments of debt where the consensus is that any gain or loss from the transaction should be recognized in full in current net earnings. The early extinguishment of the debt is prompted for the same reason that other debt instruments are extinguished, namely, that the value of the debt instrument has changed in light of current financial circumstances and early extinguishment of the debt would produce the most favorable results. Also, it is argued that any gain or loss on the extinguishment is directly related to market interest fluctuations related to prior periods. If the true market interest rate had been known at the time of issuance, there would be no gain or loss at the time of extinguishment. Also, even if market interest rates were not known but the carrying value of the bond was periodically adjusted to market, any gain or loss would be reflected at the interim dates and not in a future period. The call premium paid on extinguishment and any unamortized premium or discount are actually adjustments to the actual effective-interest rate over the outstanding life of the bond. As such, any gain or loss on the early extinguishment of debt is related to prior-period valuation differences and should be recognized immediately. (b) The immediate recognition principle is the only acceptable method of reflecting gains or losses on the early extinguishment of debt, and these amounts, if material, must be reflected as other gains and losses. LO: 1, 2, 4 Bloom: SYN, Difficulty: Moderate, Time: 20-25, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 13.4 (a) Such financing arrangements arise when (1) two or more entities form another entity to construct an operating plant that will be used by both parties; (2) the new entity borrows funds to construct the project and repays the debt from the proceeds received from the project; and (3) payment of the debt is guaranteed by the companies that formed the new entity. (b) In some cases, project financing arrangements become more formalized through the use of takeor-pay contracts or similar types of contracts. In a simple take-or-pay contract, a purchaser of goods signs an agreement with the seller to pay specified amounts periodically in return for products or services. The purchaser must make specified minimum payments even if delivery of the contracted products or services is not taken. (c) Ryan should not record the plant as its asset. The plant is to be constructed and operated by ACC. Although Ryan agrees to purchase all of the cans produced by ACC, Ryan does not have the property right to the plant, nor the right to use the plant. (d) Accounting for purchase commitments is unsettled and controversial. Some argue that these contracts should be reported as assets and liabilities at the time the contract is signed; others believe that the present recognition at the delivery date is most appropriate. FASB Concepts Statement No. 6 states that “a purchase commitment involves both an item that might be recorded as an asset and an item that might be recorded as a liability. That is, it involves both a right to receive assets and an obligation to pay . . . If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be clearly seen.” Although the discussion in Concepts Statement No. 6 does not exclude the possibility of recording assets and liabilities for purchase commitments, it contains no conclusions or implications about whether they should be recorded.
CT 13.4 (Continued) According to current practice, Ryan does not record an asset relating to the future purchase commitment. However, if the dollar amount involved is material, the details of the contract should be disclosed in a footnote to the balance sheet. In addition, if the contracted price is in excess of the purchase market price and it is expected that losses will occur when the purchase is affected, losses should be recognized in the accounts in the period during which such declines in prices take place. (e) Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not reported in a company’s balance sheet. The reasons for off-balance-sheet financing are many. First, many believe that removing debt or otherwise keeping it from the balance sheet enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. Second, loan covenants often impose a limitation on the amount of debt a company may have. As a result, off-balance-sheet financing is used because these types of commitments might not be considered in computing the debt limitation. Third, it is argued by some that the asset side of the balance sheet is severely understated because of the use of certain accounting methods (like LIFO and accelerated depreciation methods). As an offset to these lower values, some believe that part of the debt does not have to be reported. Note to instructor: Additional discussion of these type arrangements is presented in Appendix 16B related to variable interest entities. LO: 4, Bloom: C, Difficulty: Moderate, Time: 20-30, AACSB: Knowledge, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 13.5 (a) The stakeholders in the Wichita case are: Donald Lennon, president, founder, and majority stockholder. Nina Friendly, minority stockholder. Other minority stockholders. Existing creditors (debt holders). Future bondholders. Employees, suppliers, and customers. (b) The ethical issues: The desires of the majority stockholder (Donald Lennon) versus the desires of the minority stockholders (Nina Friendly and others). Doing what is right for the company and others versus doing what is best for oneself. Questions: Is what Donald wants to do legal? Is it unethical? Is Donald’s action brash and irresponsible? Who may benefit/suffer if Donald arranges a high-risk bond issue? Who may benefit/suffer if Nina Friendly gains control of Wichita? (c) The rationale provided by the student will be more important than the specific position because this is a borderline case with no right answer. LO: 1, 4 Bloom: E, Difficulty: Moderate, Time: 25-30, AACSB: Ethics, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Ethical Conduct, Communication
Codification Exercises CE13.1 Master Glossary (a)
An obligation is callable at a given date if the creditor has the right at that date to demand, or to give notice of its intention to demand, repayment of the obligation owed to it by the debtor.
(b)
The interest rate that results from a process of approximation (or imputation) required when the present value of a note must be estimated because an established exchange price is not determinable and the note has no ready market.
(c)
Long-term obligations are those scheduled to mature beyond one year (or the operating cycle, if applicable) from the date of an entity’s balance sheet.
(d)
The rate of return implicit in the loan, that is, the contractual interest rate adjusted for any deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE13.2 According to FASB ASC 470-10-50-1 (Disclosure of Long-Term Obligations): The combined aggregate amount of maturities and sinking fund requirements for all long-term borrowings shall be disclosed for each of the five years following the date of the latest balance sheet presented. (See Section 505-10-50 for disclosure guidance that applies to securities, including debt securities.) See Example 3 (Paragraph 470-10-55-10) for an illustration of this disclosure requirement. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE13.3 According to FASB ASC 470-10-45-1 (Classification of Debt that Includes Covenants): Some long-term loans contain certain covenants that must be met on a quarterly or semiannual basis. If a covenant violation occurs that would otherwise give the lender the right to call the debt, a lender may waive its call right arising from the current violation for a period greater than one year while retaining future covenant requirements. Unless facts and circumstances indicate otherwise, the borrower shall classify the obligation as noncurrent, unless both of the following conditions exist: (a)
A covenant violation that gives the lender the right to call the debt has occurred at the balance sheet date or would have occurred absent a loan modification.
(b)
It is probable that the borrower will not be able to cure the default (comply with the covenant) at measurement dates that are within the next 12 months.
See Example 1 (paragraph 470-10-55-2) for an illustration of this classification guidance. LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE13.4 According to FASB ASC 470-10-S99-2 (SAB Topic 4.A, Subordinated Debt): Subordinated debt may not be included in the stockholders’ equity section of the balance sheet. Any presentation describing such debt as a component of stockholders’ equity must be eliminated. Furthermore, any caption representing the combination of stockholders’ equity and only subordinated debts must be deleted. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a) According to FASB ASC 835-30-05 05-2 Business transactions often involve the exchange of cash or property, goods, or service for a note or similar instrument. When a note is exchanged for property, goods, or service in a bargained transaction entered into at arm’s length, there should be a general presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds. That presumption, however, must not permit the form of the transaction to prevail over its economic substance and thus would not apply if interest is not stated, the stated interest rate is unreasonable, or the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction. The use of an interest rate that varies from prevailing interest rates warrants evaluation of whether the face amount and the stated interest rate of a note or obligation provide reliable evidence for property recording the exchange and subsequent related interest. 05-3 This Subtopic provides guidance for the appropriate accounting when the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange. The circumstance may arise if the note is non-interestbearing or has a stated interest rate that is different from the rate of interest appropriate for the debt at the date of the transaction. Unless the note is recorded at its present value in this circumstance, the sales price and profit to a seller in the year of the transaction and the purchase price and cost to the buyer are misstated, and interest income and interest expense in subsequent periods are also misstated.
Codification Research Case (Continued) According to FASB ASC 835-30-15 15-2 The guidance in the Subtopic applies to receivables and payables that represent contractual rights to receive money or contractual obligations to pay money on fixed or determinable dates, whether or not there is any stated provision for interest, with certain exceptions noted below. Such receivables and payables are collectively referred to in this Subtopic as notes. Some examples are the following: a. Secured and unsecured notes b. Debentures c. Bonds d. Mortgage notes e. Equipment obligations f. Some accounts receivable and payable. (b) According to FASB ASC 835-30-25 25-3 If an established exchange price is not determinable and if the note has no ready market, the problem of determining present value is more difficult. To estimate the present value of a note under such circumstances, an applicable interest rate is approximated that may differ from the stated or coupon rate. This process of approximation is called imputation, and the resulting rate is called an imputed interest rate. Nonrecognition of an apparently small difference between the stated rate of interest and the applicable current rate may have a material effect on the financial statements if the face amount of the note is large and its term is relatively long. (c) According to FASB ASC 835-30-45
Codification Research Case (Continued) 45-1A The discount or premium resulting from the determination of present value in cash or noncash transactions is not an asset or liability separable from the note that gives rise to it. Therefore, the discount or premium shall be reported in the balance sheet as a direct deduction from or addition to the face amount of the note. It shall not be classified as a deferred charge or deferred credit. 45-2
The description of the note shall include the effective interest rate. The face amount shall also be disclosed in the financial statements or in the notes to the statements.
45-3
Amortization of discount or premium shall be reported as interest expense. Issue costs shall be reported in the balance sheet as deferred charges.
LO: 1, 4, Bloom: K, Difficulty: Simple, Time: 35-40, AACSB: Knowledge, Communication, Technology, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, Technology and Tools, AICPA PC: Communication.
CHAPTER 14 Stockholders’ Equity Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1. Stockholders’ rights; corporate form.
1, 2, 3
2. Stockholders’ equity.
4, 5, 6, 16
3
7, 9, 10, 16, 17, 18
1, 2, 3, 6, 9, 12
3. Issuance of shares.
7, 10
1, 2, 6
1, 2, 4, 5, 6, 8, 9, 18
1, 3, 4, 9, 12
4. Noncash stock transactions; lump sum sales.
8, 9
4, 5
3, 4, 5, 6, 18
1, 4
5. Preferred stock.
3, 11, 12, 13
7
9, 18
1, 3, 9, 12
6. Treasury stock transactions, cost method.
14, 15, 17
8, 9, 10
3, 6, 7, 8, 10, 18
1, 2, 3, 5, 6, 7, 9, 12
7
7. Stockholders’ equity accounts; classifications; terminology.
18
10, 11, 17, 18
6, 9, 11, 12
3
8. Dividend policy.
19, 20, 21
12, 15, 16
7, 10
9. Cash and stock dividends; stock splits; property dividends; liquidating dividends.
22, 23, 24, 25, 26
13, 14, 15, 18
6, 7, 8, 9, 10, 11
10. Restrictions of retained earnings.
27, 28
1
11, 12, 13, 14, 15
6
11. Analysis. *12. Dividend preferences and book value.
19, 20 29
16
*This material is covered in an Appendix to the chapter.
21, 22, 23, 24
2
4, 5, 6
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Describe the corporate form and the issuance of shares of stock.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 16, 18
1, 2, 3, 4, 5, 6, 7
1, 2, 3, 4, 5, 6, 8, 9, 10, 18
1, 3, 4, 9, 12
1, 2, 3
2.
Describe the accounting and reporting for reacquisition of shares.
14, 15, 17
3, 8, 9, 10
3, 6, 7, 8, 10, 18
1, 2, 3, 5, 6, 9, 12
3, 7
3.
Explain the accounting and reporting issues related to dividends.
19, 20, 21, 22 23, 24, 25, 26
11, 12, 13, 14, 15
9, 11, 12, 13, 14, 15, 18
1, 3, 6, 7, 8, 9, 10, 11, 12
4, 5, 6
4.
Indicate how to present and analyze stockholders’ equity.
27 ,28
10, 11, 16, 17, 18, 19, 20
1, 2, 3, 6, 9, 11, 12
*5. Explain the different types of preferred stock dividends and their effect on book value per share.
29
16
21, 22, 23, 24
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E14.1 E14.2 E14.3 E14.4 E14.5 E14.6 E14.7 E14.8 E14.9 E14.10 E14.11 E14.12 E14.13 E14.14 E14.15 E14.16 E14.17 E14.18 E14.19 E14.20 *E14.21 *E14.22 *E14.23 *E14.24
Recording the issuances of common stock. Recording the issuance of common and preferred stock. Stock issued for land. Lump-sum sale of stock with bonds. Lump-sum sales of stock with preferred stock. Stock issuances and repurchase. Effect of treasury stock transactions on financials. Correcting entries for equity transactions. Preferred stock entries and dividends. Analysis of equity data and equity section preparation. Equity items on the balance sheet. Cash dividend and liquidating dividend. Stock split and stock dividend. Entries for stock dividends and stock splits. Dividend entries. Computation of retained earnings. Stockholders’ equity section. Dividends and stockholders’ equity section. Comparison of alternative forms of financing. Trading on the equity analysis. Preferred dividends. Preferred dividends. Preferred stock dividends. Computation of book value per share.
Simple Simple Simple Moderate Simple Moderate Moderate Moderate Moderate Moderate Simple Simple Simple Simple Simple Simple Moderate Moderate Moderate Moderate Simple Moderate Complex Moderate
15–20 15–20 10–15 20–25 10–15 25–30 15–20 15–20 15–20 20–25 15–20 10–15 10–15 10–12 10–15 05–10 20–25 30–35 20–25
P14.1 P14.2 P14.3 P14.4 P14.5 P14.6 P14.7 P14.8 P14.9 P14.10 P14.11 P14.12
Equity transactions and statement preparation. Treasury stock transactions and presentation. Equity transactions and statement preparation. Stock transactions—lump sum. Treasury stock—cost method. Treasury stock—cost method—equity section preparation. Cash dividend entries. Dividends and splits. Stockholders’ equity section of balance sheet. Stock dividends and stock split. Stock and cash dividends. Analysis and classification of equity transactions.
Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Simple Moderate Simple Complex
50–60 25–35 25–30 20–30 30–40 30–40 15–20 20–25 20–25 35–45 25–35 35–45
Moderate Moderate Moderate Simple Simple Moderate Moderate
10–20 15–20 25–30 25–30 15–20 20–25 10–15
CT14.1 Preemptive rights and dilution of ownership. CT14.2 Issuance of stock for land. CT14.3 Conceptual issues—equity. CT14.4 Stock dividends and splits. CT14.5 Stock dividends. CT14.6 Stock dividend, cash dividend, and treasury stock. CT14.7 Treasury stock, ethics. *This material is presented in an appendix to the chapter.
10–15 10–15 10–15 10–15 15–20
Answers to Questions 1.
The basic rights of each stockholder (unless otherwise restricted) are to share proportionately: (1) in profits, (2) in management (the right to vote for directors), (3) in corporate assets upon liquidation, and (4) in any new issues of stock of the same class (preemptive right).
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
2.
The preemptive right protects existing shareholders from dilution of their ownership share in the event the corporation issues new shares.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
3.
Preferred stock commonly has preference to dividends in the form of a fixed dividend rate and a preference over common stock to remaining corporate assets in the event of liquidation. Preferred stock usually does not give the holder the right to share in the management of the company. Common stock is the residual security possessing the greater risk of loss and the greater potential for gain; it is guaranteed neither dividends nor assets upon dissolution, but it generally controls the management.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
4.
The distinction between paid-in capital and retained earnings is important for both legal and economic points of view. Legally, dividends can be declared out of retained earnings in all states, but in many states, dividends cannot be declared out of paid-in capital. Economically, management, stockholders, and others look to earnings for the continued existence and growth of the corporation.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
5.
Authorized capital stock—the total number of shares authorized by the state of incorporation for issuance Unissued capital stock—the total number of shares authorized but not issued Issued capital stock—the total number of shares issued (distributed to stockholders) Outstanding capital stock—the total number of shares issued and still in the hands of stockholders (issued less treasury stock) Treasury stock—shares of stock issued and repurchased by the issuing corporation but not retired
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
6.
Par value is an arbitrary, fixed per share amount assigned to a stock by the incorporators. It is recognized by the state of incorporation as the amount that must be paid in for each share if the stock is to be fully paid when issued. If not fully paid, the shareholder has a contingent liability for the discount that results.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
7.
The issuance for cash of no-par-value common stock at a price in excess of the stated value of the common stock is accounted for as follows: (1) Cash is debited for the proceeds from the issuance of the common stock. (2) Common Stock is credited for the stated value of the common stock. (3) Paid-in Capital in Excess of Stated Value—Common Stock is credited for the excess of the proceeds from the issuance of the common stock over its stated value.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 14 (Continued) 8.
The proportional method is used to allocate the lump sum received on sales of two or more classes of securities when the fair value or other sound basis for determining relative value is available for each class of security. In instances where the fair value of all classes of securities is not determinable in a lump-sum sale, the incremental method must be used. The value of the securities is used for those classes that are known and the remainder is allocated to the class for which fair value is not known.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
9.
The general rule to be applied when stock is issued for services or property other than cash is that the property or services be recorded at either their fair value or the fair value of the stock issued, whichever is more clearly determinable. If neither is readily determinable, the value to be assigned is generally established by the board of directors.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
10.
The direct costs of issuing stock, such as underwriting costs, accounting and legal fees, printing costs, and taxes, should be recorded as a reduction of the amounts paid in (proceeds from the sale of the stock). Issue costs are therefore debited to Paid-in Capital in Excess of Par—Common Stock.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
11. The character of preferred stock can be altered by being cumulative or noncumulative, participating or nonparticipating, convertible or nonconvertible, callable or noncallable, or redeemable. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
12. Nonparticipating means the security holder is entitled to no more than the specified fixed dividend. If the security is partially participating, it means that in addition to the specified fixed dividend the security may participate with the common stock in dividends up to a certain stated rate or amount. A fully participating security shares pro rata with the common stock dividends declared without limitation. In this case, Dagwood Inc. has a fully participating preferred stock. Cumulative means dividends not paid in any year must be made up in a later year before any profits can be distributed to common stockholders. Any dividends not paid on cumulative preferred stock constitute a dividend in arrears. A dividend in arrears is not a liability until the board of directors declares a dividend. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
13. Preferred stock is generally reported at par value as the first item in the stockholders’ equity section of a company’s balance sheet. Any excess over par value is reported as part of additional paid-in capital. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
14. The major reasons for purchasing its own shares are: (1) to provide tax-efficient distributions of excess cash to shareholders, (2) to increase earnings per share and return on equity, (3) to provide stock for employee stock compensation contracts or to meet potential merger needs, (4) to thwart takeover attempts or to reduce the number of stockholders, and (5) to make a market in the stock. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 14 (Continued) 15. (a)
Treasury stock should not be classified as an asset since a corporation cannot own itself.
(b)
The “gain” or “loss” on sale of treasury stock should not be treated as additions to or deductions from income. If treasury stock is carried in the accounts at cost, these so-called gains or losses arise when the treasury stock is sold. These “gains” or “losses” should be considered as additions to or reductions of paid-in capital. In some instances, the “loss” should be charged to Retained Earnings. “Gains” or “losses” arising from treasury stock transactions are not included as a component of net income since dealings in treasury stock represent capital transactions.
(c)
Dividends on treasury stock should never be included as income, but should be credited directly to retained earnings, against which they were incorrectly charged. Since treasury stock cannot be considered an asset, dividends on treasury stock are not properly included in net income.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
16. Additional paid-in capital results from: (1) issuance of common stock or preferred stock in excess of par on stock issued, (2) sale of treasury stock above cost, (3) recapitalizations or revisions in the capital structure, (4) conversion of convertible bonds or preferred stock, and (5) declaration of a small stock dividend. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
17. When treasury stock is purchased, the Treasury Stock account is debited and Cash is credited at cost ($290,000 in this case). Treasury Stock is a contra stockholders’ equity account and Cash is an asset. Thus, this transaction has: (a) no effect on net income, (b) decreases total assets, (c) has no effect on total paid-in capital, and (d) decreases total stockholders’ equity. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
*18. The answers are summarized in the table below: Account (a) Common Stock (b) Retained Earnings (c) Paid-in Capital in Excess of Par— Common Stock (d) Treasury Stock (e) (f) (g)
Paid-in Capital from Treasury Stock Paid-in Capital in Excess of Stated Value—Common Stock Preferred Stock
Classification Paid-in capital—capital stock Retained earnings Paid-in capital—additional paid-in capital Deducted from total paid-in capital and retained earnings Paid-in capital—additional paid-in capital Paid-in capital—additional paid-in capital Paid-in capital—capital stock
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
19. The dividend policy of a company is influenced by (1) the availability of cash, (2) the stability of earnings, (3) current earnings, (4) prospective earnings, (5) the existence or absence of contractual restrictions on working capital or retained earnings, and (6) a retained earnings balance. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 14 (Continued) 20. In declaring a dividend, the board of directors must consider the condition of the corporation such that a dividend is (1) legally permissible and (2) economically sound. In general, directors should consider the following factors in determining the legality of a dividend declaration: (1) Retained earnings, unless legally encumbered in some manner, is usually the correct basis for dividend distribution. (2) In some states, additional paid-in capital may be used for dividends, although such dividends may be limited to preferred stock. (3) Deficits in retained earnings and debits in paid-in capital accounts must be restored before payment of any dividends. (4) Dividends in some states may not reduce retained earnings below the cost of treasury stock held. In order that dividends be economically sound, the board of directors should consider: (1) the availability (liquidity) of assets for distribution; (2) agreements with creditors; (3) the effect of a dividend on investor perceptions (e.g., maintaining an expected “payout ratio”); and (4) the size of the dividend with respect to the possibility of paying dividends in future bad years. In addition, the ability to expand or replace existing facilities should be considered. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
21. Cash dividends are paid out of cash. A balance must exist in retained earnings to permit a legal distribution of profits, but having a balance in retained earnings does not ensure the ability to pay a dividend if the cash situation does not permit it. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
22. A cash dividend is a distribution of cash while a property dividend is a distribution of assets other than cash. Any dividend not based on retained earnings is a liquidating dividend. A stock dividend is the issuance of additional shares of the corporation’s stock in a nonreciprocal exchange involving existing stockholders with no change in the par or stated value. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
23. A stock dividend results in the transfer from retained earnings to paid-in capital of an amount equal to the fair value of each share (if the dividend is less than 20–25%) or the par value of each share (if the dividend is greater than 20–25%). No formal journal entries are required for a stock split, but a notation in the ledger accounts would be appropriate to show that the par value of the shares has changed. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, AICPA PC: Communication
24.
(a) A stock split effected in the form of a dividend is a distribution of corporate stock to present stockholders in proportion to each stockholder’s current holdings and can be expected to cause a material decrease in the market price per share of the stock. GAAP specifies that a distribution in excess of 20% to 25% of the number of shares previously outstanding would cause a material decrease in the market price. This is a characteristic of a stock split as opposed to a stock dividend, but, for legal reasons, the term “dividend” must be used for this distribution. From an accounting viewpoint, it should be disclosed as a stock split effected in the form of a dividend because it meets the accounting definition of a stock split as explained above.
Questions Chapter 14 (Continued) (b) The stock split effected in the form of a dividend differs from an ordinary stock dividend in the amount of other paid-in capital or retained earnings to be capitalized. An ordinary stock dividend involves capitalizing (charging) retained earnings for an amount equal to the fair value of the stock distributed. A stock split effected in the form of a dividend involves charging retained earnings for the par (stated) value of the additional shares issued. Another distinction between a stock dividend and a stock split is that a stock dividend usually involves distributing additional shares of the same class of stock with the same par or stated value. A stock split usually involves distributing additional shares of the same class of stock but with a proportionate reduction in par or stated value. The aggregate par or stated value would then be the same before and after the stock split. (c) A declared but unissued stock dividend should be classified as part of paid-in capital (stock dividend distributable) rather than as a liability in the balance sheet. A stock dividend affects only capital accounts; that is, retained earnings is decreased and paid-in capital is increased. Thus, there is no debt to be paid, and, consequently, there is no severance of corporate assets when a stock dividend is issued. Furthermore, stock dividends declared can be revoked by a corporation’s board of directors any time prior to issuance. Finally, the corporation usually will formally announce its intent to issue a specific number of additional shares, and these shares must be reserved for this purpose. LO: 3, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
25. A partially liquidating dividend will be debited to both Retained Earnings and Paid-in Capital in Excess of Par. The portion of dividends that is a return of capital should be debited to Paid-in Capital in Excess of Par. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
26. A property dividend is a nonreciprocal transfer of nonmonetary assets between company and its owners. A transfer of a nonmonetary asset to a stockholder or to another entity in a non-reciprocal transfer should be recorded at the fair value of the asset transferred, and a gain or loss should be recognized on the disposition of the asset. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
27. Retained earnings are restricted because of legal or contractual restrictions, or the necessity to protect the working capital position. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
28. Restrictions of retained earnings are best disclosed in a note to the financial statements. This allows a more complete explanation of the restriction. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 14 (Continued) *29. (a)
Preferred $ 7,000 9,000 $16,000
Current year’s dividend, 7% Participating dividend of 9% Totals
*
Common $21,000 27,000 $48,000
Total $28,000 36,000 $64,000
* The participating dividend was determined as follows: Current year’s dividend: Preferred, 7% of $100,000 = $ 7,000 Common, 7% of $300,000 = 21,000
$ 28,000
Amount available for participation ($64,000 – $28,000)
$ 36,000
Par value of stock that is to participate ($100,000 + $300,000)
$400,000
Rate of participation ($36,000 ÷ $400,000)
9%
Participating dividend: Preferred, 9% of $100,000 Common, 9% of $300,000 Dividends (b) Dividends in arrears, 7% of $100,000 Current year’s dividend, 7% Participating dividend 7.25%* Totals *Rate of participation ($29,000 ÷ $400,000)
$ 9,000 27,000 $36,000 Preferred $ 7,000 7,000 7,250 $21,250
Common
Preferred $2,000 7,000
Common
$21,000 21,750 $42,750
Total $ 7,000 28,000 29,000 $64,000
7.25%
Participating dividend: Preferred, 7.25% of $100,000 Common, 7.25% of $300,000 Dividends
$ 7,250 21,750 $29,000
(c) Dividends in arrears ($100,000 X .07) – $5,000 Current year’s dividend, 7% Remainder to common Totals
$9,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$21,000 $21,000
Total $ 2,000 7,000 21,000 $30,000
Solutions to Brief Exercises Brief Exercise 14.1 Cash .................................................................................. Common Stock (300 X $10) ...................................... Paid-in Capital in Excess of Par— Common Stock.....................................................
4,500 3,000 1,500
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.2 (a) Cash ........................................................................... Common Stock ..................................................
8,200
(b) Cash ........................................................................... Common Stock (600 $2) ................................. Paid-in Capital in Excess of Stated Value— Common Stock .............................................
8,200
8,200 1,200 7,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.3 WILCO CORPORATION Stockholders’ Equity December 31, 2025 Common stock, $5 par value ........................................... Paid-in capital in excess of par—common stock ........... Total paid-in capital .......................................................... Retained earnings ............................................................ Less: Treasury stock........................................................ Total stockholders’ equity........................................ LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$ 510,000 1,320,000 1,830,000 2,340,000 4,170,000 90,000 $4,080,000
Brief Exercise 14.4 Cash .................................................................................. Preferred Stock (100 $50) ...................................... Paid-in Capital in Excess of Par— Preferred Stock ...................................................... Common Stock (300 $10) ...................................... Paid-in Capital in Excess of Par— Common Stock ......................................................
13,500
FV of common (300 $20) ............................................... FV of preferred (100 $90)............................................... Total FV .....................................................................
$ 6,000 9,000 $15,000
Allocated to common
$6,000 $13,500 = $ 5,400 $15,000
Allocated to preferred
$9,000 $13,500 = $15,000
5,000 3,100 3,000 2,400
8,100 $13,500
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.5 Land .................................................................................. Common Stock (3,000 $5) ..................................... Paid-in Capital in Excess of Par— Common Stock ......................................................
31,000 15,000 16,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.6 Cash ($60,000 – $1,500) .................................................... Common Stock (2,000 $10) .................................... Paid-in Capital in Excess of Par— Common Stock .......................................................
58,500
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
20,000 38,500
Brief Exercise 14.7 Cash .............................................................................. Preferred Stock (500 $100) ................................ Paid-in Capital in Excess of Par— Preferred Stock ..................................................
61,500 50,000 11,500
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.8 7/1/25 Treasury Stock (100 $87) .......................... Cash ......................................................
8,700 8,700
9/1/25 Cash (60 $90) ............................................. Treasury Stock (60 $87) .................... Paid-in Capital from Treasury Stock ..................................
5,400 5,220 180
11/1/25 Cash (40 $83) ............................................. Paid-in Capital from Treasury Stock .......... Treasury Stock (40 $87) ....................
3,320 160 3,480
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.9 8/1/25 Treasury Stock (200 $80) .......................... Cash ......................................................
16,000 16,000
11/1/25 Cash (150 $70) ........................................... Retained Earnings ....................................... Treasury Stock .....................................
10,500 1,500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
12,000
Brief Exercise 14.10 Common Stock (50 $5) ............................... Paid-in Capital in Excess of Par—Common Stock (50 $45) ...... Retained Earnings ........................................ Treasury Stock .....................................
250 2,250 1,500 4,000
Brief Exercise 14.11 August 1 Retained Earnings (2,000,000 $1.00) ...... Dividends Payable .............................
2,000,000 2,000,000
August 15 No entry. September 9 Dividends Payable...................................... Cash ...................................................
2,000,000 2,000,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.12 September 21 Equity Investments .................................... Gain on Investment ($1,200,000 – $875,000) ....................
325,000
Retained Earnings ...................................... Property Dividends Payable .............
1,200,000
325,000 1,200,000
October 8 No entry. October 23 Property Dividends Payable ...................... Equity Investments ............................
1,200,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,200,000
Brief Exercise 14.13 April 20 Retained Earnings ($500,000 – $125,000) .............................. Paid-in Capital in Excess of Par— Common Stock ........................................... Dividends Payable .............................
375,000 125,000 500,000
June 1 Dividends Payable ...................................... Cash ....................................................
500,000 500,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.14 Declaration Date. Retained Earnings....................................................... Common Stock Dividend Distributable ............ Paid-in Capital in Excess of Par— Common Stock................................................ (20,000 $65 = $1,300,000; 20,000 $10 = $200,000) Distribution Date. Common Stock Dividend Distributable ..................... Common Stock...................................................
1,300,000 200,000 1,100,000
200,000 200,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 14.15 Declaration Date. Retained Earnings..................................................... Common Stock Dividend Distributable (400,000 $10) ............................................... Distribution Date. Common Stock Dividend Distributable ................... Common Stock.................................................
4,000,000 4,000,000 4,000,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 14.16
4,000,000
(a)
Preferred stockholders would receive $60,000 (.06 $1,000,000) and the remainder of $240,000 ($300,000 – $60,000) would be distributed to common stockholders.
(b)
Preferred stockholders would receive $180,000 (.06 $1,000,000 3) and the remainder of $120,000 would be distributed to the common stockholders.
LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 14.1 (15–20 minutes) January 10 (a) Cash (80,000 $6) ............................................. Common Stock (80,000 $5) ......... Paid-in Capital in Excess of Par— Common Stock (80,000 X $1) .....
480,000 400,000 80,000
March 1 Organization Expense ......................... Common Stock (5,000 $5)........... Paid-in Capital in Excess of Par— Common Stock............................
35,000 25,000 10,000
July 1 Cash (30,000 $8) ................................ Common Stock (30,000 $5) ......... Paid-in Capital in Excess of Par— Common Stock (30,000 $3) ......
240,000 150,000 90,000
September 1 Cash (60,000 $10) .............................. Common Stock (60,000 $5) ......... Paid-in Capital in Excess of Par— Common Stock (60,000 $5) ......
600,000 300,000 300,000
January 10 (b)
Cash (80,000 $6) ................................ Common Stock (80,000 $3) ......... Paid-in Capital in Excess of Stated Value—Common Stock (80,000 $3).................................
480,000 240,000 240,000
Exercise 14.1 (Continued) March 1 Organization Expense .......................... Common Stock (5,000 $3) ........... Paid-in Capital in Excess of Stated Value—Common Stock (5,000 $4) .....................................
35,000 15,000 20,000
July 1 Cash (30,000 $8) ................................. Common Stock (30,000 $3) ......... Paid-in Capital in Excess of Stated Value—Common Stock (30,000 $5) .................................
240,000 90,000 150,000
September 1 Cash (60,000 $10) ............................... Common Stock (60,000 $3) ......... Paid-in Capital in Excess of Stated Value —Common Stock (60,000 $7) .................................
600,000 180,000 420,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 14.2 (15–20 minutes) January 10 Cash (80,000 $5)......................................... Common Stock (80,000 $1) ................. Paid-in Capital in Excess of Stated Value—Common Stock ...................... (80,000 $4)
400,000 80,000 320,000
Exercise 14.2 (Continued) March 1 Cash (5,000 $108) ...................................... Preferred Stock (5,000 $100) .............. Paid-in Capital in Excess of Par— Preferred Stock .................................. (5,000 $8)
540,000 500,000 40,000
April 1 Land .............................................................. Common Stock (24,000 $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ..................... ($80,000 – $24,000)
80,000 24,000 56,000
May 1 Cash (80,000 $7) ........................................ Common Stock (80,000 $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ..................... (80,000 $6)
560,000 80,000 480,000
August 1 Organization Expense ................................. Common Stock (10,000 $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ..................... ($50,000 – $10,000)
50,000 10,000 40,000
September 1 Cash (10,000 $9) ........................................ Common Stock (10,000 $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ..................... (10,000 $8)
90,000 10,000 80,000
Exercise 14.2 (Continued) November 1 Cash (1,000 $112)....................................... Preferred Stock (1,000 $100) ............... Paid-in Capital in Excess of Par— Preferred Stock ................................... (1,000 $12)
112,000 100,000 12,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 14.3 (10–15 minutes) (a) Land ($62 25,000) ................................................. 1,550,000 Treasury Stock ($53 25,000) ........................ Paid-in Capital from Treasury Stock ..............
1,325,000 225,000
(b) One might use the cost of treasury stock. However, this is not a relevant measure of this economic event. Rather, it is a measure of a prior, unrelated event. The appraised value of the land is a reasonable alternative (if based on appropriate fair value estimation techniques). However, it is an appraisal as opposed to a market-determined price. The trading price of the stock is probably the best measure of fair value in this transaction. LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Exercise 14.4 (20–25 minutes) Incremental method Lump sum receipt (10,000 $880) Allocated to subordinated debenture (10,000 $500) Balance allocated to common stock (a) 1.
$8,800,000 (5,000,000) $3,800,000
Cash ($880 10,000) ....................................... 8,800,000 Bonds Payable ......................................... 5,000,000 Common Stock (100,000 $5) ................. 500,000 Paid-in Capital in Excess of Par— Common Stock ...................................... 3,300,000*
Exercise 14.4 (Continued) Assumes bonds properly priced; residual attributed to common stock has a questionable measure of fair value. *Computation of common stock and paid-in capital in excess of par. Balance allocated to common stock Less: Common stock (10,000 $5 10) Paid-in capital in excess of par
$3,800,000 500,000 $3,300,000
Proportional method The allocation based on fair value for one unit is Subordinated debenture $500 Common stock (10 shares $40) 400 Total fair value $900 2.
Cash .................................................................. Bond Discount ($5,000,000 – $4,888,889) ....... Bonds Payable .......................................... Common Stock (100,000 $5) ................. Paid-in Capital in Excess of Par— Common Stock ......................................
8,800,000 111,111 5,000,000 500,000 3,411,111*
*Therefore 5/9 is allocated to the bonds and 4/9 to the common stock. $8,800,000 (5/9) = $4,888,889 to Debentures $8,800,000 (4/9) = $3,911,111 to Common Paid-in capital in excess of par = $3,911,111 – $500,000 = $3,411,111 (b) One method is not better than the other. The choice of method depends on the relative reliability of the valuations for the stocks and bonds. This question is presented to stimulate some thought and class discussion. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Exercise 14.5 (10–15 minutes) (a) Fair value of Common (500 $165) Fair value of Preferred (100 $230)
$ 82,500 23,000 $105,500
Allocated to Common: $82,500/$105,500 $100,000 Allocated to Preferred: $23,000/$105,500 $100,000 Total allocation (rounded to nearest dollar) Cash ........................................................................ Common Stock (500 $10) .............................. Paid-in Capital in Excess of Par— Common Stock ($78,199 – $5,000) .............. Preferred Stock (100 $100) ............................ Paid-in Capital in Excess of Par— Preferred Stock ($21,801 – $10,000)............
$ 78,199 21,801 $100,000 100,000 5,000 73,199 10,000 11,801
(b) Lump-sum receipt Allocated to common (500 $170) Balance allocated to preferred Cash ........................................................................ Common Stock ................................................. Paid-in Capital in Excess of Par— Common Stock ($85,000 – $5,000) .............. Preferred Stock ................................................. Paid-in Capital in Excess of Par— Preferred Stock ($15,000 – $10,000) ............
$100,000 (85,000) $ 15,000 100,000 5,000 80,000 10,000 5,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Exercise 14.6 (25–30 minutes) (a) Cash [(5,000 $45) – $7,000]..................................... Common Stock (5,000 $5) ............................... Paid-in Capital in Excess of Par— Common Stock ................................................
218,000
(b) Land (1,000 $46) ...................................................... Common Stock (1,000 $5) ............................... Paid-in Capital in Excess of Par— Common Stock ($46,000 – $5,000) .................
46,000
25,000 193,000 5,000 41,000
Exercise 14.6 (Continued) Note: The market value of the stock ($46,000) is used to value the exchange because it is a more objective measure of fair value than the appraised value of the land ($50,000). (c) Treasury Stock (500 $43) ....................................... Cash ...................................................................
21,500
(d) Paid-in Capital in Excess of Par—Treasury Stock . Common Stock (500 $5)......................................... Retained Earnings (500 x $3) ................................ Treasury Stock .............................................
17,500 2,500 1,500
21,500
21,500
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Exercise 14.7 (15–20 minutes) Stockholders’ Paid-in Retained Net # Assets Liabilities Equity Capital Earnings Income 1 D NE D NE NE NE 2 I NE I I NE NE 3 I NE I D NE NE LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 14.8 (15–20 minutes) May 2
10
15 31
Cash ............................................................... Common Stock (12,000 $5) ................ Paid-in Capital in Excess of Par— Common Stock (12,000 $11) ..........
192,000
Cash ............................................................... Preferred Stock (10,000 $30).............. Paid-in Capital in Excess of Par— Preferred Stock (10,000 $30) ..........
600,000
Treasury Stock .............................................. Cash .......................................................
15,000
Cash ............................................................... Treasury Stock (500 $15) ................... Paid-in Capital from Treasury Stock (500 $2) .................................
8,500
60,000 132,000 300,000 300,000 15,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
7,500 1,000
Exercise 14.9 (15–20 minutes) (a) (1) $1,000,000 .08 = $80,000; $80,000 3 = $240,000. (2) The cumulative dividend is disclosed in a note to the stockholders’ equity section; it is not reported as a liability. (b) Preferred Stock (4,000 $100) ............................... Common Stock (4,000 7 $10) .................... Paid-in Capital in Excess of Par— Common Stock ............................................
400,000
(c) Paid-in capital Preferred stock, $100 par 8%, 10,000 shares issued Paid-in capital in excess of par— Preferred stock (10,000 $7) ..........................
280,000 120,000
$1,000,000 70,000
LO: 1, 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 14.10 (20–25 minutes) (a) (1) The par value is $2.50. This amount is obtained from either of the following: 2025—$545 ÷ 218 or 2024—$540 ÷ 216. (2) The cost of treasury shares was higher in 2025. The cost at December 31, 2025 was $46 per share ($1,564 ÷ 34) compared to the cost at December 31, 2024 of $34 per share ($918 ÷ 27). (b) Stockholders’ equity (in millions of dollars) Paid-in capital Common stock, $2.50 par value, 500,000,000 shares authorized, 218,000,000 shares issued, and 184,000,000 shares outstanding...................... Additional paid-in capital ............................................ Total paid-in capital ............................................. Retained earnings ............................................................... Total paid-in capital and retained earnings ....... Less: Cost of treasury stock (34,000,000 shares)............ Total stockholders’ equity................................... LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$ 545 931 1,476 7,167 8,643 1,564 $7,079
Exercise 14.11 (15–20 minutes) Item 1. 2. 3. 4. 5. 6. 7. 8. 9.
Assets Liabilities I NE NE NE D D NE NE NE
Stockholders’ Paid-in Equity Capital
NE I NE NE NE D I NE NE
I D NE NE D NE D NE NE
NE NE NE NE NE NE NE I NE
Retained Earnings
Net Income
I D NE NE D NE D D NE
I NE NE NE D NE D NE NE
LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 14.12 (10–15 minutes)
(a)
June 1 Retained Earnings ........................... Dividends Payable ..................
8,000,000 8,000,000
June 14 No entry on date of record. June 30 Dividends Payable ........................... Cash ......................................... (b)
8,000,000 8,000,000
If this were a liquidating dividend, the debit entry on the date of declaration would be to Additional Paid-in Capital in Excess of Par rather than Retained Earnings.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 14.13 (10–15 minutes) (a)
No entry—simply a memorandum note indicating the number of shares has increased to 18 million and par value has been reduced from $10 to $5 per share.
(b)
Retained Earnings ($10 9,000,000) ............ Common Stock Dividend Distributable ..
90,000,000
Common Stock Dividend Distributable ....... Common Stock .........................................
90,000,000
(c)
90,000,000
90,000,000
Stock dividends and splits serve the same function with regard to the securities markets. Both techniques allow the board of directors to increase the quantity of shares and reduce share prices into a desired “trading range.” For accounting purposes, the 20%–25% rule reasonably views large stock dividends as substantive stock splits. In this case, it is necessary to capitalize par value with a stock dividend because the number of shares is increased and the par value remains the same. Earnings are capitalized for purely procedural reasons.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 14.14 (10–12 minutes) (a)
(b)
(c)
Retained Earnings (15,000 $37) ................ Common Stock Dividend Distributable .. Paid-in Capital in Excess of Par— Common Stock ......................................
555,000
Common Stock Dividend Distributable ...... Common Stock .........................................
150,000
Retained Earnings (300,000 $10) .............. Common Stock Dividend Distributable ..
3,000,000
Common Stock Dividend Distributable ...... Common Stock .........................................
3,000,000
150,000 405,000 150,000 3,000,000 3,000,000
No entry is needed. The par value becomes $5 and the number of shares outstanding increases to 600,000.
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 14.15 (10–15 minutes) (a)
Retained Earnings ........................................... Common Stock Dividend Distributable . Paid-in Capital in Excess of Par— Common Stock .................................... (50,000 shares .05 $39 = $97,500)
97,500
Common Stock Dividend Distributable ......... Common Stock .......................................
25,000
25,000 72,500
25,000
(b)
No entry, memorandum note to indicate that par value is reduced to $2 and the number of shares outstanding is now 250,000 (50,000 5).
(c)
January 5, 2025 Debt Investments (trading) ............................. Gain on Investment Income ..................................................
35,000
Retained Earnings ........................................... Property Dividends Payable ..................
135,000
35,000
135,000
January 25, 2025 Property Dividends Payable .......................... Debt Investments ...................................
135,000 135,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 14.16 (5–10 minutes) Total income since incorporation ........................... Less: Total cash dividends paid............................. Total value of stock dividends ...................... Current balance of retained earnings .....................
$317,000 $60,000 30,000
90,000 $227,000
The unamortized discount on bonds payable is shown as a contra liability; the gains on treasury stock are recorded as additional paid-in capital. LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 14.17 (20–25 minutes) BRUNO CORPORATION Stockholders’ Equity December 31, 2025 Capital stock Preferred stock, $4 cumulative, par value $50 per share; authorized 60,000 shares, issued and outstanding 10,000 shares ...... Common stock, par value $1 per share; authorized 600,000 shares, issued 200,000 shares, and outstanding 190,000 shares ............................................. Total capital stock ................................. Additional paid-in capital— In excess of par—common ............................ From sale of treasury stock ........................... Total paid-in capital ............................... Retained earnings ..................................................... Total paid-in capital and retained earnings ............ Less: Treasury stock, 10,000 shares at cost .......... Total stockholders’ equity .............................
$ 500,000
200,000 700,000 $1,300,000 160,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,460,000 2,160,000 301,000 2,461,000 170,000 $2,291,000
Exercise 14.18 (30–35 minutes) (a)
1.
2.
3.
4.
5.
Dividends Payable—Preferred (2,000 $10) ..... Dividends Payable—Common (20,000 $2) ..... Cash ........................................................
20,000 40,000
Treasury Stock ................................................ Cash (1,700 $40) ..................................
68,000
Land ................................................................. Treasury Stock (700 $40) .................... Paid-in Capital From Treasury Stock ....
30,000
Cash (500 $105) .............................................. Preferred Stock (500 $100) ................... Paid-in Capital in Excess of Par— Preferred Stock .....................................
52,500
Retained Earnings (1,900* $45) ..................... Common Stock Dividend Distributable (1,900 $5) ............................................. Paid-in Capital in Excess of Par— Common Stock......................................
85,500
60,000
68,000
28,000 2,000
50,000 2,500
9,500 76,000
*(20,000 – 1,700 + 700 = 19,000; 19,000 .10) 6. 7.
Common Stock Dividend Distributable ........... Common Stock.........................................
9,500
Retained Earnings ............................................ Dividends Payable—Preferred (2,500 $10) ........................................... Dividends Payable—Common (20,900* $2) .........................................
66,800
*(19,000 + 1,900)
9,500
25,000 41,800
Exercise 14.18 (Continued) (b)
ANNE CLEVES COMPANY Stockholders’ Equity December 31, 2025
Stockholders’ equity Paid-in-capital Capital stock Preferred stock, 10%, $100 par, 10,000 shares authorized, 2,500 shares issued and outstanding ...................................................... Common stock, $5 par, 100,000 shares authorized, 21,900 shares issued, 20,900 shares outstanding ........................................... Total capital stock........................................ Additional paid-in capital ......................................... Total paid-in capital ..................................... Retained earnings ......................................................... Total paid-in capital and retained earnings ................ Less: Cost of treasury stock (1,000 shares common) . Total stockholders’ equity ...........................................
$250,000 109,500 $ 359,500 205,500 565,000 627,700 1,192,700 40,000 $1,152,700
Computations: Preferred stock $200,000 + $50,000 = $250,000 Common stock $100,000 + $9,500 = $109,500 Additional paid-in capital: $125,000 + $2,000 + $2,500 + $76,000 = $205,500 Retained earnings: $450,000 – $85,500 – $66,800 + $330,000 = $627,700 Treasury stock $68,000 – $28,000 = $40,000 LO: 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 14.19 (20–25 minutes) (a)
Mary Ann Benson Company is the more profitable in terms of return on total assets. This may be shown as follows: Benson Company
$960,000 $4,200,000
= 22.86%
Kingston Company
$864,000 $4,200,000
= 20.57%
Exercise 14.19 (Continued) It should be noted that these returns are based on net income related to total assets, where the ending amount of total assets is considered representative. If the return on total assets uses net income before interest but after taxes in the numerator, the rates of return on total assets are the same as shown below: $960,000 $4,200,000
Benson Company
Kingston Company
(b)
= 22.86%
$864,000 + $120,000 – $24,000 = $4,200,000 =
$960,000 $4,200,000 22.86%
Kingston Company is the more profitable in terms of return on common stockholders’ equity. This may be shown as follows: $864,000 Kingston Company = 32% $2,700,000 Benson Company
$960,000 $3,600,000
= 26.67%
(Note to instructor: To explain why the difference in return on assets and return on common stockholders’ equity occurs, the following schedule might be provided to the student.)
Funds Supplied Current liabilities Long-term debt Common stock Retained earnings
Kingston Company Rate of Return Funds on Funds at Supplied 22.86%* $ 300,000 $ 68,580 1,200,000 274,320 2,000,000 457,200 700,000 160,020 $4,200,000 $960,120
*Determined in part (a), 22.86%
Cost of Funds $ 0 96,000** 0 0 $96,000
Accruing to Common Stock $ 68,580 178,320 457,200 160,020 $864,120
Exercise 14.19 (Continued) **The cost of funds is the interest of $120,000 ($1,200,000 .10). This interest cost must be reduced by the tax savings (20%) related to the interest. The schedule indicates that the income earned on the total assets (before interest cost) was $960,120. The interest cost (net of tax) of this income was $96,000, which indicates a net return to the common equity of $864,120. (c)
The Kingston Company earned a net income per share of $8.64 ($864,000 ÷ 100,000) while Benson Company had an income per share of $6.62 ($960,000 ÷ 145,000). Kingston Company has borrowed a substantial portion of its assets at a cost of 10% and has used these assets to earn a return in excess of 10%. The excess earned on the borrowed assets represents additional income for the stockholders and has resulted in the higher income per share. Due to the debt financing, Kingston has fewer shares of stock outstanding.
(d)
Yes, from the point of view of income it is advantageous for the stockholders of the Kingston Company to have long-term debt outstanding. The assets obtained from incurrence of this debt are earning a higher return than their cost to the Kingston Company. Book value per share.
(e)
Kingston Company
$2,000,000 + $700,000 = $27.00 100,000
Benson Company
$2,900,000 + $700,000 = $24.83 145,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Exercise 14.20 (15–20 minutes) (a)
Return on common stockholders’ equity: $213,718 $213,718 = $875,000 + $375,000 $1,250,000 = 17.1% $135,000 = 13.5% $1,000,000 Emporia Plastics, Inc. is trading on the equity successfully, since its return on common stockholders’ equity is greater than interest paid on bonds. Rate of interest paid on bonds payable:
(b)
Exercise 14.20 (Continued) Note: Some analysts use after-tax interest expense to compute the bond rate. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 14.21 (10–15 minutes) Preferred
Common
Total
$74,000
$90,000
$42,000
$90,000
Preferred
Common
Total
$57,778
$32,222
$90,000
Common
Total $32,000 16,000
$20,000 12,222 $32,222
20,000 22,000* $90,000
(a) Preferred stock is noncumulative, nonparticipating (2,000 $100 .08) Remainder ($90,000 – $16,000)
$16,000
(b) Preferred stock is cumulative, nonparticipating ($16,000 3) Remainder ($90,000 – $48,000)
$48,000
(c) Preferred stock is cumulative, participating
The computation for these amounts is as follows:
Dividends in arrears (2 $16,000) Current dividend Pro-rata share to common (5,000 $50 .08) Balance dividend pro-rata
Preferred $32,000 16,000
9,778 $57,778
*Additional amount available for participation ($90,000 – $32,000 – $16,000 – $20,000) Par value of stock that is to participate Preferred (2,000 $100) $200,000 Common (5,000 $50) 250,000
22,000
450,000
Exercise 14.21 (Continued) Rate of participation $22,000 ÷ $450,000 Participating dividend Preferred, .048889 $200,000 Common, .048889 $250,000
4.8889%
$ 9,778 12,222 $22,000 Note to instructor: Another way to compute the participating amount is as follows: Preferred
$200,000 X $22,000 $450,000
Common
$250,000 X $22,000 $450,000
$ 9,778 12,222 $22,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Exercise 14.22 (15–20 minutes)
(a) Preferred stock is cumulative, fully participating
Preferred
Common
Total
$36,000
$330,000
$366,000
Common
Total
The computation for these amounts is as follows: Preferred Dividends in arrears (.07 $10 20,000) Current dividend Preferred Common (.07 $100 30,000) Balance dividend pro-rata
$14,000
$ 14,000
14,000 8,000 $36,000
*Additional amount available for participation ($366,000 – $14,000 – $224,000)
$210,000 120,000 $330,000
224,000 128,000* $366,000
$128,000
*Exercise 14.22 (Continued) Par value of stock that is to participate ($200,000 + $3,000,000) Rate of participation $128,000 ÷ $3,200,000 Participating dividend Preferred, .04 $200,000 Common, .04 $3,000,000
$3,200,000 4% $
8,000 120,000 $128,000
Note to instructor: Another way to compute the participating amount is as follows: Preferred
$200,000 X $128,000 $3,200,000
Common
$3,000,000 $3,200,000 X $128,000
(b) Preferred stock is noncumulative and nonparticipating
$
8,000
120,000 $128,000
Preferred
Common
Total
$14,000
$352,000
$366,000
Preferred
Common
Total
$17,250
$348,750
$366,000
The computation for these amounts is as follows: Current dividend (preferred) (.07 $10 20,000) Remainder to common ($366,000 – $14,000)
(c) Preferred stock is noncumulative and participating in distributions in excess of 10% on common
$ 14,000 352,000 $366,000
*Exercise 14.22 (Continued) The computation for these amounts is as follows: Preferred Current year Preferred (.07 $10 20,000) Common (.07 $3,000,000) Additional 3% to common (.03 $3,000,000) Balance dividend pro-rata
Common
Total
$210,000
$ 14,000 210,000
90,000 48,750 $348,750
90,000 52,000* $366,000
$14,000
3,250 $17,250
*Additional amount available for participation ($366,000 – $14,000 – $210,000 – $90,000) Par value of stock that is to participate ($200,000 + $3,000,000) Rate of participation $52,000 ÷ $3,200,000 Participating dividend Preferred .01625 $200,000 Common .01625 $3,000,000
$ 52,000 $3,200,000 1.625% $ 3,250 48,750 $52,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Exercise 14.23 (15.20 minutes) Assumptions
Year 2023 2024 2025 2026
Paidout $13,000 $26,000 $57,000 $76,000
(a) Preferred, noncumulative and nonparticipating Preferred Common $5.20 $6.00 $6.00 $6.00
-0$ .73 $2.80 $4.07
(b) Preferred, cumulative and fully participating Preferred Common $ 5.20 $ 6.80 $14.25 $19.00
-0$ .60 $1.43 $1.90
*Exercise 14.23 (Continued) The computations for part (a) are as follows: 2023 Dividends paid Amount due preferred (2,500 $100 .06) Preferred per share ($13,000 ÷ 2,500) Common per share
$13,000 $15,000 $5.20 –0–
2024 Dividends paid Amount due preferred Amount due common Preferred per share ($15,000 ÷ 2,500) Common per share ($11,000 ÷ 15,000)
$26,000 (15,000) $11,000 $6.00 $ .73
2025 Dividends paid Amount due preferred Amount due common Preferred per share ($15,000 ÷ 2,500) Common per share ($42,000 ÷ 15,000)
$57,000 (15,000) $42,000 $6.00 $2.80
2026 Dividends paid Amount due preferred Amount due common Preferred per share ($15,000 ÷ 2,500) Common per share ($61,000 ÷ 15,000)
$76,000 (15,000) $61,000 $6.00 $4.07
The computations for part (b) are as follows: 2023 Dividends paid Amount due preferred (2,500 $100 .06) Preferred per share ($13,000 ÷ 2,500) Common per share *Exercise 14.23 (Continued)
$13,000 $15,000 $5.20 –0–
2024 Dividends paid Amount due preferred In arrears ($15,000 – $13,000) Current Amount due common ($26,000 – $17,000) Preferred per share ($17,000 ÷ 2,500) Common per share ($9,000 ÷ 15,000)
$26,000 2,000 15,000 $17,000 $ 9,000 $6.80 $ .60
2025 Dividends paid Amount due preferred Current (2,500 $100 .06) Amount due common Current (15,000 $10 .06) Amount available for participation ($57,000 – $15,000 – $9,000) Par value of stock that is to participate ($250,000 + $150,000) Rate of participation $33,000 ÷ $400,000 Participating dividend Preferred (.0825 $250,000) Common (.0825 $150,000) Total amount per share—Preferred Current $15,000 Participation 20,625 $35,625 ÷ 2,500 Total amount per share—Common Current $ 9,000 Participation 12,375 $21,375 ÷ 15,000 *Exercise 14.23 (Continued)
$57,000 $15,000 $ 9,000 $33,000 $400,000 8.25% $20,625 $12,375
$14.25
$1.43
2026 Dividends paid Amount due preferred Current (2,500 $100 .06) Amount due common Current (15,000 $10 .06)
$76,000 $15,000 $ 9,000
Amount available for participation ($76,000 – $15,000 – $9,000) Par value that is to participate ($250,000 + $150,000) Rate of participation $52,000 ÷ $400,000 Participating dividend Preferred (.13 $250,000) Common (.13 $150,000)
$52,000 $400,000 13% $32,500 $19,500
Total amount per share—Preferred Current $15,000 Participation 32,500 $47,500 ÷ 2,500
$19.00
Total amount per share—Common Current $ 9,000 Participation 19,500 $28,500 ÷ 15,000
$1.90
LO: 5, Bloom: AP, Difficulty: Complex, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Exercise 14.24 (10–15 minutes) (a)
Common stock Stockholders’ equity Preferred stock Common stock Retained earnings Dividends in arrears (3 years at 8%) Remainder to common*
Shares outstanding Book value per share ($1,130,000 ÷ 750,000) *Balance in retained earnings ($800,000 – $40,000 – $260,000) Less: Dividends to preferred Available to common (b) Stockholders’ equity Preferred stock Liquidating premium Common stock Retained earnings Dividends in arrears (3 years at 8%) Remainder to common*
Shares outstanding Book value per share ($1,100,000 ÷ 750,000)
Preferred stock $500,000
$ 750,000
380,000 $1,130,000
120,000 ________ $620,000
750,000 $1.51 $500,000 120,000 $380,000
$500,000 30,000 $ 750,000
350,000 $1,100,000
120,000 ________ $650,000
750,000 $1.47
*Balance in retained earnings ($800,000 – $40,000 – $260,000) Less: Liquidating premium to preferred Dividends to preferred Available to common LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Time and Purpose of Problems
$500,000 30,000 120,000 $350,000
Problem 14.1 (Time 50–60 minutes) Purpose—to provide the student with an understanding of the necessary entries to account for a corporation’s stock transactions. This problem involves such concepts as stock sold for cash, noncash stock transactions, and declaration and distribution of stock dividends. The student is required to prepare the respective journal entries and the stockholders’ equity section of the balance sheet to reflect these transactions. Problem 14.2 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to record the acquisition of treasury stock and its sale at three different prices. In addition, a stockholders’ equity section of the balance sheet must be prepared. Problem 14.3 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to record seven different transactions involving stock issuances, reacquisitions, and dividend payments. Throughout the problem, the student needs to keep track of the shares outstanding. Problem 14.4 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the necessary entries to account for a corporation’s stock transactions. This problem involves such concepts as a capital stock assessment, lump-sum sales of capital stock, and a noncash stock exchange. The student is required to prepare the journal entries to reflect these transactions. Problem 14.5 (Time 30–40 minutes) Purpose—to provide the student with an understanding of the proper entries to reflect the reacquisition, and reissuance of a corporation’s shares of stock. The student is required to record these treasury stock transactions under the cost method, assuming the FIFO method for purchase and sale purposes. Problem 14.6 (Time 30–40 minutes) Purpose—to provide the student with an understanding of the necessary entries to account for a corporation’s stock transactions. This problem involves such concepts as the reacquisition, and reissuance of shares of stock; plus a declaration and payment of a cash dividend. The student is required to prepare the respective journal entries and the stockholders’ equity section of the balance sheet to reflect these transactions. Problem 14.7 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the proper accounting for the declaration and payment of cash dividends on both preferred and common stock. This problem also involves a dividend arrearage on preferred stock, which will be satisfied by the issuance of shares of treasury stock. The student is required to prepare the necessary journal entries for the dividend declaration and payment, assuming that they occur simultaneously. Problem 14.8 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the accounting effects related to stock dividends and stock splits. The student is required to analyze their effect on total assets, common stock, paid-in capital, retained earnings, and total stockholders’ equity. Problem 14.9 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the effect which a series of transactions involving such items as the issuance and reacquisition of common and preferred stock, and a stock dividend, have on the company’s equity accounts. The student is required to prepare the stockholders’ equity section of the balance sheet in proper form reflecting the above transactions.
Time and Purpose of Problems (Continued) Problem 14.10 (Time 35–45 minutes) Purpose—to provide the student with an understanding of the differences between a stock dividend and a stock split. Acting as a financial advisor to the Board of Directors, the student must report on each option and make a recommendation. Problem 14.11 (Time 25–35 minutes) Purpose—to provide the student with an understanding of the proper accounting for the declaration and payment of both a cash and stock dividend. The student is required to prepare both the necessary journal entries to record cash and stock dividends and the stockholders’ equity section of the balance sheet, including a note to the financial statements setting forth the basis of the accounting for the stock dividend. Problem 14.12 (Time 35–45 minutes) Purpose—to provide the student a comprehensive problem involving all facets of the stockholders’ equity section. The student must prepare the stockholders’ equity section of the balance sheet, analyzing and classifying a dozen different transactions to come up with proper accounts and amounts. A good review of Chapter 14.
Solutions to Problems Problem 14.1
(a) January 11 Cash (20,000 $16) .................................................. Common Stock (20,000 $10) ........................ Paid-in Capital in Excess of Par—Common Stock .............................................................. February 1 Equipment ................................................................ Buildings .................................................................. Land .......................................................................... Preferred Stock (4,000 $100) ......................... Paid-in Capital in Excess of Par—Preferred Stock ..............................................................
320,000 200,000 120,000
50,000 160,000 270,000 400,000 80,000
July 29 Treasury Stock (1,800 $17) ................................... Cash ..................................................................
30,600
August 10 Cash (1,800 $14) .................................................... Retained Earnings (1,800 $3)................................ Treasury Stock .................................................
25,200 5,400*
30,600
30,600
*(The debit is made to Retained Earnings because no Paid-in Capital *from Treasury Stock exists.)
Problem 14.1 (Continued) December 31 Retained Earnings ................................................... Dividend Payable ............................................. *Common Stock Cash Dividend: Common shares outstanding Common cash dividend
37,000 37,000* 20,000 $.25 $5,000
Preferred Stock cash dividend: 4,000 $100 .08 = $32,000 Total cash dividends: $5,000 + $32,000 = $37,000 December 31 Income Summary ..................................................... Retained Earnings............................................ (b)
175,700 175,700
PHELPS CORPORATION Stockholders’ Equity December 31, 2025 Capital stock Preferred stock—par value $100 per share, 8% cumulative and nonparticipating, 5,000 shares authorized, 4,000 shares issued and outstanding .......... $400,000 Common stock—par value $10 per share, 50,000 shares authorized, 20,000 shares issued and outstanding ........ 200,000 Total capital stock ................................... $600,000 Additional paid-in capital In excess of par—preferred ............................. 80,000 In excess of par—common.............................. 120,000 200,000 Total paid-in capital ................................. 800,000 Retained earnings 133,300* Total stockholders’ equity ...................... $933,300 *($175,700 – $5,400 – $37,000)
LO: 1, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 50-60, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 14.2
(a)
February 1 Treasury Stock ($19 2,000)................................... Cash .......................................................
38,000
March 1 Cash ($17 800) ...................................................... Retained Earnings ($2 800) .................................. Treasury Stock ($19 800) ...................
13,600 1,600
March 18 Cash ($14 500) ...................................................... Retained Earnings ($5 500) .................................. Treasury Stock ($19 500) ...................
7,000 2,500
April 22 Cash ($20 600) ...................................................... Treasury Stock ($19 600) ................... Paid-in Capital from Treasury Stock .................................................. (b)
38,000
15,200
9,500 12,000 11,400 600
CLEMSON COMPANY Stockholders’ Equity April 30, 2025 Common stock, $5 par value, 20,000 shares issued, 19,900 shares outstanding .................... $100,000 Paid-in capital in excess of par— common stock ..................................................... 300,000 Paid-in capital from treasury stock ........................ 600 Total paid-in capital ..................................... $400,600 Retained earnings* .................................................. 445,900 846,500 Less: Treasury stock (100 shares)** ..................... 1,900 Total stockholders’ equity ........................... $844,600 *Retained earnings (beginning balance) ............... $320,000 March 1 reissuance ................................................ (1,600) March 18 reissuance .............................................. (2,500) Net income for period ............................................ 130,000 Retained earnings (ending balance) ..................... $445,900
Problem 14.2 (Continued) **Treasury stock (beginning balance) ................... February 1 purchase (2,000 shares) ................... March 1 sale (800 shares) .................................... March 18 sale (500 shares) .................................. April 22 sale (600 shares) .................................... Treasury stock (ending balance) ........................ LO: 2, 4, Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$
0 38,000 (15,200) (9,500) (11,400) $ 1,900
Problem 14.3 HATCH COMPANY Stockholders’ Equity December 31, 2026 Capital Stock Preferred stock, $20 par, 8%, 180,000 shares issued and outstanding ....................................... Common stock, $2.50 par, 4,100,000 shares issued, 4,080,000 shares outstanding ................. Total capital stock ............................... Additional paid-in capital In excess of par—preferred........................ In excess of par—common ........................ From treasury stock ................................... Total paid-in capital ............................. Retained earnings .............................................. Total paid-in capital and retained earnings ...... Less: Treasury stock (20,000 shares common) ........................ Total stockholders’ equity ..................
$ 3,600,000 10,250,000 $13,850,000 $ 260,000 27,750,000 10,000
Supporting balances are indicated in the following T-accounts. Preferred Stock Bal. 3,000,000 1. 600,000 3,600,000 Paid-in Capital in Excess of Par—Common Stock Bal. 27,000,000 4. 750,000 27,750,000
28,020,000 41,870,000 4,272,000 46,142,000 200,000 $45,942,000
Problem 14.3 (Continued) Common Stock Bal. 10,000,000 3. 250,000 10,250,000 Retained Earnings Bal. 4,500,000 288,000 10. 2,100,000 2,040,000 4,272,000
8. 9.
Paid-in Capital in Excess of Par— Preferred Stock Bal. 200,000 2. 60,000 260,000
5.
Treasury Stock 300,000 6. 100,000 200,000
Paid-in Capital from Treasury Stock 7. 10,000 10,000 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
Jan. 1 30,000 $20 Jan. 1 30,000 $2 Feb. 1 50,000 $5 Feb. 1 50,000 $15 July 1 30,000 $10 Sept. 15 10,000 $10 Sept. 15 10,000 $1 Dec. 31 3,600,000 .08 Dec. 31 4,080,000* $0.50 *[(2,000,000 + 50,000) 2] – 30,000 + 10,000 Dec. 31 Net income
LO: 1, 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 14.4 -1Cash .................................................................................. Discount on Bonds Payable ............................................ Bonds Payable .......................................................... Preferred Stock ......................................................... Paid-in Capital in Excess of Par—Preferred Stock ($106 – $50) ..................................................
10,000 106 10,000 50 56
-2Equipment (500 $16) ...................................................... Common Stock ......................................................... Paid-in Capital in Excess of Par—Common Stock .......................................................................
8,000 5,000 3,000
(Assuming the stock is regularly traded, the value of the stock would be used.) If the stock is not regularly traded, the equipment would be recorded at its estimated fair value. -3Cash .................................................................................. Preferred Stock ......................................................... Paid-in Capital in Excess of Par—Preferred Stock ($5,974 – $5,000) .......................................... Common Stock ......................................................... Paid-in Capital in Excess of Par—Common Stock ($4,826 – $3,750) .......................................... *Fair value of common (375 $14) Fair value of preferred (100 $65) Aggregate
10,800 5,000 974* 3,750 1,076* $ 5,250 6,500 $11,750
Allocated to common:
$5,250 $10,800 = $ 4,826 $11,750
Allocated to preferred:
$6,500 $10,800 = $11,750
Total allocated
5,974 $10,800
Problem 14.4 (Continued) -4Equipment ......................................................................... Preferred Stock .......................................................... Paid-in Capital in Excess of Par—Preferred Stock ($3,300 – $2,500)........................................... Common Stock .......................................................... Paid-in Capital in Excess of Par—Common Stock ($3,200 – $2,000)........................................... *Fair value of equipment Less: Market value of common stock (200 $16) Total value assigned to preferred stock
6,500 2,500 800* 2,000 1,200* $6,500 3,200 $3,300
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 14.5 (a)
(b)
(c)
(d)
Treasury Stock (380 $40) ................................. Cash .............................................................
15,200
Treasury Stock (300 $45) ................................. Cash .............................................................
13,500
Cash (350 $42) .................................................. Treasury Stock (350 $40).......................... Paid-in Capital from Treasury Stock (350 $2) ...................................................
14,700
Cash (110 $38) .................................................. Paid-in Capital from Treasury Stock .................. Treasury Stock ............................................
4,180 620
*30 shares purchased at $40 = 80 shares purchased at $45 = (Cost of treasury shares sold using FIFO =
$1,200 3,600 $4,800
15,200
13,500
14,000 700
4,800*
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 14.6
(a)
-1Treasury Stock (280 $97) ......................................... Cash ......................................................................
27,160
-2Retained Earnings ....................................................... Dividends Payable [(4,800 – 280) $20] ..............
90,400
-3Dividends Payable ...................................................... Cash ......................................................................
90,400
-4Cash (280 $102) ......................................................... Treasury Stock ..................................................... Paid-in Capital from Treasury Stock (280 $5) ....
27,160
90,400
90,400 28,560 27,160 1,400
-5Treasury Stock (500 $105) ........................................ Cash ......................................................................
52,500
-6Cash (350 $96)........................................................... Paid-in Capital from Treasury Stock .......................... Retained Earnings ....................................................... Treasury Stock (350 $105) ................................
33,600 1,400 1,750
52,500
36,750
Problem 14.6 (Continued) (b)
WASHINGTON COMPANY Stockholders’ Equity December 31, 2026 Common stock, $100 par value, authorized 8,000 shares; issued 4,800 shares, 4,650 shares outstanding ............................... Retained earnings (restricted in the amount of $15,750* by the acquisition of treasury stock)................................................. Total paid-in capital and retained earnings ..................................... Less: Treasury stock (150 shares) .................... Total stockholders’ equity .......................... *($52,500 – $36,750) **($294,000 – $90,400 – $1,750 + $94,000)
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$480,000 295,850** 775,850 15,750 $760,100
Problem 14.7 (a)
For preferred dividends in arrears:
Retained Earnings ...................................................... Treasury Stock ...................................................
18,000 18,000*
*1,500 shares of treasury stock issued as dividend; 1,500 $12 = $18,000 For 6% preferred current year dividend: Retained Earnings ....................................................... Cash.....................................................................
18,000 18,000*
*(.06 $300,000) For $.30 per share common dividend: Retained Earnings ...................................................... Cash....................................................................
89,610 89,610*
*Since all preferred dividends must be paid before the common dividend, outstanding common shares include— As of Dec. 31, 2026 (300,000 – 2,800) ............... Preferred distribution........................................ Common dividend ............................................. Amount of common cash dividend ..................
297,200 shares 1,500 shares 298,700 shares .30 /share $ 89,610
(b) The suggested cash dividend could be paid even if state law did restrict the retained earnings balance in the amount of the cost of treasury stock. Total dividends would be $125,610,* which is adequately covered by the cash balance. The retained earnings balance, after adding the 2026 net income (estimated at $77,000), is sufficient to cover the dividends.**
Problem 14.7 (Continued) *Preferred dividends in arrears (.06 $300,000) .... Current preferred dividend (.06 $300,000).......... Common dividend ($.30 298,700) ....................... Total cash dividend ................................................
$ 18,000 18,000 89,610 $125,610
**Beginning balance .................................................. Estimated net income ............................................ Total balance available .......................................... If restricted by cost of treasury shares ................. Available to pay dividends.....................................
$105,000 77,000 182,000 (33,600) $148,400
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 14.8 Transactions: (a) Assuming Myers Co. declares and pays a $.50 per share cash dividend. (1) Total assets—decrease $2,000 [($20,000 ÷ $5) $.50] (2) Common stock—no effect (3) Paid-in capital in excess of par—no effect (4) Retained earnings—decrease $2,000 (5) Total stockholders’ equity—decrease $2,000 (b) Myers declares and issues a 10% stock dividend when the market price of the stock is $14. (1) Total assets—no effect (2) Common stock—increase $2,000 (4,000 .10) $5 (3) Paid-in capital in excess of par—increase $3,600 (400 $14) – $2,000 (4) Retained earnings—decrease $5,600 ($14 400) (5) Total stockholders’ equity—no effect (c) Myers declares and issues a 30% stock dividend when the market price of the stock is $15 per share. (1) Total assets—no effect (2) Common stock—increase $6,000 (4,000 .30) $5 (3) Paid-in capital in excess of par—no effect (4) Retained earnings—decrease $6,000 (5) Total stockholders’ equity—no effect (d) Myers declares and distributes a property dividend. (1) Total assets—decrease $12,000 (2,000 $6)—($8,000 gain less $20,000 dividend) (2) Common stock—no effect (3) Paid-in capital in excess of par—no effect (4) Retained earnings—decrease $12,000—($8,000 gain less $20,000 dividend) (5) Total stockholders’ equity—decrease $12,000
Problem 14.8 (Continued) Note: The journal entries made for the previous transaction are: Equity Investments ($10 – $6) 2,000 .................. Gain on Investment ........................................ (To record increase in value of securities to be issued)
8,000
Retained Earnings ($10 x 2,000)…………………… Equity Investments .......................................... (To record distribution of property dividend)
20,000
8,000
(e) Myers declares a 2-for-1 stock split (1) Total assets—no effect (2) Common stock—no effect (3) Paid-in capital in excess of par—no effect (4) Retained earnings—no effect (5) Total stockholders’ equity—no effect LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
20,000
Problem 14.9 VICARIO CORPORATION Stockholders’ Equity December 31, 2027 Capital stock: Preferred stock, $100 par value 10,000 shares authorized, 5,000 shares issued & outstanding .............................................. $500,000 Common stock, $50 par value 15,000 shares authorized, 8,000 shares issued 7,700 shares outstanding ... Total capital stock......................................... Additional paid-in capital: In excess of par—preferred................................... In excess of par—common ................................... From treasury stock—preferred ........................... Total paid-in capital ...................................... Retained earnings Total paid-in capital and retained earnings ......... Less: Cost of treasury stock (300 shares—common) .............................. Total stockholders’ equity............................
400,000 $ 900,000 65,000 59,000* 4,700
128,700 1,028,700 237,400** 1,266,100 19,200 $1,246,900
*[($57 – $50) 7,000 + ($60 – $50) 1,000] **$610,000 – $312,600 – ($60 1,000 shares) LO: 1, 2, 3, 4, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 14.10 To:
Oregon Inc. Board of Directors
From:
Good Student, Financial Advisor
Date:
Today
Subject:
Report on the effects of a stock dividend and a stock split INTRODUCTION
As financial advisor to the Board of Directors for Oregon Inc., I have been asked to report on the effects of the following options for creating interest in Oregon Inc. stock: a 20% stock dividend, a 100% stock dividend, and a 2-for1 stock split. The board wishes to maintain stockholders’ equity as it presently appears on the most recent balance sheet. The Board also wishes to generate interest in stock purchases, and the current market price of the stock ($110 per share) may be discouraging potential investors. Finally, the Board thinks that a cash dividend at this point would be unwise. RECOMMENDATION In order to meet the needs of Oregon Inc., the board should choose a 2-for-1 stock split. The stock split is the only option that would not change the dollar balances in the stockholders’ equity section of the company’s balance sheet. DISCUSSION OF OPTIONS The three above-mentioned options would all result in an increased number of common shares outstanding. Because the shares would be distributed on a pro-rata basis to current stockholders, each stockholder of record would maintain his/her proportion of ownership after the declaration. All three options would probably generate significant interest in the stock.
Problem 14.10 (Continued) A 20% STOCK DIVIDEND This option would increase the shares outstanding by 20 percent, which translates into 800,000 additional shares of $10 par value common stock. The problem with this type of stock dividend is that GAAP requires these shares to be accounted for at their current fair value if it significantly exceeds par. The following journal entry must be made to record this dividend. Retained Earnings ($110 800,000).................... Common Stock Dividend Distributable ...... Paid-in Capital in Excess of Par— Common Stock ..........................................
88,000,000 8,000,000 80,000,000
Although the Common Stock Dividend Distributable and the Paid-in Capital accounts increase, Retained Earnings decreases dramatically. This reduction in Retained Earnings may hinder Oregon’s success with the subsequent stock offer. A 100% STOCK DIVIDEND This option would double the number of $10 par value common stock currently issued and outstanding. Because this type of dividend is considered, in substance, a stock split, the shares do not have to be accounted for at fair value. Instead, Retained Earnings is reduced only by the par value of the additional shares, while Common Stock Dividend Distributable and, later, Common Stock are increased for that same amount. However, when 4,000,000 shares are already issued and outstanding, the reduction in Retained Earnings reflecting the stock dividend is still great: $40,000,000. In addition, no increase in any Paid-in Capital account occurs. The following journal entry would be made to record the declaration of this dividend: Retained Earnings ($10 4,000,000) .................. Common Stock Dividend Distributable ......
40,000,000 40,000,000
Problem 14.10 (Continued) A 2-FOR-1 STOCK SPLIT This option doubles the number of shares issued and outstanding; however, it also cuts the par value per share in half. No accounting treatment beyond a memorandum entry is required for the split because the effect of splitting the par value cancels out the effect of doubling the number of shares. Therefore, Retained Earnings remains unchanged, as does the Common Stock and Paid-in Capital accounts. In addition, the decreased fair value will encourage investors who might otherwise consider the stock too expensive. CONCLUSION To generate the greatest interest in Oregon Inc. stock while maintaining the present balances in the stockholders’ equity section of the balance sheet, you should opt for the 2-for-1 stock split. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 14.11 (a) May 5, 2025 Retained Earnings.............................................. Dividends Payable ($0.60 per share on 3,000,000) ..................
1,800,000 1,800,000
June 30, 2025 Dividends Payable ............................................. Cash ...............................................................
1,800,000 1,800,000
(b) November 30, 2025 Retained Earnings (.06 3,000,000 $34) ........ Common Stock Dividend Distributable (.06 3,000,000 $10).......... Paid-in Capital in Excess of Par—Common Stock ................
6,120,000 1,800,000 4,320,000
December 31, 2025 Common Stock Dividend Distributable .............. Common Stock..................................................
(c)
1,800,000 1,800,000
EARNHART CORPORATION Stockholders’ Equity December 31, 2025 Common stock—$10 par value, issued 3,180,000 shares ............................................... Additional paid-in capital .................................. Retained earnings ............................................. Total stockholders’ equity ..........................
$31,800,000 9,320,000 20,780,000 $61,900,000
Problem 14.11 (Continued) Statement of Retained Earnings For the Year Ended December 31, 2025 Balance, January 1 ................................. Add: Net income ................................... Less: Dividends on common stock: Cash ............................................. Stock (see note) ........................... Balance, December 31............................
$24,000,000 4,700,000 28,700,000 $1,800,000 6,120,000
7,920,000 $20,780,000
Schedule of Additional Paid-in Capital For the Year Ended December 31, 2025 Balance, January 1 ................................. Excess of fair value over par value of 180,000 shares of common stock distributed as a dividend (see note)....... Balance, December 31............................
$5,000,000
4,320,000 $9,320,000
Note: The 6% stock dividend (180,000 shares) was declared on November 30, 2025. For the purposes of the dividend, the stock was assigned a price of $34 per share. The par value of $10 per share ($1,800,000) was credited to Common Stock and the excess of $24 ($34 – $10) per share ($4,320,000) to Paid-in Capital in Excess of Par—Common Stock. LO: 3, 4, Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 14.12 PENN COMPANY Stockholders’ Equity June 30, 2026 Capital stock 8% preferred stock, $25 par value, cumulative and nonparticipating, 100,000 shares authorized, 40,000 shares issued and outstanding—Note A................ $1,000,000 Common stock, $10 par value, 300,000 shares authorized, 115,400 shares issued with 1,500 shares held in the treasury ....... Total capital stock .............................................. Additional paid-in capital In excess of par-preferred .......................................... In excess of par-common ........................................... From treasury stock ................................................... Total paid-in capital ...........................................
1,154,000 $2,154,000 760,000 2,821,800* 1,500
Retained earnings Total paid-in capital and retained earnings .... Less: Treasury stock, 1,500 shares at cost ... Total stockholders’ equity ............................
3,583,300 5,737,300 409,200 6,146,500 58,500 $6,088,000
Note A: Penn Company is in arrears on the preferred stock in the amount of $40,000. * Paid-In Capital in Excess of Par—Common Stock: Issue of 85,000 shares ($31 – $10) $1,785,000 Plot of land 170,000 Issue of 20,000 shares (3/1/19) 640,000 [20,000 ($42 – $10)] 5,400 shares as dividend [5,400 ($52 – $10)] 226,800 $2,821,800
Problem 14.12 (Continued) Account Balances Common Stock 850,000 50,000 200,000 54,000 1,154,000 Preferred Stock 1,000,000
Paid-in Capital in Excess of Par—Common Stock 1,785,000 170,000 640,000 226,800 2,821,800 Paid-in Capital in Excess of Par—Preferred Stock 760,000
Treasury Stock 78,000 19,500 58,500
Paid-in Capital from Treasury Stock 1,500
Retained Earnings 690,000 280,800 40,000 40,000 409,200 Note that the Penn Company is authorized to issue 300,000 shares of $10 par value common and 100,000 shares of 8%, $25 par value, cumulative and nonparticipating preferred.
Problem 14.12 (Continued) Entries supporting the balances. Common Stock 1.
2.
3.
Entries Cash ................................................................. 2,635,000 Common Stock ........................................ Paid-in Capital in Excess of Par— Common Stock ..................................... Land ................................................................. Common Stock ........................................ Paid-in Capital in Excess of Par— Common Stock .....................................
220,000
Cash ................................................................. Common Stock ........................................ Paid-in Capital in Excess of Par— Common Stock .....................................
840,000
850,000 1,785,000 50,000 170,000 200,000 640,000
At the beginning of the year, Penn had 110,000 common shares outstanding, of which 85,000 shares were issued at $31 per share, resulting in $850,000 (85,000 shares at $10) of common stock and $1,785,000 of additional paid-in capital on common stock (85,000 shares at $21). The 5,000 shares exchanged for a plot of land would be recorded at $50,000 of common stock and $170,000 of paid-in capital (use the current fair value of the land on July 24 to value the stock issuance). The 20,000 shares issued in 2024 at $42 a share resulted in $200,000 of common stock and $640,000 of paid-in capital. Preferred Stock Cash ................................................................. 1,760,000 Preferred Stock ....................................... Paid-in Capital in Excess of Par— Preferred Stock.....................................
1,000,000 760,000
Problem 14.12 (Continued) The issuance of 40,000 shares of preferred at $44 resulted in $1,000,000 (40,000 shares at $25) of preferred stock outstanding and $760,000 (40,000 shares at $19) of paid-in capital on preferred. Treasury Stock November 30 Treasury Stock ........................................... Cash .......................................................
78,000 78,000
June 20 Cash ............................................................ Paid-in Capital from Treasury Stock .... Treasury Stock ...................................
21,000 1,500 19,500
The 2,000 shares of treasury stock purchased resulted in a debit balance of treasury stock of $78,000. Later, 500 shares were sold at $21,000, which brings the balance down to $58,500 (1,500 shares at $39 per share). The sale of the treasury shares above cost ($21,000 minus $19,500 cost) is recorded in a separate paid-in capital amount. Stock Dividend December 15 Retained Earnings ................................... 280,800** Common Stock ................................... Paid-in Capital in Excess of Par— Common Stock. ............................... *Shares outstanding, beginning of year: 110,000 Treasury stock (2,000) 108,000 .05 = **5,400 Shares $52
54,000* 226,800
5,400 $10 Par $54,000
Problem 14.12 (Continued) The 5% stock dividend resulted in an increase of 5,400 shares. Recall that there were 110,000 shares outstanding at the beginning of the year. The purchase of 2,000 treasury shares occurred before the stock dividend, bringing the number of shares outstanding at the time of the dividend (December 2025) to 108,000 shares. The resale of 500 treasury shares occurred after the stock dividend. Retained Earnings The cash dividends only affect the retained earnings. Note that the preferred stock is in arrears for the dividends that should have been declared in June 2026. Ending retained earnings is the beginning balance of $690,000 plus net income of $40,000, less the preferred dividend of $40,000 and the common stock dividend of $280,800 (5,400 shares at $52), resulting in an ending balance of $409,200. LO: 1, 2, 3, 4, Bloom: AP, Difficulty: Complex, Time: 35-45, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 14.1 Financial Reporting Problem (a)
P&G’s preferred stock has a stated value of $1 per share.
(b)
P&G’s common stock has a stated value of $1 per share. Like many companies, the stated value of P&G’s common stock is small relative to its market value.
(c)
At June 30, 2020, P&G had 4,009.2 million shares of common stock issued. This represents 40.1 percent (10,000 million) of P&G’s authorized common stock.
(d)
At June 30, 2020 and June 30, 2019, P&G had 2,479.7 (4,009.2 – 1,529.5) million and 2,504.7 (4,009.2 – 1,504.5) million shares of common stock outstanding, respectively.
(e)
The cash dividends caused P&G’s Retained Earnings to decrease by $7,814,000 (including both common and preferred dividends).
(f)
Return on common stockholders’ equity: 2020:
($13,103 – $263) / [($45,624 + $46,266)/2] = 27.9%
2019:
($3,966 – $263) / [($46,266 + $51,326)/2] = 7.6%
(g) Payout ratio: 2020:
$7,814/($13,103 – $263) = 60.9%
2019:
$7,519/($3,966 – $263) = 203.1%
(h) Price range for the quarter ended June 30, 2020: High—$128.07 Low—$94.34 Note to instructor: Stock price information can be found in P&G’s full 10-K on the internet. LO: 4, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Comparative Analysis Case (Amounts in $ millions) (a) Par value: Coca-Cola, $0.25 per share. PepsiCo, $0.012/3 per share. (b) Percentage of authorized shares issued: Coca-Cola, 7,040 ÷ 11,200 = 62.86%. PepsiCo, 1,867 ÷ 3,600 = 51.86%. (c) Treasury shares, year-end 2020: Coca-Cola, 2,738 shares. PepsiCo, 487 shares. (d) Common or capital stock shares outstanding, year-end 2020: Coca-Cola, 7,040 – 2,738 = 4,302 PepsiCo, 1,867 – 487 = 1,380 (e)
Coca-Cola declared cash dividends in 2020, reducing retained earnings by $7,047 PepsiCo declared cash dividend in 2020, reducing retained earnings by $5,589
(f)
Return on common stockholders’ equity. 2020: Coca-Cola,
$7,768 $19,140
= 40.59%
PepsiCo,
$7,175 $14,120
= 50.8%
Comparative Analysis Case (Continued) During 2020, PepsiCo earned a higher return on its stockholders’ equity. (g) Payout ratios for 2020. Coca-Cola,
$7,047 $7,768
= 90.72%
PepsiCo,
$5,509 $7,175
= 76.78%
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Financial Statement Analysis Cases UYJ14.3 Kellogg Company (a) Management might purchase treasury stock to provide to stockholders a tax-efficient method for receiving cash from the corporation. In addition, it might have to repurchase shares to have them available to issue to employees exercising options to purchase stock, or management might purchase treasury stock because it feels that its stock price is too low. It may believe that by purchasing shares it is signaling to the market that the price is too low. Management might also use excess cash to purchase stock to ward off a hostile takeover. Finally, management might purchase stock in an effort to change its capital structure. If it purchases stock and issues debt (or at least does not retire debt), it will increase the percentage of debt in its capital structure. (b) Earnings per share is calculated by dividing net income less preferred dividends by the weighted-average number of shares outstanding during the year. If shares are reduced by treasury stock purchases, the denominator (weighted-average number of shares outstanding) is reduced. As a result, earnings per share is often increased. However, because corporate assets are reduced by the purchase of the treasury stock, earnings potential may decrease. If this occurs, the effect on earnings per share may be mitigated. (c) One measure of solvency is the ratio of debt divided by total assets. This ratio shows how many dollars of assets are backing up each dollar of debt, should the company become financially troubled. For the current and prior year, this can be calculated as follows: Current Year
Prior Year
($11,867 ÷ $15,474) = 76.69%
($12,302 ÷ $15,153) = 81.19%
This represents a decrease in the ratio of debt to total assets. It appears that Kellogg’s solvency is improving. Nonetheless, a debt to total assets ratio of approximately 77% means that Kellogg is highly leveraged and that its financial flexibility may be weak.
Financial Statement Analysis Cases (Continued) UYJ14.4 Wiebold, Inc. (a)
The date of record marks the time when ownership of the outstanding shares is determined for dividend purposes. This in turn identifies which shareholders will receive the stock dividend. This date is also used when a stock split occurs. The date of distribution is when the additional shares are distributed (issued) to stockholders.
(b)
The purpose of a stock split is to increase the marketability of the stock by lowering its market price per share. This may make it easier for the corporation to issue additional shares of stock.
(c)
The effects are (1) no effect, (2) no effect, (3) increase, and (4) decrease.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ14.5 Accounting, Analysis, and Principles Accounting January 15, 2025 Retained Earnings ($1.05 60,000) ....................... Cash ................................................................
63,000 63,000
April 15, 2025 Retained Earnings [(.10 60,000) $14] ............... Common Stock .............................................. Paid-in Capital in Excess of Par— Common Stock .........................................
84,000 60,000 24,000
May 15, 2025 Treasury Stock (2,000 $15) .................................. Cash ................................................................
30,000 30,000
November 15, 2025 Cash ($18 1,000)................................................... Paid-in Capital from Treasury Stock ............ Treasury Stock ...............................................
18,000 3,000 15,000
December 31, 2025 Income Summary.................................................... Retained Earnings .........................................
370,000 370,000
Accounting, Analysis, and Principles (Continued) The ending balances are indicated in the following partial balance sheet: AGASSI CORPORATION Balance Sheet December 31, 2025 Capital stock Common stock—par value $10 per share, 66,000 shares issued and 65,000 outstanding (1)................................... $ 660,000 Additional paid-in capital In excess of par— common (2) .................................................... $524,000 From treasury stock ......................................... 3,000 527,000 Total paid-in capital ................................. 1,187,000 Retained earnings (3) .............................................. 843,000 2,030,000 Less: Treasury stock (4) .......................................... 15,000 Total stockholders’ equity....................................... $2,015,000 (1) $600,000 + $60,000 (2) $500,000 + $24,000 (3) $620,000 – $63,000 – $ 84,000 + $370,000 (4) $30,000 – $15,000 Analysis Payout ratio: $63,000 ÷ $ 370,000 = 17.03% Return on common stockholders’ equity: $370,000 ÷ [($1,720,000 + $2,015,000) ÷ 2] = 19.81% Principles Treasury stock sold above or below cost does not result in gains or losses because treasury stock does not meet the definition of an asset. Rather, it is unissued equity. Furthermore, gains or losses should not be recorded, because share repurchases and reissues are transactions with its own stockholders; the effects of such transactions should not be recorded in income. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 14.1 (Time 10–20 minutes) Purpose—to provide the student with some familiarity with the applications of the capital stock share system. This case requires the student to analyze the concept dealing with the dilution of ownership interest and the establishment of any necessary corrective actions to compensate an existing stockholder for this dilution effect. CT 14.2 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss the bases for recording the issuance of stock in exchange for nonmonetary assets. CT 14.3 (Time 25–30 minutes) Purpose—to provide a five-part theory case on equity based on Statement of Financial Accounting Concepts No. 6. It requires defining terms and analyzing the effects of equity transactions on financial statement elements. CT 14.4 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the conceptual framework that underlies a stock dividend and a stock split. The student is required to explain what a stock dividend is, the amount of retained earnings to be capitalized in connection with a stock dividend, and how it differs from a stock split from both a legal standpoint and an accounting standpoint. This case also requires an explanation of the various reasons why a corporation declares a stock dividend or a stock split. CT 14.5 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the theoretical concepts and implications that underlie the issuance of a stock dividend. The student is required to discuss the arguments against either considering the stock dividend as income to the recipient or issuing stock dividends on treasury shares. CT 14.6 (Time 20–25 minutes) Purpose—to provide the student with a situation containing a cash dividend declaration, a stock dividend, and a reacquisition and reissuance of shares requiring the student to explain the accounting treatment. CT 14.7 (Time 10–15 minutes) Purpose—to provide an opportunity for the student to consider and discuss the ethical issues involved when the control of a corporation is at stake. The student should recognize the potential conflict between the CEO’s personal will and the responsibility and accountability the CEO has to the stockholders.
Solutions to Critical Thinking CT 14.1 (a)
To share proportionately in any new issues of stock of the same class (the preemptive right).
(b)
Derek Wallace bought an additional $100,000 par value stock. His original ownership was $200,000 ($250,000 .80). Thus, he increased his ownership by 100/200 (50%). This imbalance can be corrected by issuing to Ms. Baker, at par, shares equal to 50% of her present holdings of $25,000 or stock with a par value of $12,500. Other stockholders should also be offered the right to purchase shares equal to 50% of their holdings in order that all stockholders may retain the same proportionate interest as before the issuance of additional shares.
(c)
No information is given with respect to the fair value of the stock. In this situation, an estimate for fair value could be developed based on market transactions involving comparable assets. Otherwise, discounted expected cash flows could be used to approximate fair value. In this closely held company, and in the absence of reliable fair value data, the book value might be used for the computation of the amount of the cash settlement. Book value of Ms. Baker’s capital stock, June 30, 2025, before issuance of additional shares, 25/250 $422,000 ..................................... Less: Book value after issuance of additional shares to Derek Wallace, 25/350 $522,000 .................................................................................... Loss in book value and amount of cash settlement .......................................
$42,200 37,286 $ 4,914
LO: 1, Bloom: C, Difficulty: Moderate, Time: 10-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication
CT 14.2 (a)
The general rule to be applied when stock is issued for services or property other than cash is that the property or services be recorded at either their fair value or the fair value of the stock issued, whichever is more clearly determinable.
(b)
If the fair value of the land is readily determinable, it is used as a basis for recording the exchange. The fair value could be determined by observing the cash sales price of similar pieces of property or through independent appraisals.
(c)
If the fair value of the land is not readily determinable, but the fair value of the stock issued is determinable, the fair value of the stock is used as a basis for recording the exchange. If the stock is traded on a stock exchange, the fair value can be determined from that day’s cash sales of the stock. If the stock is traded over the counter, recent sales or bid prices can be used to estimate fair value.
(d)
If Martin intentionally records this transaction at an amount greater than fair value, both assets and stockholders’ equity will be overstated. This overvaluation of stockholders’ equity from the inflated asset value is referred to as watered stock. This excess can be eliminated by writing down the overvalued assets with a corresponding charge to the appropriate paid-in capital accounts.
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 14.3 (a)
Equity, or net assets, is the owners’ residual interest in the assets of an entity that remains after deducting liabilities; in other words, equity equals assets less liabilities. Assets are probable future economic benefits controlled by a particular entity as the result of past transactions or events, and liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity which result from past transactions or events; therefore, equity can be defined as future economic benefits which will not be sacrificed to satisfy present obligations.
(b)
Transactions or events that change owners’ equity include revenues and expenses, gains and losses, investments by owners, distributions to owners, and changes within owners’ equity.
(c)
Investments by owners are increases in net assets resulting from transfers by other entities of something of value to obtain ownership. Examples of investments by owners are issuance of preferred or common stock, conversion of convertible bonds, reissuance of treasury stock, assessments on stock, and issuance of stock warrants. Generally, investments by owners cause an increase in assets in addition to the increase in equity.
(d)
Distribution to owners are decreases in net assets resulting from transferring assets to owners, rendering services for owners, or incurring liabilities to owners. Examples of distributions to owners are cash or property dividends and the purchase of treasury stock. Dividends generally initially cause an increase in liabilities but eventually cause a decrease in assets in addition to the decrease in equity. The purchase of treasury stock causes a decrease in assets in addition to the decrease in equity.
(e)
Some examples of changes within owners’ equity that do not change the total amount of owners’ equity are retirement of treasury stock, quasi-reorganization (except revaluing of assets), conversion of preferred stock into common stock, stock dividends, and retained earnings appropriations.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 14.4 (a)
A stock dividend is the issuance by a corporation of its own stock to its stockholders on a pro-rata basis without receiving payment therefor. The stock dividend results in an increase in the amount of the legal or stated capital of the enterprise. The dividend may be charged to retained earnings or to any other capital account that is not a part of legal capital. (1) From a legal standpoint, a stock split is distinguished from a stock dividend in that a split results in an increase in the number of shares outstanding and a corresponding decrease in the par or stated value per share. A stock dividend, though it results in an increase in the number of shares outstanding, does not result in a decrease in the par or stated value of the shares. (2) From an accounting standpoint, the major distinction is that a stock dividend requires a journal entry to decrease retained earnings and increase paid-in capital, while there is no entry for a stock split. In addition, from the accounting standpoint the distinction between a stock dividend and a stock split is dependent upon the intent of the board of directors in making the declaration. If the intent is to give to stockholders some separate evidence of a part of their pro-rata interests in accumulated corporate earnings, the action results in a stock dividend. If the intent is to issue enough shares to reduce the market price per share of the stock, the action results in a stock split, regardless of the form it may take. In other words, if the action takes the form of a stock dividend but reduces the market price markedly, it should be considered a stock split (effected in the form of a stock dividend). Such reduction will seldom occur unless the number of shares issued is at least 20% to 25% of the number previously outstanding.
CT 14.4 (Continued) (b)
The usual reason for issuing a stock dividend is to give the stockholders something on a dividend date and yet conserve working capital. A stock dividend that is charged to retained earnings reduces the total accumulated earnings, and all stock dividends reduce the per-share earnings. Issuing a stock dividend to achieve these ends would be a public relations gesture in that the public would be less likely to criticize the corporation for high profits or undue retention of earnings. A stock dividend also may be issued for the purpose of obtaining a wider distribution of the stock. Although this is the main consideration in a stock split, it may be a secondary consideration in the issuance of a stock dividend. The issuance of a series of stock dividends will accomplish the same objective as a stock split. A stock split is intended to obtain wider distribution and improved marketability of shares by means of a reduction in the fair value of the company’s shares.
(c)
The amount of retained earnings to be capitalized in connection with a stock dividend (in the accounting sense) might be (1) the legal minimum (usually par or stated value), (2) the average paid-in capital per outstanding share, or (3) the fair value of the shares. The third basis is generally recommended because recipients tend to regard the market value of the stock received as a dividend as the amount of earnings distributed to them. If the corporation in such cases does not capitalize an amount equal to the fair value of the shares distributed as a dividend, there is left in the corporation’s retained earnings account an amount of earnings that the stockholders believe has been distributed to them. This amount would be subject to further stock dividends or to cash dividends. The recipients might thus be misled into believing that the company’s distributions—and earnings—are greater than they actually are. If the per-share fair value of the stock is materially reduced as a result of a distribution (usually 20%–25% of shares outstanding or more), no matter what form the distribution takes, the action is in substance a stock split and should be so designated and treated as such.
LO: 3, Bloom: AN, Difficulty: Simple, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 14.5 (a)
The case against treating an ordinary stock dividend as income is supported by a majority of accounting authorities. It is based upon “entity” and “proprietary” interpretations. If the corporation is considered an entity separate from stockholders, the income of the corporation is corporate income and not income to stockholders, although the equity of the stockholders in the corporation increases as income to the corporation increases. This position is consistent with the interpretation that a dividend is not income to the recipient until it is realized as a result of a division, distribution, or severance of corporate assets. The stock dividend received merely redistributes each stockholder’s equity over a larger number of shares. Representing the stock dividend under this interpretation may lead to the incorrect perception that the effect is to reduce the recipient’s proportionate share of the corporation’s equity. A similar position is based upon a “proprietary” interpretation. Income of the corporation is considered income to the owners and, hence, stock dividends represent only a reclassification of equity since there is no increase in total proprietorship.
CT 14.5 (Continued) (b)
The case against issuing stock dividends on treasury stock rests principally upon the argument that stock reacquired by the corporation is a “reduction of capital” through the payment of cash to reduce the number of outstanding shares. According to this view, the corporation cannot obtain a proprietary interest in itself when it reacquires its own stock. The retained earnings are considered divisible only among the owners of outstanding shares and only the outstanding shares are entitled to a stock dividend. In those states that permit treasury shares to participate in the distribution accompanying a stock dividend or stock split, practice is influenced by the planned use of the treasury shares (such as, the issuance of treasury shares in connection with employee stock options). Unless there are specific uses for the treasury stock, no useful purpose is served by issuing additional shares to treasury.
LO:3, 4, Bloom: C, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 14.6 (a)
Mask Company should account for the purchase of the treasury stock on August 15, 2025, by debiting Treasury Stock and crediting Cash for the cost of the purchase, $18,000 (1,000 shares $18 per share). Mask should account for the sale of the treasury stock on September 14, 2025, by debiting Cash for the selling price (500 shares $20 per share), crediting Treasury Stock for cost (500 shares $18 per share), and crediting Paid-in Capital from Treasury Stock for the excess of the selling price over the cost (500 shares $2 per share). The remaining treasury stock (500 shares $18 per share) should be presented separately in the stockholders’ equity section of Mask’s December 31, 2025, balance sheet as an unallocated reduction of stockholders’ equity. These shares are considered issued but not part of common stock outstanding.
(b)
Mask should account for the stock dividend by debiting Retained Earnings for $21 per share (the market price of the stock in October 2025, the date of the stock dividend) multiplied by the 1,950 shares distributed. Mask should then credit Common Stock for the par value of the common stock ($10 per share) multiplied by the 1,950 shares distributed, and credit Paid-In Capital in Excess of Par—Common Stock for the excess of the fair value ($21 per share) over the par value ($10 per share) multiplied by the 1,950 shares distributed. Total stockholders’ equity does not change, but, because this is considered a small stock dividend, recognition has been made of capitalization of retained earnings equivalent to the fair value of the additional shares resulting from the stock dividend.
(c)
Mask should account for the cash dividend on December 20, 2025, the declaration date, by debiting Retained Earnings and crediting Dividends Payable for $1 per share multiplied by the number of shares outstanding 21,450. A cash dividend is a distribution to the corporation’s stockholders. The liability for this distribution is incurred on the declaration date, and it is a current liability because it is payable within one year (January 10, 2026). The effect of the cash dividend on Mask’s balance sheet at December 31, 2025, is an increase in current liabilities and a decrease in retained earnings.
LO: 2, 3, Bloom: NA, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 14.7 (a)
The stakeholders are the dissident stockholders, the other stockholders, potential investors, creditors, and Kenseth.
(b)
The ethical issues are honesty, job security, and personal responsibility to others. That is, by using her inside information and her authority to do the buy-back, she can benefit herself at the potential expense of other stakeholders.
(c)
It is important for Kenseth to consider what is good for the corporation, not just for her (in finance terminology, an agency issue). Kenseth should consider the following questions: (1) Are there better uses for the cash? (2) Can she possibly win over the dissidents in some other way? (3) Would this buyout be in the long-term best interest of all parties?
LO: 2, Bloom: NA, Difficulty: Moderate, Time: 10-15, AACSB: Ethics, Reflective Thinking Skills, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Codification Exercises CE14.1 Master Glossary (a)
A security that is convertible into another security based on a conversion rate. For example, convertible preferred stock that is convertible into common stock on a two-for-one basis (two shares of common for each share of preferred).
(b)
An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to give the recipient shareholders some ostensibly separate evidence of a part of their respective interests in accumulated corporate earnings without distribution of cash or other property that the board of directors deems necessary or desirable to retain in the business. A stock dividend takes nothing from the property of the corporation and adds nothing to the interests of the stockholders; that is, the corporation’s property is not diminished and the interests of the stockholders are not increased. The proportional interest of each shareholder remains the same.
(c)
An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price and, thereby, of obtaining wider distribution and improved marketability of the shares. Sometimes called a stock split-up.
(d)
Contractual rights of security holders to receive dividends or returns from the security issuer’s profits, cash flows, or returns on investments.
LO: 1, Bloom: K, Difficulty: Simple, Time: 15-20, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE14.2 According to FASB ASC 505-20-25-3 (Stock Dividends and Stock Splits): 25-3 The point at which the relative size of the additional shares issued becomes large enough to materially influence the unit market price of the stock will vary with individual entities and under differing market conditions and, therefore, no single percentage can be established as a standard for determining when capitalization of retained earnings in excess of legal requirements is called for and when it is not. Except for a few instances, the issuance of additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment as a stock dividend as described in paragraph 505-20-30-3. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE14.3 According to FASB ASC 340-10-S99-1 (Deferred Costs and Other Assets—SEC Materials): Specific incremental costs directly attributable to a proposed or actual offering of securities may properly be deferred and charged against the gross proceeds of the offering. However, management salaries or other general and administrative expenses may not be allocated as costs of the offering and deferred costs of an aborted offering may not be deferred and charged against proceeds of a subsequent offering. A short postponement (up to 90 days) does not represent an aborted offering. LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE14.4 According to FASB ASC 505-30-25-7 (Treasury Stock—Recognition): 25-7 After an entity’s repurchase of its own outstanding common stock, sometimes it may either retire the repurchased shares and issue additional common shares, or, as an alternative, resell the repurchased shares. In either case, the price received may differ from the amount paid to repurchase the shares. While the net asset value of the shares of common stock outstanding in the hands of the public may be increased or decreased by such repurchase and retirement, such transactions relate to the capital of the corporation and do not give rise to corporate profits or losses. There is no essential difference between the following: a.
The repurchase and retirement of a corporation’s own common stock and the subsequent issue of common shares.
b.
The repurchase and resale of its own common stock.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
Codification Research Case (a)
See FASB ASC 505-10-50.
(b)
(FASB ASC 505-10-20.—Glossary) 1. Security—is defined as evidence of debt or ownership or a related right. It includes options and warrants as well as debt and stock. 2. Participation rights—are contractual rights of security holders to receive dividends or returns from the security issuer’s profits, cash flows, or returns on investments. 3. Preferred stock—is a security that has preferential rights compared to common stock.
(c)
FASB ASC 505-10-50-3. An entity shall explain, in summary form within its financial statements, the pertinent rights and privileges of the various securities outstanding. Examples of information that shall be disclosed are dividend and liquidation preferences, participation rights, call prices and dates, conversion or exercise prices or rates and pertinent dates, sinking-fund requirements, unusual voting rights, and significant terms of contracts to issue additional shares. An entity shall disclose within its financial statements the number of shares issued upon conversion, exercise, or satisfaction of required conditions during at least the most recent annual fiscal period and any subsequent interim period presented.
LO: 4, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CHAPTER 15 Dilutive Securities and Earnings Per Share Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Convertible debt and preferred stock.
1, 2, 3, 4, 5, 6, 7
1, 2, 3
1, 2, 3, 4, 5, 6, 24, 25,
2
1
2.
Warrants and debt.
2, 3, 8, 9
4, 5
7, 8, 9
1
1, 3
3.
Stock options, restricted stock.
1, 10, 11, 12, 13, 14, 15
6, 7, 8, 9
10, 11, 12, 13, 14
1, 3, 4
2, 4
4.
Earnings Per Share (EPS)—terminology.
18, 24
5.
EPS—Determining potentially dilutive securities.
19, 20, 21
13, 14, 15
22, 23, 27
6.
EPS—Treasury stock method.
22, 23
16
28
5
7.
EPS—Weightedaverage computation.
16, 17
11, 12
15, 16, 17, 18, 21
5, 6, 7, 8, 9
8.
EPS—General objectives.
24, 25
10, 13
9.
EPS—Comprehensive calculations.
26
10.
EPS—Contingent shares.
*11.
Stock appreciation rights.
5, 6
5, 6 19, 20, 21, 22, 23, 24, 25, 26, 27, 28
5, 7, 8, 9
16
27
9
17
29, 30
*This material is dealt with in an Appendix to the chapter.
5, 6
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1. Describe the accounting for the issuance, conversion, and retirement of convertible securities.
1, 2, 4, 5, 6, 7
1, 2, 3
1, 2, 3, 4, 5, 6
1, 2
1
2. Contrast the accounting for stock warrants with stock rights.
3, 8, 9
4, 5
1, 7, 8, 9
1
1, 3
3. Describe the accounting and reporting for stock compensation plans.
10, 11, 12, 13, 14, 15
6, 7, 8, 9
10, 11, 12, 13, 14
1, 3, 4
2, 4
4. Compute basic earnings per share.
16, 17
10, 11, 12, 13
15, 16, 17, 18, 19, 20, 21
6, 7, 8, 9
5
5. Compute diluted earnings per share.
18, 19, 20, 21, 22, 23, 24, 25
14, 15, 16
22, 23, 24, 25, 26, 27, 28
5, 7, 8
5, 6
17
29, 30
*6. Explain the accounting for stock-appreciation rights plans. *7. Compute earnings per share in a complex situation.
26
5, 9
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E15.1 E15.2 E15.3 E15.4 E15.5 E15.6 E15.7 E15.8 E15.9 E15.10 E15.11 E15.12 E15.13 E15.14 E15.15 E15.16 E15.17 E15.18 E15.19 E15.20 E15.21 E15.22 E15.23 E15.24 E15.25 E15.26 E15.27 E15.28 *E15.29 *E15.30
Issuance and conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Issuance of bonds with warrants. Issuance of bonds with detachable warrants. Issuance of bonds with stock warrants. Issuance and exercise of stock options. Issuance, exercise, and termination of stock options. Issuance, exercise, and termination of stock options. Accounting for restricted stock. Accounting for restricted stock. Weighted-average number of shares. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS with convertible bonds, various situations. EPS with convertible bonds. EPS with convertible bonds and preferred stock. EPS with convertible bonds and preferred stock. EPS with options, various situations. EPS with contingent issuance agreement. EPS with warrants. Stock-appreciation rights. Stock-appreciation rights.
Simple Simple Simple Moderate Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Simple Simple Moderate Simple Simple Simple Simple Simple Simple Complex Moderate Moderate Moderate Moderate Simple Moderate Moderate Moderate
15–20 15–20 10–15 15–20 10–20 25–35 10–15 10–15 15–20 15–25 15–25 15–25 10–15 10–15 15–25 10–15 10–15 10–15 20–25 10–15 10–15 20–25 15–20 20–25 10–15 20–25 10–15 15–20 15–25 15–25
P15.1 P15.2 P15.3 P15.4 P15.5 P15.6 P15.7 P15.8 *P15.9
Entries for various dilutive securities. Entries for conversion, amortization, and interest of bonds. Stock option plan. Stock-based compensation. EPS with complex capital structure. Basic EPS: Two-year presentation. Computation of basic and diluted EPS. Computation of basic and diluted EPS. EPS with stock dividend and discontinued operations.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex
35–40 45–50 30–35 25–30 30–35 30–35 35–45 25–35 30–40
CT15.1 CT15.2 CT15.3 CT15.4 CT15.5 CT15.6
Warrants issued with bonds and convertible bonds. Ethical issues—compensation plan. Stock warrants—various types. Stock compensation plans. EPS: Preferred dividends, options, and convertible debt. EPS, antidilution.
Moderate Simple Moderate Moderate Moderate Moderate
20–25 15–20 15–20 25–35 25–35 25–35
Answers to Questions 1.
Securities such as convertible bonds, convertible preferred stock, stock options and warrants are dilutive because their features indicate that the holders of the securities can become common shareholders. When the common shares are issued, there will be a reduction—dilution—in earnings per share.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
2.
Lower Interest Costs—Generally convertible debt offers a lower interest rate to investors because investors place a high value of the conversion feature. For example, Ford Motor’s recent convertible debt has a zero-interest rate attached to its convertibles. If Ford decided to issue straight debt with no conversion feature, its interest cost would be much higher. Ford does not have to pay any interest because investors are betting that Ford will continue to sell cars at a profit and will make great inroads into the electric vehicle market. Manage capital structure—Issuers often have a call feature attached to the convertible debt (as you learned in Chapter 13). This feature enables the Issuer to have some control over its capital structure if its debt to equity becomes too high. A good example of managing its capital structure is Tesla which issued convertibles in 2013, 2014, 2017 and 2019. It was able to fund part of its growth using these securities by calling these bonds at certain points thereby reducing its debtto-equity ratio. This process enabled Tesla to receive funds at a low interest rate as it invested in the development of its electric car business. Many fast-growing high-tech companies use convertibles to fund their expansion.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
3.
Convertible debt and debt issued with stock warrants are similar in that: (1) both allow the issuer to issue debt at a lower interest cost than would generally be available for straight debt; (2) both allow the holders to purchase the issuer’s stock at less than market value if the stock appreciates sufficiently in the future; (3) both provide the holder the protection of a debt security if the value of the stock does not appreciate; and (4) both are complex securities which contain elements of debt and equity at the time of issue. Convertible debt and debt with stock warrants are different in that: (1) if the market price of the stock increases sufficiently, the issuer can force conversion of convertible debt into common stock by calling the issue for redemption, but the issuer cannot force exercise of the warrants; (2) convertible debt may be essentially equity capital, whereas debt with stock warrants is debt with the additional right to acquire equity; and (3) the conversion option and the convertible debt are inseparable and, in the absence of separate transferability, do not have separate values established in the market; whereas debt with detachable stock warrants can be separated into debt and the right to purchase stock, each having separate values established by the transactions in the market.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
4.
The accounting treatment of the $160,000 “sweetener” to induce conversion of the bonds into common shares represents a departure from GAAP because the FASB views the transaction as the retirement of debt. Therefore, the FASB requires that the “sweetener” of $160,000 be reported as an expense.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
5.
(a) From the point of view of the issuer, the conversion feature of convertible debt results in a lower cash interest cost than in the case of nonconvertible debt. In addition, the issuer in planning its long-range financing may view the convertible debt as a means of raising equity capital over the long term. Thus, if the market value of the underlying common stock increases sufficiently after the issue of the debt, the issuer will usually be able to force conversion of the convertible debt into common stock by calling the issue for redemption. Under the market conditions, the issuer can effectively eliminate the debt. On the other hand, if the market value of the common stock does not increase sufficiently to result in the conversion of the debt, the issuer will have
Questions Chapter 15 (Continued) received the benefit of the cash proceeds to the scheduled maturity dates at a relatively low cash interest cost. (b) The purchaser obtains an option to receive either the face amount of the debt upon maturity or the specified number of common shares upon conversion. If the market value of the underlying common stock increases above the conversion price, the purchaser (either through conversion or through holding the convertible debt containing the conversion option) receives the benefits of appreciation. On the other hand, should the value of the underlying company stock not increase, the purchaser could nevertheless expect to receive the principal and (lower) interest. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
6.
The view that separate accounting recognition should be accorded the conversion feature of convertible debt is based on the premise that there is an economic value inherent in the conversion feature or call on the common stock and that the value of this feature should be recognized for accounting purposes by the issuer. It may be argued that the call is not significantly different in nature from the call contained in an option or warrant and its issue is thus a type of capital transaction. The fact that the conversion feature coexists with certain senior security characteristics in a complex security and cannot be physically separated from these elements or from the instrument does not constitute a logical or compelling reason why the values of the various elements should not receive separate accounting recognition. The fact that the eventual outcome of the option granted the purchaser of the convertible debt cannot be determined at date of issuance is not relevant to the question of effectively reflecting in the accounting records the various elements of the complex document at the date of issuance. The conversion feature has a value at date of issuance and should be recognized. Moreover, the difficulties of implementation are not insurmountable and should not be relied upon to govern the conclusion.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
7.
The method used by the company to record the exchange of convertible debentures for common stock can be supported on the grounds that when the company issued the convertible debentures, the proceeds could represent consideration received for the stock. Therefore, when conversion occurs, the book value of the obligation is simply transferred to the stock exchanged for it. Further justification is that conversion represents a transaction with stockholders which should not give rise to a gain or loss. On the other hand, recording the issue of the common stock at the book value of the debentures is open to question. It may be argued that the exchange of the stock for the debentures completes the transaction cycle for the debentures and begins a new cycle for the stock. The consideration or value used for this new transaction cycle should then be the amount which would be received if the debentures were sold rather than exchanged, or the amount which would be received if the related stock were sold, whichever is more clearly determinable at the time of the exchange. This method recognizes changes in values which have occurred and subordinates a consideration determined at the time the debentures were issued.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
8.
Cash ............................................................................................... Discount on Bonds Payable ............................................................ Bonds Payable ........................................................................ Paid-in Capital—Stock Warrants ............................................. Value of bonds with warrants Value of warrants Value of bonds without warrants
$3,000,000 (100,000) $2,900,000
3,000,000 100,000 3,000,000 100,000
Questions Chapter 15 (Continued) In this case, the incremental method is used since no separate value is given for the bonds without the warrants. LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
9.
If a corporation decides to issue new shares of stock, the old stockholders generally have the right, referred to as a stock right, to purchase newly issued shares in proportion to their holdings. No entry is required when rights are issued to existing stockholders. Only a memorandum entry is needed to indicate that the rights have been issued. If exercised, the corporation simply debits Cash for the proceeds received, credits Common Stock for the par value, and any difference is recorded with a credit to Paid-in Capital in Excess of Par.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
10.
Companies are required to use the fair value method to recognize compensation cost. For most stock option plans compensation cost is measured at the grant date and allocated to expense over the service period, which typically ends on the vesting date.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
11.
This plan would not be considered compensatory. Plans are considered compensatory unless they satisfy all three of the following conditions: (1) substantially all full-time employees may participate on an equitable basis, (2) the discount from market price is small, and (3) the plan offers no substantive option feature.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
12.
The profession recommends that the fair value of a stock option be determined on the date on which the option is granted to a specific individual. At the date the option is granted, the corporation foregoes the alternative of selling the shares at the then prevailing price. The market price on the date of grant may be presumed to be the value which the employer had in mind. It is the value of the option at the date of grant, rather than the grantor’s ultimate gain or loss on the transaction, which for accounting purposes constitutes whatever compensation the grantor intends to pay.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
13.
GAAP requires that compensation expense be recognized over the service period. Unless otherwise specified, the service period is the vesting period—the time between the grant date and the vesting date.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
14.
Using the fair value approach, total compensation expense is computed based on the fair value of the options on the date the options are granted to the employees. Fair value is estimated using an acceptable option pricing model (such as the Black-Scholes option-pricing model).
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
15.
The advantages of using restricted stock to compensate employees are: (1) The restricted stock never becomes completely worthless; (2) it generally results in less dilution than stock options; and (3) it better aligns the employee incentives with the companies’ incentives.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 15 (Continued) 16.
Weighted-average number of shares outstanding Jan. 1 − Sept. 30 400,000 X 9/12 = ............................................ Oct. 1 − Dec. 31 600,000 X 3/12 = ............................................. Weighted-average number of shares outstanding ..................... Net income ........................................................................................ Preferred dividends ........................................................................... Income available to common stockholders ....................................... Earnings per share =
$1,600,000 450,000
300,000 150,000 450,000 $2,000,000 (400,000) $1,600,000
= $3.56
LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
17.
The computation of the weighted-average number of shares outstanding requires restatement of the shares outstanding before the stock dividend or split. The additional shares outstanding as a result of a stock dividend or split are assumed to have been outstanding since the beginning of the year. Shares outstanding prior to the stock dividend or split are adjusted so that these shares are stated on the same basis as shares issued after the stock dividend/split.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
18.
(a) Basic earnings per share is the amount of earnings for the period available to each share of common stock outstanding during the reporting period. (b) Potentially dilutive security is a security which can be exchanged for or converted into common stock and therefore upon conversion or exercise could dilute (or decrease) earnings per share. Included in this category are convertible securities, options, warrants, and other rights. (c)
Diluted earnings per share is the amount of earnings for the period available to each share of common stock outstanding and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period.
(d) Complex capital structure exists whenever a company’s capital structure includes dilutive securities. (e) Potential common stock is not common stock in form but does enable its holders to obtain common stock upon exercise or conversion. LO: 5, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
19.
Convertible securities are potentially dilutive securities and part of diluted earnings per share if their conversion increases the EPS numerator less than it increases the EPS denominator; i.e., the EPS with conversion is less than the EPS before conversion.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 15 (Continued) 20.
The concept that a security may be the equivalent of common stock has evolved to meet the reporting needs of investors in corporations that have issued certain types of convertible securities, options, and warrants. A potentially dilutive security is a security which is not, in form, common stock but which enables its holder to obtain common stock upon exercise or conversion. The holders of these securities can expect to participate in the appreciation of the value of the common stock resulting principally from the earnings and earnings potential of the issuing corporation. This participation is essentially the same as that of a common stockholder except that the security may carry a specified dividend yielding a return different from that received by a common stockholder. The attractiveness to investors of this type of security is often based principally upon this potential right to share in increases in the earnings potential of the issuing corporation rather than upon its fixed return or upon other senior security characteristics. In addition, the call characteristic of the stock options and warrants gives the investor potential control over a far greater number of shares per dollar of investment than if the investor owned the shares outright.
LO: 5, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
21.
Convertible securities are considered to be potentially dilutive securities whenever their conversion would decrease earnings per share. If this situation does not result, conversion is not assumed and only basic EPS is reported.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
22.
Under the treasury-stock method, diluted earnings per share should be determined as if outstanding options and warrants were exercised at the beginning of year (or date of issue if later) and the funds obtained thereby were used to purchase common stock at the average market price for the period. For example, if a corporation has 10,000 warrants outstanding exercisable at $54, and the average market price of the common stock during the reported period is $60, the $540,000 which would be realized from exercise of warrants and issuance of 10,000 shares would be an amount sufficient to acquire 9,000 shares; thus, 1,000 shares would be added to the outstanding common shares in computing diluted earnings per share for the period. However, to avoid an incremental positive effect upon earnings per share, options and warrants should enter into the computation only when the average market price of the common stock exceeds the exercise price of the option or warrant.
LO: 5, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
23.
Yes, if warrants or options are present, an increase in the market price of the common stock can increase the number of potentially dilutive common shares by decreasing the number of shares repurchasable. In addition, an increase in the market price of common stock can increase the compensation expense reported in a stock-appreciation rights plan. This would decrease net income and, consequently, earnings per share.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
24.
Antidilution is an increase in earnings per share resulting from the assumption that convertible securities have been converted or that options and warrants have been exercised, or other shares have been issued upon the fulfillment of certain conditions. For example, an antidilutive condition would exist when the dividend or interest requirement (net of tax) of a convertible security exceeds the current EPS multiplied by the number of common shares issuable upon conversion of the security. This may be illustrated by assuming a company in the following situation: Net income ........................................................................................................ Weighted-average number of shares outstanding .............................................. 6% Bonds payable (convertible into 5,000 shares of common stock) ................. Tax rate ............................................................................................................. Basic earnings per share = $10,000/20,000 shares = $.50
$ 10,000 20,000 $100,000 20%
Questions Chapter 15 (Continued) Earnings per share assuming conversion of the bonds: Net income................................................................................................. Bond interest (net of tax) = (1 – .20) ($100,000 X .06) ............................... Adjusted net income .................................................................................. Earnings per share assuming conversion =
$14,800 20,000 + 5,000
$10,000 4,800 $14,800
= $.59
This antidilutive effect occurs because the bond interest (net of tax) of $4,800 is greater than the current EPS of $.50 multiplied by the number of shares issuable upon conversion of the bonds (5,000 shares). LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
25.
Both basic earnings per share and diluted earnings per share must be presented in a complex capital structure. When discontinued operations are reported, per share amounts should be shown for income from continuing operations, income, and net income.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*26.
Antidilution when multiple securities are involved is determined by ranking the securities for maximum possible dilution in terms of per share effect. Starting with the most dilutive, earnings per share is reduced until one of the securities maintains or increases earnings per share. When an increase in earnings per share occurs, the security that causes the increase in earnings per share is excluded. The previous computation therefore provided the maximum dilution.
LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 15.1 .
Cash ($4,000,000 X .99) ............................................... Discount on Bonds Payable ....................................... Bonds Payable ................................................. ...
3,960,000 40,000 4,000,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.2 Bonds Payable ............................................................. Discount on Bonds Payable ................................ Common Stock (2,000 X 50 X $10) ...................... Paid-in Capital in Excess of Par— Common Stock..................................................
2,000,000 30,000 1,000,000 970,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.3 Preferred Stock (1,000 X $50) ..................................... Paid-in Capital in Excess of Par— Preferred Stock ($60 – $50) X 1,000 ....................... Common Stock (2,000 X $10) .............................. Paid-in Capital in Excess of Par—Common Stock ($60 X 1,000) – (2,000 X $10) ..................
50,000 10,000 20,000 40,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.4 Cash ............................................................................. Discount on Bonds Payable ($2,000,000 – $1,940,784) ........................................ Bonds Payable ..................................................... Paid-in Capital—Stock Warrants ........................
2,020,000 59,216 2,000,000 79,216
Fair value of bonds (2,000 X $1,000 X .98) ................. Fair value of warrants (2,000 X $40) ........................... Aggregate fair value ....................................................
$1,960,000 80,000 $2,040,000
Allocated to bonds [($1,960/$2,040) X $2,020,000] .... Allocated to warrants [($80/$2,040) X $2,020,000] .....
$1,940,784 79,216 $2,020,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.5
Cash ............................................................................... Discount on Bonds Payable [$2,000,000 X (1 – .98)] .............................................. Bonds Payable ....................................................... Paid-in Capital—Stock Warrants ..........................
2,020,000 40,000 2,000,000 60,000*
*$2,000,000 X (1.01 – .98) LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.6 1/1/25 No entry 12/31/25 Compensation Expense ............................. Paid-in Capital—Stock Options ............................................ 12/31/26 Compensation Expense ............................. Paid-in Capital—Stock Options ............................................
75,000 75,000 75,000 75,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.7 1/1/25 Unearned Compensation ........................... Common Stock (2,000 X $5) ............... Paid in Capital in Excess of Par— Common Stock [($65 – $5) X 2,000] ........................... 12/31/25 Compensation Expense ............................. Unearned Compensation ....................
130,000 10,000 120,000 65,000 65,000
Brief Exercise 15.7 (continued) 12/31/26 Compensation Expense ............................. Unearned Compensation ....................
65,000 65,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.8 12/31/25 Compensation Expense ............................. Paid-in Capital-Restricted Stock Units ...
65,000
12/31/26 Compensation Expense ............................. Paid-in Capital-Restricted Stock Units ...
65,000
Paid-in Capital-Restricted Stock Units ... Common Stock (2,0000 X $5) ............. Paid-in Capital in Excess of Par— ..... Common Stock [($65 − $5) X 2,000] ..
65,000
65,000 130,000 10,000 120,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.9 1/1/25 Unearned Compensation ............................. Common Stock .......................................... Paid-in Capital in Excess of Par— Common Stock ...................................... 12/31/25 Compensation Expense ............................... Unearned Compensation ($75,000 ÷ 3) ....
75,000 10,000 65,000 25,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.10 $1,000,000 – (100,000 X $2) = $3.20 per share 250,000 shares LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
25,000
Brief Exercise 15.11 Dates Outstanding
Shares Outstanding
Fraction of Year
Weighted Shares
1/1–4/30 5/1–6/30 7/1–9/30 10/1–12/31
120,000 180,000 170,000 180,000
4/12 2/12 3/12 3/12
40,000 30,000 42,500 45,000 157,500
LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.12 (a) (300,000 X 4/12) + (330,000 X 8/12) = 320,000 (b) 330,000 (The 30,000 shares issued in the stock dividend are assumed outstanding from the beginning of the year.) LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.13 Earnings per share Income from continuing operations ($600,000/100,000) . Discontinued operations (loss) ($120,000/100,000) ........ Net income ($480,000/100,000) .........................................
$ 6.00 (1.20) $ 4.80
LO: 4, 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.14 Net income ................................................................................. Adjustment for interest, net of tax [$40,000* X (1 – .20)] ........ Adjusted net income ................................................................. Weighted-average number of shares outstanding adjusted for dilutive securities (100,000 + 16,000) ................................... Diluted EPS ................................................................................ *$800,000 X .05 LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$300,000 32,000 332,000 ÷116,000 $2.86
Brief Exercise 15.15 Net income ................................................................................. Weighted-average number of shares adjusted for dilutive securities (50,000 + 10,000) ............................... Diluted EPS ................................................................................
$270,000 ÷ 60,000 $4.50
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 15.16 Proceeds from assumed exercise of 45,000 options (45,000 X $10) ........................................................... Shares issued upon exercise ................................................... Treasury shares purchasable ($450,000 ÷ $15) ....................... Incremental shares .................................................................... Diluted EPS =
$300,000 = 200,000 + 15,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 15.17 2025:
(5,000 X $4) X .50 = $10,000
2026:
(5,000 X $9) – $10,000 = $35,000
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$450,000 45,000 (30,000) 15,000 $1.40
Solutions to Exercises Exercise 15.1 (15–20 minutes) 1.
2.
Cash ($20,000,000 X .99) ............................... Discount on Bonds Payable ......................... Bonds Payable ........................................
19,800,000 200,000
Cash................................................................ Discount on Bonds Payable ......................... Bonds Payable ........................................ Paid-in Capital—Stock Warrants ...........
19,600,000 1,200,000
Value of bonds plus warrants ($20,000,000 X .98) Less: Value of warrants (200,000 X $4) Value of bonds 3.
20,000,000
20,000,000 800,000
$19,600,000 800,000 $18,800,000
Debt Conversion Expense ............................ Bonds Payable ............................................... Discount on Bonds Payable ................... Common Stock ....................................... Paid-in Capital in Excess of Par............. Cash .........................................................
75,000 10,000,000 55,000 1,000,000 8,945,000* 75,000
*[($10,000,000 – $55,000) – $1,000,000] LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Exercise 15.2 (15–20 minutes) (a) Interest Payable ($200,000 X 2/6) .................. Interest Expense ($200,000 X 4/6) + $2,712 .. Discount on Bonds Payable ................... Cash ($4,000,000 X .10 ÷ 2)..................... *Calculations: $4,000,000 x .10 x 6/12 = $200,000 Par value Issuance price Total discount
$4,000,000 (3,920,000) $ 80,000
66,667 136,045 2,712* 200,000
Exercise 15.2 (Continued) Months remaining Discount per month ($80,000 ÷ 118) Discount amortized (4 X $678)
118 $678 $2,712
(b) Bonds Payable .................................................... Discount on Bonds Payable......................... Common Stock (30,000 X $20) ..................... Paid-in Capital in Excess of Par ..................
1,500,000 27,458 600,000 872,542*
*($1,500,000 – $27,458) – $600,000 Calculations: $1,500,000/$4,000,000 = 3/8 Discount related to 3/8 of the bonds ($80,000 X 3/8) Less: Discount amortized [($30,000 ÷ 118) X 10] Unamortized bond discount
$30,000 2,542 $27,458
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.3 (10–20 minutes) Conversion recorded at book value of the bonds: Bonds Payable ............................................................ Premium on Bonds Payable ...................................... Preferred Stock (500 X 20 X $50) ....................... Paid-in Capital in Excess of Par (Preferred Stock) .............................................
500,000 7,500 500,000 7,500
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.4 (15–20 minutes) (a) Cash ..................................................................... 10,800,000 Bonds Payable ............................................ 10,000,000 Premium on Bonds Payable ....................... 800,000 (To record issuance of $10,000,000 of 8% convertible debentures for $10,800,000. The bonds mature in twenty years, and each $1,000 bond is convertible into five shares of $30 par value common stock) Exercise 15.4 (Continued)
(b) Bonds Payable ............................................... Premium on Bonds Payable (Schedule 1) .............................................. Common Stock, $15 par (Schedule 2) ....................................... Paid-in Capital in Excess of Par ............ (To record conversion of 30% of the outstanding 8% convertible debentures after giving effect to the 2-for-1 stock split)
3,000,000 216,000 450,000 2,766,000
Schedule 1 Computation of Unamortized Premium on Bonds Converted Premium on bonds payable on January 1, 2024 Amortization for 2024 ($800,000 ÷ 20) Amortization for 2025 ($800,000 ÷ 20) Premium on bonds payable on January 1, 2026 Bonds converted Unamortized premium on bonds converted
$800,000 $40,000 40,000
(80,000) 720,000 X 30% $216,000
Schedule 2 Computation of Common Stock Resulting from Conversion Number of shares convertible on January 1, 2024: Number of bonds ($10,000,000 ÷ $1,000) Number of shares for each bond Stock split on January 1, 2025 Number of shares convertible after the stock split % of bonds converted Number of shares issued Par value/per share Total par value
10,000 X 5
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
50,000 X 2 100,000 X 30% 30,000 X $15 $450,000
Exercise 15.5 (10–20 minutes) Interest Expense ............................................................. Discount on Bonds Payable ................................... [$10,240 ÷ 64 = $160; $160 X 4] Cash (.10 X $500,000 X 1/2) .................................... (Assumed that the interest accrual was reversed as of January 1, 2026; if the interest accrual was not reversed, interest expense would be $17,307 and interest payable would be debited for $8,333)
25,640
Bonds Payable ................................................................ Discount on Bonds Payable ($10,240 – $640) ....... Common Stock ($25 X 6 X 500) .............................. Paid-in Capital in Excess of Par.............................
500,000
640 25,000
9,600 75,000 415,400*
*($500,000 – $9,600) – $75,000 LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.6 (25–35 minutes) (a)
(b)
December 31, 2026 Interest Expense .................................................... Premium on Bonds Payable .................................. ($80,000 X 1/20) Cash ($4,000,000 X .08 X 6/12) ........................ January 1, 2027 Bonds Payable ....................................................... Premium on Bonds Payable .................................. Common Stock ................................................ [8 X $100 X ($400,000/$1,000)] Paid-in Capital in Excess of Par ..................... *Total premium ($4,000,000 X .02) Less: Premium amortized ($80,000 X 2/10) Balance Bonds converted ($400,000 ÷ $4,000,000) Related premium ($64,000 X 10%)
$80,000 16,000 $64,000 10% 6,400
156,000 4,000 160,000 400,000 6,400* 320,000 86,400
Exercise 15.6 (Continued) (c)
March 31, 2027 Interest Expense ..................................................... Premium on Bonds Payable .................................. ($6,400 ÷ 8 years) X 3/12 Interest Payable............................................... ($400,000 X .08 X 3/12) Bonds Payable ........................................................ Premium on Bonds Payable .................................. Common Stock ................................................ Paid-in Capital in Excess of Par ..................... *Premium as of January 1, 2027 for $400,000 of bonds $6,400 ÷ 8 years remaining X 3/12 Premium as of March 31, 2027 for $400,000 of bonds
(d)
7,800 200 8,000 400,000 6,200* 320,000 86,200
$6,400 (200) $6,200
June 30, 2027 Interest Expense ..................................................... Premium on Bonds Payable .................................. Interest Payable ...................................................... ($400,000 X .08 X 1/4)*** Cash .................................................................
124,800 3,200 8,000 136,000*
[Premium to be amortized: ($80,000 X .80) X 1/20 = $3,200, or $51,200** ÷ 16 (remaining interest and amortization periods) = $3,200] ***Total to be paid: ($3,200,000 X .08 ÷ 2) + $8,000 = $136,000 ***Original premium 2025 amortization 2026 amortization Jan. 1, 2027 write-off Mar. 31, 2027 amortization Mar. 31, 2027 write-off
$80,000 (8,000) (8,000) (6,400) (200) (6,200) $51,200
***Assumes interest accrued on March 31. If not, debit Bond Interest Expense for $132,800. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.7 (10–15 minutes) (a) Basic formulas: Value of bonds without warrants X Issue price = Value assigned to bonds Value of bonds without warrants + Value of warrants Value of warrants X Issue price = Value assigned to warrants Value of bonds without warrants + Value of warrants $136,000 $136,000 + $24,000
X $152,000 = $129,200
$24,000 $136,000 + $24,000
X $152,000 =
22,800 $152,000
Value assigned to bonds
Value assigned to warrants Total
Cash ........................................................................ Discount on Bonds Payable .................................. ($170,000 – $129,200) Bonds Payable ............................................... Paid-in Capital—Stock Warrants ...................
152,000 40,800 170,000 22,800
(b) When the warrants are non-detachable, separate recognition is not given to the warrants. The accounting treatment parallels that given convertible debt because the debt and equity element cannot be separated. The entry if warrants were non-detachable is: Cash ........................................................................ Discount on Bonds Payable .................................. Bonds Payable ...............................................
152,000 18,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
170,000
Exercise 15.8 (10–15 minutes) September 1, 2025 Cash ($4,160,000 + $90,000) .................................... Bonds Payable (4,000 X $1,000)....................... Premium on Bonds Payable—Schedule 1 ...... Paid-in Capital—Stock Warrants— Schedule 1......................................................... Interest Expense—Schedule 2 ......................... (To record the issuance of the bonds)
4,250,000 4,000,000 136,000 24,000 90,000
Schedule 1 Premium on Bonds Payable and Value of Stock Warrants Sales price (4,000 X $1,040) Less: Face value of bonds
$4,160,000 4,000,000 160,000
Deduct value assigned to stock warrants (4,000 X 2 = 8,000; 8,000 X $3) Premium on bonds payable
24,000 $ 136,000
Schedule 2 Accrued Bond Interest to Date of Sale Face value of bonds Interest rate Annual interest
$4,000,000 X .09 $ 360,000
Accrued interest for 3 months – ($360,000 X 3/12)
$
90,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.9 (10–15 minutes) (a) Cash ($2,000,000 X 1.02) .......................... Discount on Bonds Payable .................... [(1 – .98) X $2,000,000] Bonds Payable ..................................... Paid-in Capital—Stock Warrants ........ *$2,040,000 – ($2,000,000 X .98)
2,040,000 40,000 2,000,000 80,000*
Exercise 15.9 (Continued) (b) Market value of bonds without warrants ($2,000,000 X .98) Market value of warrants (2,000 X $30) Total market value $1,960,000 $2,020,000
X $2,040,000 = $1,979,406
$60,000 X $2,040,000 = $2,020,000
60,594 $2,040,000
$1,960,000 60,000 $2,020,000
Value assigned to bonds
Value assigned to warrants Total
Cash ........................................................................ Discount on Bonds Payable .................................. Bonds Payable ................................................... Paid-in Capital—Stock Warrants ......................
2,040,000 20,594 2,000,000 60,594
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.10 (15–25 minutes) January 2, 2026 No entry (total compensation cost is $450,000) December 31, 2026 Compensation Expense .............................. 225,000 Paid-in Capital—Stock Options .......... [To record compensation expense for 2026 (1/2 X $450,000)]
225,000
December 31, 2027 Compensation Expense ............................. 225,000 Paid-in Capital—Stock Options ......... [To record compensation expense for 2027 (1/2 X $450,000)]
225,000
Exercise 15.10 (Continued) January 3, 2028 Cash (20,000 X $40) ..................................... Paid-in Capital—Stock Options .................. ($450,000 X 20,000/30,000) Common Stock (20,000 X $10) ............ Paid-in Capital in Excess of Par .......... (To record issuance of 20,000 shares of $10 par value stock upon exercise of options at option price of $40)
800,000 300,000 200,000 900,000
(Note to instructor: The market price of the stock has no relevance in the prior entry and the following one.) May 1, 2028 Cash (10,000 X $40) ........................................... Paid-in Capital—Stock Options ........................ ($450,000 X 10,000/30,000) Common Stock........................................... Paid-in Capital in Excess of Par—Common Stock ............................. (To record issuance of 10,000 shares of $10 par value stock upon exercise of options at option price of $40)
400,000 150,000 100,000 450,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.11 (15–25 minutes) January 1, 2026 No entry December 31, 2026 Compensation Expense .................................... Paid-in Capital—Stock Options ............. ($350,000 X 1/2) (To recognize compensation expense for 2026)
175,000 175,000
Exercise 15.11 (Continued) April 1, 2027 Paid-in Capital—Stock Options ........................ Compensation Expense ......................... ($175,000 X 2,000/20,000) (To record termination of stock options held by resigned employees) December 31, 2027 Compensation Expense .................................... Paid-in Capital—Stock Options ............. ($350,000 X 1/2 X 18,000/20,000) (To recognize compensation expense for 2027) March 31, 2028 Cash (12,000 X $25) ........................................... Paid-in Capital—Stock Options ........................ ($350,000 X 12,000/20,000) Common Stock ....................................... Paid-in Capital in Excess of Par............. (To record exercise of stock options)
17,500 17,500
157,500 157,500
300,000 210,000 120,000 390,000
Note: There are 6,000 options unexercised as of March 31, 2028 (20,000 – 2,000 – 12,000). LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.12 (15–25 minutes) January 1, 2024 No entry December 31, 2024 Compensation Expense ............................. Paid-in Capital—Stock Options .......... ($400,000 X 1/2) December 31, 2025 Compensation Expense ............................. Paid-in Capital—Stock Options ..........
200,000 200,000
200,000 200,000
Exercise 15.12 (Continued) May 1, 2026 Cash (8,000 X $20) ....................................... Paid-in Capital—Stock Options .................. Common Stock (8,000 X $5) ................ Paid-in Capital in Excess of Par—Common Stock .......................
160,000 320,000* 40,000 440,000
*($400,000 X 8,000/10,000) January 1, 2028 Paid-in Capital—Stock Options .................. Paid-in Capital—Expired Stock Options ($400,000 – $320,000) ........
80,000 80,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.13 (10–15 minutes) (a)
January 1, 2025 Unearned Compensation ............................... 120,000 Common Stock (4,000 X $5) .................... 20,000 Paid-in Capital Excess of Par— Common Stock ..................................... 100,000 December 31, 2026 Compensation Expense ................................. Unearned Compensation ($120,000 ÷ 4) ...
(b)
30,000 30,000
March 4, 2027 Common Stock ............................................... 20,000 Paid-in Capital Excess of Par— Common Stock ............................................ 100,000 Unearned Compensation ........................ Compensation Expense (2 X $30,000) ....
(c)
60,000 60,000
January 1, 2025 No entry December 31, 2026 Compensation Expense ................................ Paid-in Capital-Restricted Stock Units ...
Exercise 15.13 (Continued)
30,000 30,000
(d)
March 4, 2027 Paid-in Capital-Restricted Stock Units ......... Compensation Expense ..........................
60,000 60,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.14 (10–15 minutes) (a)
January 1, 2025 Unearned Compensation ............................... 500,000 Common Stock ($10 X 10,000) ................ 100,000 Paid-in Capital in Excess of Par— Common Stock...................................... 400,000 December 31, 2026 Compensation Expense ($500,000 ÷ 5) ......... 100,000 Unearned Compensation .......................... 100,000
(b)
(c)
July 25, 2029 Common Stock ............................................... 100,000 Paid-in Capital in Excess of Par— Common Stock ............................................... 400,000 Compensation Expense .......................... 400,000 Unearned Compensation......................... 100,000 January 1, 2025 No entry December 31, 2026 Compensation Expense ($500,000 5) ......... 100,000 Paid-in Capital-Restricted Stock Units ... 100,000
(d)
July 25, 2029 Paid-in Capital-Restricted Stock Units ......... 400,000 Compensation Expense .......................... 400,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.15 (15–25 minutes) (a) 2,200,000 shares Jan. 1, 2024–Sept. 30, 2024 (2,000,000 X 9/12) Retroactive adjustment for stock dividend Jan. 1, 2024–Sept. 30, 2024, as adjusted Oct. 1, 2024–Dec. 31, 2024 (2,200,000 X 3/12)
1,500,000 X 1.10 1,650,000 550,000 2,200,000
Another way to view this transaction is that the 2,000,000 shares at the beginning of the year must be restated for the stock dividend regardless of where in the year the stock dividend occurs. (b) 3,700,000 shares Jan. 1, 2025–Mar. 31, 2025 (2,200,000 X 3/12) Apr. 1, 2025–Dec. 31, 2025 (4,200,000 X 9/12) (c) 7,400,000 shares 2025 weighted-average number of shares previously computed Retroactive adjustment for stock split (d) 8,400,000 shares Jan. 1, 2026–Mar. 31, 2026 (4,200,000 X 3/12) Retroactive adjustment for stock split Jan. 1, 2026–Mar. 31, 2026, as adjusted Apr. 1, 2026–Dec. 31, 2026 (8,400,000 X 9/12)
550,000 3,150,000 3,700,000 3,700,000 X 2 7,400,000 1,050,000 X 2 2,100,000 6,300,000 8,400,000
Another way to view this transaction is that the 4,200,000 shares at the beginning of the year must be restated for the stock split regardless of where in the year the stock split occurs. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 15.16 (10–15 minutes) (a) Dates Outstanding
Event Beginning balance Issued shares Stock dividend Reacquired shares Stock split Reissued shares
Jan. 1–Jan. 31 Feb. 1–Feb. 28 Mar. 1–Apr. 30 May 1–May 31 June 1–Sept. 30 Oct. 1–Dec. 31
Shares Outstanding 480,000 600,000 660,000 560,000 1,680,000 1,740,000
Restatement 1.1 X 3.0 1.1 X 3.0 3.0 3.0
Fraction of Year
Weighted Shares
1/12 1/12 2/12 1/12 4/12 3/12
132,000 165,000 330,000 140,000 560,000 435,000 1,762,000
Weighted-average number of shares outstanding
(b)
Earnings Per Share =
(c)
Earnings Per Share =
$3,456,000 (Net Income) = $1.96 1,762,000 (Weighted-average Number Shares Outstanding) $3,456,000 – $900,000 1,762,000
(d) Income from continuing operationsa Loss from discontinued operationsb Net income
= $1.45
$2.21 (.25) $1.96
a
Net income Add: Loss from discontinued operations Income from continuing operations a
$3,456,000 432,000 $3,888,000
$3,888,000 1,762,000 = $2.21
b
$(432,000) 1,762,000 = $(.25)
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.17 (10–15 minutes) Dates Shares Event Outstanding Outstanding Beginning balance Jan. 1–Apr. 30 200,000 Issued shares May 1–Oct. 31 208,000 Reacquired shares Nov. 1–Dec. 31 194,000 Weighted-average number of shares outstanding
Fraction of Year 4/12 6/12 2/12
Weighted Shares 66,667 104,000 32,333 203,000
Income per share from continuing operations ($249,690 + $40,600 = $290,290; $290,290 ÷ 203,000 shares) Loss from discontinued operations per share, net of tax ($40,600 ÷ 203,000) Net income per share ($249,690 ÷ 203,000)
$1.43 (.20) $1.23
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Exercise 15.18 (10–15 minutes) Event
Dates Outstanding
Shares Outstanding
Beginning balance Jan. 1–Apr. 1 750,000 Issued shares May 1–July. 1 1,050,000 Reacquired shares Aug. 1–Dec. 31 900,000 Weighted-average number of shares outstanding
Restatement
Fraction of Year
Weighted Shares
2 2 2
4/12 3/12 5/12
500,000 525,000 750,000 1,775,000
Net income Preferred dividend (50,000 X $100 X 8%)
$2,500,000 (400,000) $2,100,000
Net income applicable to common stock $2,100,000 = Weighted-average number of shares outstanding 1,775,000 = $1.18 LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.19 (20–25 minutes) Earnings per share of common stock: Income from continuing operations* Loss from discontinued operations, net of tax** Net income***
$1.78 (.16) $1.62
Income data: Income from continuing operations Deduct 6% dividend on preferred stock Common stock income from continuing operations Deduct loss from discontinued operations, net of tax Net income available for common stockholders Dates Outstanding
Shares Outstanding
$15,000,000 300,000 14,700,000 1,340,000 $13,360,000
Fraction of Year
Weighted Shares
January 1–March 31 7,500,000 3/12 April 1–December 31 8,500,000 9/12 Weighted-average number of shares outstanding
1,875,000 6,375,000 8,250,000
*$14,700,000 ÷ 8,250,000 shares = $1.78 per share (income from continuing operations) **($1,340,000) ÷ 8,250,000 shares = ($.16) per share (discontinued operations loss, net of tax) ***$13,360,000 ÷ 8,250,000 shares = $1.62 per share (net income) LO: 4, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.20 (10–15 minutes) Income from continuing operations Discontinued operations gain, net of applicable income tax of $18,000 Net income Per share of common stock: Income from continuing operations* Discontinued operations gain, net of tax** Net income***
$300,000 72,000 $372,000 $ .84 .25 $1.09
Exercise 15.20 (Continued) Dates Outstanding
Shares Outstanding
Fraction of Year
Weighted Shares
January 1–March 31 200,000 3/12 April 1–June 30 250,000 3/12 July 1–Sept. 30 330,000 3/12 Oct. 1–Dec 31. 360,000 3/12 Weighted-average number of shares outstanding
50,000 62,500 82,500 90,000 285,000
$300,000 – preferred dividends of $60,000 (6% of $1,000,000) = $240,000 (income available to common stockholders) ***$240,000 ÷ 285,000 shares = $.84 per share (income from continuing operations) ***$72,000 ÷ 285,000 shares = $.25 per share (discontinued gain, net of tax) ***$312,000 ÷ 285,000 shares = $1.09 per share (net income)
Note: Net income available to common stock of $312,000 (Net income of $372,000 less preferred dividends of $60,000). LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.21 (10–15 minutes)
Event Beginning balance Issued shares Reacquired shares
Dates Shares Outstanding Outstanding Jan. 1–March 31 900,000 April 1–Sept. 30 1,350,000 Oct. 1–Dec. 31 1,240,000
Fraction of Year 3/12 6/12 3/12
Weighted-average number of shares outstanding— unadjusted Stock dividend, 2/15/2026 Weighted-average number of shares outstanding— adjusted
Weighted Shares 225,000 675,000 310,000
1,210,000 X 1.05 1,270,500
Exercise 15.21 (Continued) Net income Preferred dividend (280,000 X $50 X 7%)
$2,530,000 (980,000) $1,550,000
Earnings per share for 2025: Net income applicable to common stock
=
Weighted-average number of shares outstanding
$1,550,000
= $1.22
1,270,500
LO: 4, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.22 (20–25 minutes) (a) Revenues Expenses: Other than interest Bond interest (60 X $1,000 X .08) Income before income taxes Income taxes (20%) Net income
$17,500 $8,400 4,800
13,200 4,300 860 $ 3,440
Diluted earnings per share: $3,440 + (1 – .20)($4,800) = $7,280 2,000 + 6,000 8,000
=
$.91
(b) Revenues Expenses: Other than interest Bond interest (60 X $1,000 X .08 X 4/12) Income before income taxes Income taxes (20%) Net income
$17,500 $8,400 1,600
10,000 7,500 1,500 $ 6,000
Diluted earnings per share: $6,000 + (1 – .20)($1,600) 2,000 + (6,000 X 1/3 yr.)
Exercise 15.22 (Continued)
= $7,280 4,000
=
$1.82
(c) Revenues Expenses: Other than interest Bond interest (60 X $1,000 X .08 X 1/2) Bond interest (40 X $1,000 X .08 X 1/2) Income before income taxes Income taxes (20%) Net income
$17,500 $8,400 2,400 1,600
12,400 5,100 1,020 $ 4,080
Diluted earnings per share (see note): $4,080 + (1 – .20)($4,000) 2,000 + (2,000 X 1/2 yr.) + 4,000 + (2,000 X 1/2)
=
$7,280 8,000
=
$.91
Note: The answer is the same as (a). In both (a) and (c), the bonds are assumed converted for the entire year. LO: 5, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.23 (15–20 minutes) (a) (1)
Number of shares for basic earnings per share. Dates Outstanding
Shares Outstanding
Fraction of Year
Weighted Shares
Jan. 1–Mar. 31 800,000 3/12 200,000 April 1–Dec. 1 1,200,000 9/12 900,000 Weighted-average number of shares outstanding 1,100,000 OR Number of shares for basic earnings per share: Initial issue of stock April 1, 2025 issue (3/4 X 400,000) Total
800,000 shares 300,000 shares 1,100,000 shares
Exercise 15.23 (Continued) (2)
Number of shares for diluted earnings per share: Dates Outstanding
Shares Outstanding
Fraction of Year
Jan. 1–Mar. 31 800,000 3/12 April 1–June 30 1,200,000 3/12 July 1–Dec. 31 1,224,000* 6/12 Weighted-average number of shares outstanding
Weighted Shares 200,000 300,000 612,000 1,112,000
*1,200,000 + [($600,000 ÷ 1,000) X 40] (b) (1) (2)
Earnings for basic earnings per share: After-tax net income Earnings for diluted earnings per share: After-tax net income Add back interest on convertible bonds (net of tax): Interest ($600,000 X .08 X 1/2) Less income taxes (20%) Total
$1,540,000 $1,540,000 $24,000 4,800
19,200 $1,559,200
[Note to instructor: In this problem, the earnings per share computed for basic earnings per share is $1.40 ($1,540,000 ÷ 1,100,000) and the diluted earnings per share is $1.40 (technically $1.40215). As a result, only one earnings per share number would be presented.] LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.24 (20–25 minutes) (a) Net income for basic earnings per share Add: Adjustment for interest (net of tax) Net income for diluted earnings per share *Maturity value Stated rate Cash interest Discount amortization [(1.00 – .98) X $5,000,000 X 1/10] Interest expense 1 – tax rate (20%) After-tax interest
$9,500,000 288,000* $9,788,000 $5,000,000 X ,07 350,000 10,000 360,000 X .80 $ 288,000*
$5,000,000/$1,000 = 5,000 debentures Increase in diluted earnings per share denominator: 5,000 X 18 90,000 Earnings per share: Basic EPS Diluted EPS
$9,500,000 ÷ 2,000,000 = $4.75 $9,788,000 ÷ 2,090,000 = $4.68
(b) If the convertible security were preferred stock, basic EPS would be the same assuming there were no preferred dividends declared and the preferred was noncumulative. For diluted EPS, the numerator would be the net income amount and the denominator would be 2,090,000. That is, any preferred dividends would not be deducted from the numerator for diluted EPS. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.25 (10–15 minutes) (a) Net income Add: Interest savings (net of tax) [$120,000 X (1 – .20)] Adjusted net income $2,000,000 ÷ $1,000 = 2,000 bonds X 15 30,000 shares Diluted EPS: $496,000 ÷ (100,000 + 30,000) = $3.82
$400,000 96,000 $496,000
Exercise 15.25 (Continued) Note: Basic EPS ($400,000 ÷ 100,000) = $4.00 which is greater than dilutive EPS. (b) Shares outstanding Add: Shares assumed to be issued (10,000* X 5) Shares outstanding adjusted for dilutive securities
100,000 50,000 150,000
*$1,000,000 ÷ $100 Diluted EPS: ($400,000 – $0) ÷ 150,000 = $2.67 Note: Preferred dividends are not deducted since preferred stock was assumed converted into common stock. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 15.26 (20–25 minutes) (a) Shares assumed issued on exercise Proceeds (1,000 X $6 = $6,000) Less: Treasury shares purchased ($6,000/$20) Incremental shares
Diluted EPS =
Diluted 1,000 300 700
$50,000 = $4.67 (rounded) 10,000 + 700
(b) Shares assumed issued on exercise Proceeds = $6,000 Less: Treasury shares purchased ($6,000/$20)
Diluted 1,000 300 700 X 3/12
Incremental shares Diluted EPS =
$50,000 = $4.91 (rounded) 10,000 + 175
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
175
Exercise 15.27 (10–15 minutes) (a) The contingent shares would have to be reflected in diluted earnings per share because the earnings level is currently being attained. (b) Because the earnings level is not being currently attained, contingent shares are not included in the computation of diluted earnings per share. LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 15.28 (15–20 minutes) (a)
Diluted The warrants are dilutive because the option price ($10) is less than the average market price ($15). Incremental shares =
$15 – $10 X 15,000 = $15
5,000
OR Proceeds from assumed exercise: (15,000 warrants X $10 exercise price) Treasury shares purchasable with proceeds: ($150,000 ÷ $15 average market price) Incremental shares issued: (15,000 shares issued less 10,000 purchased) (b) Basic EPS = $3.60 ($360,000 ÷ 100,000 shares) (c) Diluted EPS = $3.43 ($360,000 ÷ 105,000 shares) LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$150,000 10,000 5,000
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Schedule of Compensation Expense Stock Appreciation Rights (150,000)
Date
Fair Value
Cumulative Compensation Recognizable
Percentage Accrued
Compensation Accrued to Date
Expense 2022
12/31/22
$4
$600,000
25%
$ 150,000 (75,000) 75,000 1,050,000 1,125,000 225,000 $1,350,000
$150,000
12/31/23 12/31/24 12/31/25
1 10 9
150,000 1,500,000 1,350,000
50% 75% 100%
Expense 2023
Expense 2024
$(75,000) $1,050,000 $225,000
(For Instructor Use Only)
(b) Compensation Expense ............................................................. Liability under Stock Appreciation Plan ............................
225,000
(c) Liability under Stock Appreciation Plan ................................... Cash (150,000 X $9) .............................................................
1,350,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Expense 2025
225,000 1,350,000
*Exercise 15.29 (15–25 Minutes)
Copyright © 2022 WILEY
(a)
15-38
(a)
Schedule of Compensation Expense Stock Appreciation Rights (30,000) Cumulative Compensation Recognizable
Percentage Accrued
12/31/22
$6
$180,000
25%
12/31/23 Copyright © 2022 WILEY
12/31/24 12/31/25 12/31/26
9 15 6 18
270,000 450,000 180,000 540,000
50% 75% 100% —
Compensation Accrued to Date $ 45,000 90,000 135,000 202,500 337,500 (157,500) 180,000 360,000 $540,000
Expense 2022
Expense 2023
Expense 2024
Expense 2025
Expense 2026
$45,000 $90,000 $202,500 $(157,500) $360,000
Kieso, Intermediate Accounting, 18/e, Solutions Manual
(b) 2022 Compensation Expense .................................................................... Liability under Stock Appreciation Plan ....................................
45,000
2025 Liability under Stock Appreciation Plan .......................................... Compensation Expense .............................................................
157,500
2026 Compensation Expense .................................................................... Liability under Stock Appreciation Plan ....................................
360,000
(For Instructor Use Only)
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
45,000
157,500
360,000
*Exercise 15.30 (15–25 Minutes)
15-39 Date
Fair Value
Time and Purpose of Problems Problem 15.1 (Time 35–40 minutes) Purpose—to provide the student with an opportunity to prepare entries to properly account for a series of transactions involving the issuance and exercise of common stock rights and detachable stock warrants, plus the granting and exercise of stock options. The student is required to prepare the necessary journal entries to record these transactions and the stockholders’ equity section of the balance sheet as of the end of the year. Problem 15.2 (Time 45–50 minutes) Purpose—to provide the student with an understanding of the entries to properly account for convertible debt. The student is required to prepare the journal entries to record the conversion, amortization, and interest in connection with these bonds on specified dates. Problem 15.3 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the entries to properly account for a stockoption plan over a period of years. The student is required to prepare the journal entries when the stock-option plan was adopted, when the options were granted, when the options were exercised, and when the options expired. Problem 15.4 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the entries to properly account for a stock option and restricted stock plan. The student is asked to identify the important features of an employee stock-purchase plan. Problem 15.5 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the effect options and convertible bonds have on the computation of the weighted-average number of shares outstanding with regard to basic EPS and diluted EPS. Preferred stock dividends must also be computed. Problem 15.6 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the proper computation of the weightedaverage number of shares outstanding for two consecutive years. The student is also asked to determine whether the capital structure presented is simple or complex. A two-year comparative income statement with appropriate EPS presentation is also required. Problem 15.7 (Time 35–45 minutes) Purpose—to provide the student with an opportunity to calculate the number of shares used to compute basic and diluted earnings per share which is complicated by a stock dividend, a stock split, and several issues of common stock during the year. To be determined are the number of shares to compute basic EPS, the number of shares to compute diluted EPS, and the numerator for computing basic EPS. Problem 15.8 (Time 25–35 minutes) Purpose—to provide the student with a problem with multiple dilutive securities which must be analyzed to compute basic and diluted EPS. Problem 15.9 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to calculate the weighted-average number of common shares for computing earnings per share and to prepare a comparative income statement including earnings per share data. In addition, the student explains a simple capital structure and the earnings per share presentation for a complex capital structure.
Solutions to Problems Problem 15.1
(a) 1.
2.
Memo Entry (memo entry made to indicate the number of rights issued). Cash .................................................................. Discount on Bonds Payable* .......................... Bonds Payable ......................................... Paid-in Capital—Stock Warrants** ..........
208,000 8,000 200,000 16,000
**Allocated to Bonds: $96 X $208,000 = $192,000; $96 + $8 Discount = $200,000 – $192,000 = $8,000 **Allocated to Warrants: $8 X $208,000 = $16,000 $96 + $8 3.
Cash* ................................................................ Common Stock (9,500 X $10) .................. Paid-in Capital in Excess of Par— Common Stock .................................
304,000 95,000 209,000
*[(100,000 – 5,000) rights exercised ÷ *[(10 rights/share)] X $32 = $304,000 4.
Cash* ................................................................ Paid-in Capital—Stock Warrants ($16,000 X 80%) ........................................... Common Stock (1,600 X $10) .................. Paid-in Capital in Excess of Par— Common Stock ...................................... *.80 X $200,000/$100 per bond = 1,600 *warrants exercised; 1,600 X $30 = $48,000
48,000 12,800 16,000 44,800
Problem 15.1 (Continued) 5.
Compensation Expense* ................................ Paid-in Capital—Stock Options ..............
100,000 100,000
*$10 X 10,000 options = $100,000 6.
For options exercised: Cash (9,000 X $30)........................................... Paid-in Capital—Stock Options (.90 X $100,000) ............................................ Common Stock (9,000 X $10) .................. Paid-in Capital in Excess of Par— Common Stock ..................................... For options lapsed: Paid-in Capital—Stock Options...................... Compensation Expense ..........................
270,000 90,000 90,000 270,000 10,000 10,000
(Note to instructor: This entry provides an opportunity to indicate that a credit to Compensation Expense occurs when the employee fails to fulfill an obligation, such as remaining in the employ of the company. Conversely, if a stock option lapses because the stock price is lower than the exercise price, then a credit to Paid-in Capital—Expired Stock Options occurs.) (b) Stockholders’ Equity: Paid-in Capital: Common Stock, $10 par value, authorized 1,000,000 shares, 320,100a shares issued and outstanding ......................... Paid-in Capital in Excess of Par— Common Stock*...................................... Paid-in Capital—Stock Warrants* ............ Retained Earnings ............................................ Total Stockholders’ Equity .......................
$3,201,000 1,123,800 3,200 $4,328,000 750,000 $5,078,000
*These two accounts often are combined into one category called Additional Paid-in Capital, for financial reporting purposes.
Problem 15.1 (Continued) Calculations:
At beginning of year ....................... From stock rights (entry #3) .......... From stock warrants (entry #4) ..... From stock options (entry #6) ....... Total .........................................
Common Stock
Paid-in Capital in Excess of Par
300,000 shares 9,500 shares 1,600 shares 9,000 shares a 320,100 shares
$ 600,000 209,000 44,800 270,000 $1,123,800
LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None
Problem 15.2
(a)
Entries at August 1, 2026 Bonds Payable ......................................................... Discount on Bonds Payable (Schedule 1) ...... Common Stock (8 X 250 X $100) ..................... Paid-in Capital in Excess of Par— Common Stock .............................................. (To record the issuance of 2,000 shares of common stock in exchange for $250,000 of bonds and the write-off of the discount on bonds payable)
250,000 4,815* 200,000 45,185**
*($54,000 X 1/10) X (107/120) **($250,000 – $4,815) – $200,000 Interest Payable ....................................................... Cash ($250,000 X .12 X 1/12) ............................ (To record payment in cash of interest accrued on bonds converted as of August 1, 2026)
2,500 2,500
Problem 15.2 (Continued) (b)
Entries at August 31, 2026 Interest Expense...................................................... Discount on Bonds Payable (Schedule 1) ...... (To record amortization of one month’s discount on $2,250,000 of bonds)
405* 405
*($54,000 X 90%) X (1/120) Interest Expense...................................................... Interest Payable ($2,250,000 X .12 X 1/12) ...... (To record accrual of interest for August on $2,250,000 of bonds at 12%) (c)
22,500 22,500
Entries at December 31, 2026 (Same as August 31, 2026, and the following closing entry) Income Summary .................................................... Interest Expense (schedule 2) ......................... (To close expense account)
292,675 292,675
Schedule 1 Monthly Amortization Schedule Unamortized discount on bonds payable: Amount to be amortized over 120 months ..................................... Amount of monthly amortization ($54,000 ÷ 120) .......................... Amortization for 13 months to July 31, 2026 ($450 X 13) .............. Balance unamortized 7/31/26 ($54,000 – $5,850)............................ 10% applicable to debentures converted ....................................... Balance August 1, 2026 ................................................................... Remaining monthly amortization over remaining 107 months ($43,335 ÷ 107) ...............................................................................
$54,000 $ 450 $ 5,850 $48,150 (4,815) $43,335 $
405
Schedule 2 Interest Expense Schedule Amortization of bond discount charged to bond interest expense in 2026 would be as follows: 7 months X $450 ............................... $3,150 5 months X $405 ............................... 2,025 Total ........................................... $5,175 Problem 15.2 (Continued)
Interest on Bonds: 12% on $2,500,000 ........................................................................... Amount per month ($300,000 ÷ 12) ................................................ 12% on $2,250,000 ........................................................................... Amount per month ($270,000 ÷ 12) ................................................ Interest for 2026 would be as follows: 7 months X $25,000.................................................................. 5 months X $22,500.................................................................. Total .................................................................................. Total interest Amortization of discount .................. Cash interest paid ............................. Bond interest expense .....................
$
5,175 287,500 $292,675
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 45-50, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$300,000 $ 25,000 $270,000 $ 22,500 $175,000 112,500 $287,500
Problem 15.3 2024
No journal entry would be recorded at the time the stock option plan was adopted. However, a memorandum entry in the journal might be made on November 30, 2024, indicating that a stock option plan had authorized the future granting to officers of options to buy 70,000 shares of $5 par value common stock at $9 a share.
2025
January 2 No entry December 31 Compensation Expense .................................... Paid-in Capital—Stock Options ................ (To record compensation expense attributable to 2025—22,000 options at $4)
2026
December 31 Compensation Expense .................................... Paid-in Capital—Stock Options ................ (To record compensation expense attributable to 2026—20,000 options at $4)
88,000 88,000
80,000 80,000
Problem 15.3 (Continued) Paid-in Capital—Stock Options ....................... Paid-in Capital—Expired Stock Options ................................................... (To record lapse of president’s and vice president’s options to buy 22,000 shares) 2027
December 31 Cash (20,000 X $9) ............................................ Paid-in Capital—Stock Options (20,000 X $4) ................................................... Common Stock (20,000 X $5) ................... Paid-in Capital in Excess of Par— Common Stock ....................................... (To record issuance of 20,000 shares of $5 par value stock upon exercise of options at option price of $9)
88,000 88,000
180,000 80,000 100,000 160,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 15.4 January 1, 2025 (a)
No entry December 31, 2025 Compensation Expense ([$6 X 5,000] ÷ 5) .... Paid-in Capital—Stock Options ............
6,000 6,000
January 1, 2025 (b)
Unearned Compensation ($40 X 700) ........... Common Stock ($1 X 700) ..................... Paid-in Capital in Excess of Par— Common Stock ...................................
28,000 700 27,300
December 31, 2025 Compensation Expense ($28,000 ÷ 5)........... Unearned Compensation ...................... (c)
(c) (d)
5,600 5,600
January 1, 2025 No entry. December 31, 2025 Compensation Expense ($28,000 ÷ 5)........... Paid-in Capital-Restricted Stock Units .
5,600 5,600
No change for part (a), unless the fair value of the options change. For part (b): January 1, 2025 Unearned Compensation ($45 X 700) ........... Common Stock ($1 X 700) ..................... Paid in Capital in Excess of Par— Common Stock ...................................
Problem 15.4 (Continued)
31,500 700 30,800
December 31, 2025 Compensation Expense ($31,500 ÷ 5) .......... Unearned Compensation .....................
6,300 6,300
For part (c): January 1, 2025 No entry. December 31, 2025 Compensation Expense ($31,500 ÷ 5) ........... Paid-in Capital-Restricted Stock Units . (e)
6,300 6,300
Numbers (1) substantially all employees may participate; (2) The discount from market is small (less than 5%); and (3) The plan offers no substantive option feature, are the three criteria that must be met for an employee stock-purchase plan to be non-compensatory. The fourth provision—there is no preferred stock outstanding—is irrelevant.
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Problem 15.5
The computation of Fitzgerald Pharmaceutical Industries’ basic earnings per share and the diluted earnings per share for the fiscal year ended June 30, 2025, are shown below. (a) Basic earnings per share
Net income – Preferred dividends = Weighted-average number of shares outstanding $1,500,000 – $75,0001 = 1,000,000 =
$1,425,000 1,000,000
= $1.425 or $1.43 per share 1
Preferred dividend = .06 X $1,250,000 = $75,000
(b) Diluted earnings per share =
Net income – Preferred dividends + Interest (net of tax) Weighted-average number of shares outstanding + Potentially dilutive common shares
=
$1,500,000 – $75,0001 + $320,0002 1,000,000 + 250,0003 + 50,0004
=
$1,745,000 1,300,000
= $1.3423 or $1.34 per share Use “if converted” method for 8% bonds Adjustment for interest expense (net of tax) ($5,000,000 X .08 X .8) ............................................. *Problem 15.5 (Continued) 2
$320,000
3
4
Shares assumed to be issued if converted $5,000,000 ÷ $1,000/bond X 50 shares ........................
250,000
Use treasury stock method to determine incremental shares outstanding Proceeds from exercise of options (200,000 X $15) ..........................................................
$3,000,000
Shares issued upon exercise of options .................... Shares purchasable with proceeds (Proceeds ÷ Average market price) ($3,000,000 ÷ $20) ..................................................... Incremental shares outstanding.......................... LO: 5, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
200,000 (150,000) 50,000
Problem 15.6
(a) Melton Corporation has a simple capital structure since it does not have any potentially dilutive securities. (b) The weighted-average number of shares outstanding that Melton Corporation would use in calculating earnings per share for the fiscal years ended May 31, 2025, and May 31, 2026, is 1,600,000 and 2,200,000 respectively, calculated as follows: Event
Dates Outstanding
Beginning balance June 1–Sept. 30 New Issue Oct. 1–May 31
Event Beginning balance New Issue
Dates Outstanding June 1–Nov. 30 Dec. 1–May 31
Shares Fraction Outstanding Restatement of Year 1,000,000 1,500,000
1.20 1.20
4/12 8/12
Shares Fraction Outstanding Restatement of Year 1,800,000 2,600,000
6/12 6/12
Weighted Shares 400,000 1,200,000 1,600,000 Weighted Shares 900,000 1,300,000 2,200,000
Problem 15.6 (Continued) (c)
MELTON CORPORATION Comparative Income Statement For Fiscal Years Ended May 31, 2025 and 2026 2025
2026
Income from operations .......................................... $1,800,000 Interest expense1 ..................................................... 240,000 Income before taxes ................................................ 1,560,000 Income taxes at 20% ................................................ 312,000 Net income................................................................ $1,248,000
$2,500,000 240,000 2,260,000 452,000
Income from continuing operations Loss from discontinued operations net of income taxes of $120,000.................................... Net income ........................................................
1,808,000
Earnings per share (May 31, 2025) Net income ........................................................ Earnings per share (May 31, 2026) Income from continuing operations ……………. Loss from discontinued operations, net of income taxes ........................................................ Net income ........................................................
480,000 $1,328,000 $ 0.742 $0.793 0.224 $0.575
Problem 15.6 (Continued) 1
Interest expense
2
= $2,400,000 X .10 = $240,000
Earnings per share =
=
(Net Income – Preferred Dividends) Weighted-Average Number of Common Shares ($1,248,000 − $60,000*) 1,600,000
= $0.74 per share *Preferred dividends = (No. of Shares X Par Value X Dividend %)
= (20,000 X $50 X .06) = $60,000 per year 3
Earnings per share =
($1,808,000 – $60,000) 2,200,000
= $0.79 per share
4
Earnings per share = =
Loss from Discontinued Operations Weighted-Average Number of Shares Outstanding ($480,000) 2,200,000
= ($0.22) per share
5
Earnings per share = =
Net Income – Preferred Dividends Weighted-Average Number of Shares Outstanding $1,328,000 – $60,000 2,200,000
= $0.58 (Difference due to rounding) LO: 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 15.7
(a) The number of shares used to compute basic earnings per share is 4,951,000, as calculated below. Dates Shares Fraction Weighted Event Outstanding Outstanding Restatement of Year Shares Beginning Balance, including 5% stock dividend Jan. 1–Mar. 31 2,100,000 2.0 3/12 1,050,000 Conversion of preferred stock Apr. 1–June 30 2,520,000 2.0 3/12 1,260,000 Stock split July 1–July. 31 5,040,000 1/12 420,000 Issued shares for building Aug. 1–Oct. 31 5,340,000 3/12 1,335,000 Purchase of Treasury stock Nov. 1–Dec. 31 5,316,000 2/12 886,000 Total number of common shares to compute basic earnings per share 4,951,000
(b) The number of shares used to compute diluted earnings per share is 5,791,000, as shown below. Number of shares to compute basic earnings per share ................................. Convertible preferred stock— still outstanding (300,000 X 2 X 1.05) ............. Convertible preferred stock— converted (400,000 X 2 X 1.05 X 3/12) ............. Number of shares to compute diluted earnings per share ...........................................
4,951,000 630,000 210,000 5,791,000
(c) The adjusted net income to be used as the numerator in the basic earnings per share calculation for the year ended December 31, 2026, is $10,350,000, as computed below. After-tax net income ........................................... Preferred stock dividends March 31 (700,000 X $.75) ........................... June 30, September 30, and December 31 (300,000 X $.75 X 3) .................................. Adjusted net income
$11,550,000 $525,000 675,000
(1,200,000) $10,350,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 15.8 (a)
$1,200,000 – $240,000** 600,000*
Basic EPS =
= $1.60 per share *$6,000,000 ÷ $10 **$4,000,000 X .06 (b)
Diluted EPS
(Net income – Preferred dividends) = Weighted-average number of shares outstanding + Potentially dilutive common shares = =
$1,200,000 – $240,000** 600,000* + 15,000a $960,000 615,000
= $1.56 per share a
Market price – Option price X Number of options = incremental shares Market price $25 – $20 X 75,000 = 15,000 $25
The convertible preferred stock and the convertible bonds are not included since conversion would be antidilutive. Following the procedures in Appendix 16B for analysis of multiple dilutive securities, we first compute the dilutive effect for each security and rank from smallest to largest: Options: $0/15,000 = $0 Convertible bonds: $112,000/60,000 = $1.87 Preferred: $240,000/120,000 = $2 EPS with options: $1,200,000 – $240,000 = $1.56 600,000 + 15,000 This is less than basic EPS. =
Problem 15.8 (Continued) Continuing to bonds: =
=
$1,200,000 – $240,000 + $112,000b 600,000 + 15,000 + 60,000c $1,072,000 675,000
= $1.59 per share $2,000,000 X .07 X (1 – .20) ($2,000,000 ÷ $1,000) X 30 shares/bond
b c
$1.59 > $1.56, which is greater than diluted EPS with the options. Thus, we exclude the convertible bonds from EPS calculations. Continuing to the preferred stock: Diluted EPS with preferred.
=
=
$1,200,000 600,000 + 15,000 + 120,000 $1,200,000 735,000
= $1.63 per share > $1.56 with just the options (we ignore the bonds). Thus, the convertible preferred is antidilutive. That is, conversion of the preferred stock increases the numerator $240,000 ($4,000,000 X .06) and the denominator 120,000 shares [(4,000,000 ÷ 100) X 3]. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 15.9
(a)
Weighted-Average Shares
Total as of June 1, 2024 Issue of September 1, 2024 Total as of May 31, 2026
(b)
Before Stock Dividend 1,000,000 400,000 1,400,000
After Stock Dividend 1,200,000 480,000 1,680,000
1. 1,200,000 X 3/12 = 1,680,000 X 9/12 = Total
300,000 1,260,000 1,560,000
2. 1,680,000 X 12/12
1,680,000
CHRISTINA CORPORATION Comparative Income Statement For the Years Ended May 31, 2026 and 2025 2026 $1,400,000 280,000 1,120,000
2025 $660,000 132,000 528,000
320,000 $ 800,000
$528,000
Per share of common stock Income from continuing operations .................. Loss from discontinued operations, net of tax ...................................................................
$0.521 (0.19)4
$0.183 –
Net income .............................................................
$0.332
$0.18
Income from operations before income taxes .... Income taxes (20%) ............................................... Income from continuing operations .................... Loss from discontinued operations less applicable income taxes of $80,000.......... Net income .............................................................
Problem 15.9 (Continued) EPS calculations =
Net income – Preferred dividends Weighted-average common shares
Preferred dividends = 40,000 X $100 X .06 = $240,000 Discontinued operations loss per share calculation
=
Loss from discontinued operations Weighted-average common shares
($1,120,000 – $240,000) ÷ 1,680,000 = $0.52 ($800,000 – $240,000) ÷ 1,680,000 = $0.33 3 ($528,000 – $240,000) ÷ 1,560,000 = $0.18 4 ($320,000) ÷ 1,680,000 = ($0.19) 1 2
(c) 1.
A corporation’s capital structure is regarded as simple if it consists only of common stock and includes no potentially dilutive securities. Christina Corporation has a simple capital structure because it has not issued any convertible securities, warrants, or stock options, and there are no existing rights or securities that are potentially dilutive of its earnings per common share.
2.
A corporation having a complex capital structure would be required to make a dual presentation of earnings per share; i.e., both basic earnings per share and diluted earnings per share. This assumes that the potentially dilutive securities are not antidilutive. The basic earnings per share computation uses only the weightedaverage of the common stock outstanding. The diluted earnings per share computation assumes the conversion or exercise of all potentially dilutive securities that are not antidilutive.
LO: 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UYJ 15.1 Financial Reporting Problem (a) (1) Under P&G’s stock-based compensation plan (Note 7), 14,277,000 options were granted during 2020. (2) At June 30, 2020, 102,702,000 options were exercisable by eligible managers. (3) In 2020, 28,722,000 options were exercised at an average price of $70.34. (4) The total stock–based compensation expense for stock options was $249,000,000, $246,000,000 and $220,000,000 for 2020, 2019 and 2018, respectively. Total compensation expense for restricted stock, RSUs and PSUs was $309,000,000, $269,000,000, and $175,000,000 in 2020, 2019, and 2018 respectively. (5) The accounts to which the proceeds from these option exercises are credited are Common Stock and Additional Paid-in Capital. (6) The number of outstanding options at June 30, 2020, is 149,872,000 at an average exercise price of $84.71. (b)
(In millions—except per share) Weighted-average common shares Diluted earnings per share
2020 2,625.8 $4.96
2019 2,539.5 $1.43
2018 2,656.7 $3.67
(c) In addition to options, P&G has restricted stock, restricted stock unit (RSU) and performance stock unit (PSU) awards for key managers and directors. LO: 1, 5, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 15.2 Comparative Analysis Case (a)
Coca-Cola sponsors restricted stock award plans, performance share units and stock option plans under its 2014 Equity plan. PepsiCo grants stock options to employees under its Long-Term Incentive Plan.
(b) Options outstanding at year-end 2020
Coca-Cola 88,000,000
PepsiCo 10,640,000
Options granted during 2020
Coca-Cola 7,000,000
PepsiCo 1,847,000
Options exercised during 2020
Coca-Cola 23,000,000
PepsiCo 2,440,000
Average exercise price during 2020
Coca-Cola $35.67
PepsiCo $73.37
(c)
(d)
(e)
(f)
Diluted Earnings Per Share Coca-Cola PepsiCo 2020 $1.79 $5.12 2019 $2.07 $5.20 2018 $1.50 $8.78
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 15.3 Financial Statement Analysis Case (a) Account 2025 (,000) Current Liabilities 554,114 Convertible Debt 648,020 Total Liabilities 1,228,313 Stockholders’ Equity 176,413 Net Income 58,333 (1) Return on Assets
4.15% = Net Income/Total Assets $58,333/($1,228,313 + $176,413) (2) Return on Common 33.07% = Net Income/Stockholders’ Stockholders’ Equity Equity $58,333/$176,413 (3) Debt to Assets 87.44% = Total Debt/Total Assets $1,228,313/($1,228,313 + $176,413) (b) Ragatz is doing very well. Its ROA and ROE are above the industry average. However, its debt level is quite high, compared to the industry. This may suggest it is a riskier investment and may require a higher rate of return than the 5% coupon. Investors likely were attracted to the convertible bonds due to the possibility that Ragatz’s stock price will increase, and they can cash in on these gains when they convert to common stock. (c) Under GAAP, the debt and equity components of a convertible bond are not separately recorded as liabilities and stockholders’ equity. If Merck had non-convertible bonds with detachable warrants, Merck would allocate the bond amount between debt and equity. Therefore, the same should be done for Ragatz to make its ratios comparable Assuming an equity component of $150,000, for the Ragatz bonds, the following adjusted amounts would be used in the analysis. Reclassified: Account 2025 (,000) Current Liabilities 554,114 Convertible Debt 498,020 Total Liabilities 1,078,313 Stockholders’ Equity 326,413 Net Income 58,333 (1) Return on Assets (2) Return on Common Stockholders’ Equity (3) Debt to Assets
4.15% = Net Income/Total Assets 17.9% = Net Income/Stockholders’ Equity $58,333/$326,413 76.8% = Total Debt/Total Assets $1,078,313/($1,078,313 + $326,413)
Financial Statement Analysis Case (Continued) The adjustment results in Ragatz reporting a higher level of stockholders’ equity and less debt. Although Ragatz reports the same ROA, but lower ROE, the debt to assets ratio is in line with the industry level, suggesting Ragatz may not be as risky as the earlier analysis suggests. The 5% rate may be about right. LO: 1, Bloom: K, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 15.4 Accounting, Analysis, and Principles Accounting (a)
Under U.S. GAAP, proceeds from the issuance of convertible debt are recorded entirely as debt.
Cash .................................................................. Bonds Payable ........................................
200,000
(b)
2025
2024
Net income (a)
$30,000
$27,000
Weighted-average number of shares outstanding (b)
10,000
10,000
Basic EPS (a ÷ b)
$3.00
$2.70
Net income
$30,000
$27,000
Add: Interest savings ($200,000 X 6%)
12,000
12,000
Adjusted net income (a)
$42,000
$39,000
Outstanding shares
10,000
10,000
Shares upon conversion (200 X 30)
6,000
6,000
Total shares for diluted EPS (b)
16,000
16,000
Diluted EPS (a ÷ b)
$2.63
$2.44
200,000
Basic EPS
Diluted EPS
Accounting, Analysis, and Principles (Continued) (c) Bond Conversion Expense** ............................ Bonds Payable ................................................... Common Stock* ...................................... Paid-in-Capital in Excess of Par— Common Stock* ................................. Cash .........................................................
7,500 150,000 9,000 141,000 7,500
*$200,000 X .75 = $150,000 of bonds converted $150,000 ÷ $1,000 per bond = 150 bonds 150 bonds X 30 shares per bond = 4,500 new shares issued 4,500 shares X $2 par value = $9,000 increase in common stock account $150,000 - $9,000 = $141,000 increase in paid-in capital account **150 bonds X $50 per bond = $7,500 bond conversion expense
Analysis EPS Presentation: Net income Basic EPS Diluted EPS
2025 $30,000 $3.00 $2.63
2024 $27,000 $2.70 $2.44
EPS standards are important to analysts who rely on reported earnings per share numbers in their analyses. A price-earnings (P-E) ratio is the price per share divided by earnings per share. Analysts use P-E ratios in a variety of analyses, including the evaluation of earnings quality and the assessment of a company's growth prospects. The more variation in how companies compute EPS, the less comparable are EPS numbers across companies and across time for the same company.
Accounting, Analysis, and Principles (Continued) Principles IFRS for convertible debt primarily differs from U.S. GAAP on convertible debt in that IFRS requires that companies split the proceeds from issuance into a debt component and an equity component. For example, in part (a) we recorded the proceeds from Garner’s bond issue entirely as bonds payable – a liability. Under IFRS, Garner would be required to estimate the portion of the proceeds attributable to the equity component of the bonds. If, for example, Garner estimated the equity component of the convertible bonds to be worth $70,000 Garner would make an entry like this: Cash .................................................................. Discount on Bonds Payable ............................ Bonds Payable ........................................ Share Premium-Conversion Equity .......
200,000 70,000 200,000 70,000
Supporters of the IFRS treatment would argue that separating the bond issue into liability and equity components provides more representational faithful information into the financial statements. That is, the resulting financial statements do a better job of representing the underlying economics of the transaction. When bond investors buy bonds with a conversion feature, they are very likely paying something for the option to convert (i.e., investors value the option to become equity holders). Supporters of the U.S. treatment would argue that estimating the value of the conversion option is difficult and that the resulting number is not very reliable. Thus, IFRS potentially sacrifices reliability in favor of representationally faithfulness while U.S. GAAP does the reverse. LO: 1, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, Research, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 15.1 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the underlying rationale behind the accounting treatments for the issuance of convertible bonds versus the situation when the debt instrument and the warrants are separable. The student is required to describe the differences that exist in accounting for the original proceeds of these two types of issuances, and the arguments which have been presented in support of these differences. This case also requires the interpretation of a situation involving an issuance of long-term notes and warrants, and the preparation of the necessary journal entry. CT 15.2 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss the ethical issues related to an earnings– based compensation plan. CT 15.3 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the proper accounting and conceptual merits for the issuance of stock warrants to three different groups: existing stockholders, key employees, and purchasers of the company’s bonds. This problem requires the student to explain and discuss the reasons for using warrants, the significance of the price at which the warrants are issued (or granted) in relation to the current market price of the company’s stock, and the necessary information that should be disclosed in the financial statements when stock warrants are outstanding for each of the groups. CT 15.4 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to respond to a contrary view of the FASB’s standard on “Accounting for Stock-Based Compensation,” and to defend the concept of neutrality in financial accounting and reporting. CT 15.5 (Time 25–35 minutes) Purpose—to provide the student with an understanding of how earnings per share is affected by preferred dividends and convertible debt. The student is required to explain how preferred dividends and convertible debt are handled for EPS computations. The student is also required to explain when the “treasury stock method” is applicable in EPS computations. CT 15.6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to articulate the concepts and procedures related to antidilution. Responses are provided in a written memorandum.
Solutions to Critical Thinking CT 15.1 (a)
(1)
When the debt instrument and the option to acquire common stock are inseparable, as in the case of convertible bonds, the entire proceeds of the bond issue should be allocated to the debt and the related premium or discount accounts. When the debt and the warrants are separable, the proceeds of their sale should be allocated between them. The basis of allocation is their relative fair values. As a practical matter, these relative values are usually determined by reference to the price at which the respective instruments are traded in the open market. Thus, if the debt alone would bring six times as much as would the stock warrants if sold separately, one-seventh of the total proceeds should be apportioned to the warrants and six-sevenths to the debt securities. That portion of the proceeds assigned to the warrants should be accounted for as paid-in capital. The result may be that the debt is issued at a reduced premium or at a discount.
(2)
In the case of convertible debt there are two principal reasons why all the proceeds should be ascribed to the debt. First, the option is inseparable from the debt. The investor in such securities has two mutually exclusive choices: be a creditor and later receive cash for the security; or give up all rights as a creditor and become a stockholder. There is no way to retain one right while selling the other. Second, the valuation of the conversion option or the debt security without the conversion option presents practical problems. For example, in the absence of separate transferability, no separate market values are established and the only values which could be assigned to each would be subjective. Separability of the debt and the warrants and the establishment of a market value for each results in an objective basis for allocating proceeds to the two different equities—creditors’ and stockholders’—involved.
(3)
(b)
Arguments have been advanced that accounting for convertible debt should be the same as for debt issued with detachable stock purchase warrants. Convertible debt has features of debt and stockholders’ equity, and separate recognition should be given to those characteristics at the time of issuance. Difficulties encountered in separating the relative values of the features are not insurmountable and, in any case, should not result in a solution which ignores the problem. In effect, the company is selling a debt instrument and a call on its stock. Coexistence of the two features in one instrument is no reason why each cannot receive its proper accounting recognition. The practical difficulties of estimation of the relative values may be overcome with reliable professional advice. Allocation is a wellrecognized accounting technique and could be applied in this case once reliable estimates of the relative values are known. If the convertible feature was added in order to sell the security at an acceptable price, the value of the convertible option is obviously material and recognition is essential. The question of whether or not the purchaser will exercise the option is not relevant to reflecting the separate elements at the time of issuance.
Cash ............................................................................................. Discount on Bonds Payable ($18,000,000 X 22%) ....................... Bonds Payable ...................................................................... Paid-in Capital—Stock Warrants ...........................................
20,040,000 3,960,000 18,000,000 6,000,000
To record issuance of bonds at 22% discount with options to buy 1,200,000 shares of the company’s $10 par common stock at a price of $18. Debt matures in ten years in equal annual installments of $1,800,000 and warrants, if not exercised, lapse as bonds mature. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 15.2 (a)
Devers recognizes that altering the estimate will benefit Adkins and other executive officers of the company. Current stockholders and investors will be forced to pay out the bonuses, with the altered estimate as a critical factor.
(b)
The accountant’s decision should not be based on the existence of the compensation plan.
(c)
Adkins’s request should be denied.
LO: 3, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Ethical, Reflective Thinking, Communication, AICPA BB: Professional Demeanor, AICPA FC: Reporting, AICPA PC: Communication
CT 15.3 (a)
(b)
1.
The objective of issuing warrants to existing stockholders on a pro-rata basis is to raise new equity capital. This method of raising equity capital may be used because of preemptive rights on the part of a company’s stockholders and also because it is likely to be less expensive than a public offering.
2.
The purpose of issuing stock warrants to certain key employees, usually in the form of a non-qualified stock option plan, is to increase their interest in the long-term growth and income of the company and to attract new management talent. Also, this issuance of stock warrants to key employees under a stock-option plan frequently constitutes an important element in a company’s executive compensation program. Though such plans result in some dilution of the stockholders’ equity when shares are issued, the plans provide an additional incentive to the key employees to operate the company efficiently.
3.
Warrants to purchase shares of its common stock may be issued to purchasers of a company’s bonds in order to stimulate the sale of the bonds by increasing their speculative appeal and aiding in overcoming the objection that rising price levels cause money invested for long periods in bonds to lose purchasing power. The use of warrants in this connection may also permit the sale of the bonds at a lower interest cost.
1.
Because the purpose of issuing warrants to existing stockholders is to raise new equity capital, the price specified in the warrants must be sufficiently below the current market price to reasonably assure that they will be exercised. Because the success of the offering depends entirely on the current market price of the company’s stock in relation to the exercise price of the warrants, and because the objective is to raise capital, the length of time over which the warrants can be exercised is very short, frequently 60 days.
2.
Warrants may be offered to key employees below, at, or above the market price of the stock on the day the rights are granted except for incentive stock-option plans. If a stock-option plan is to provide a strong incentive, warrants that can be exercised shortly after they are granted and expire, say, within two or three years, usually must be exercisable at or near the market price at the date of the grant. Warrants that cannot be exercised for a number of years after they are granted or those that do not lapse for a number of years after they become exercisable may, however, be priced somewhat above the market price of the stock at the date of the grant without eliminating the incentive feature. This does not upset the principal objective of stock option plans, heightening the interest of key employees in the long-term success of the company.
CT 15.3 (Continued) 3. Income tax laws impose no restrictions on the exercise price of warrants issued to purchasers of a company’s bonds. The exercise price may be above, equal to, or below the current market price of the company’s stock. The longer the period of time during which the warrant can be exercised, however, the higher the exercise price can be and still stimulate the sale of the bonds because of the increased speculation appeal. Thus, the significance of the length of time over which the warrants can be exercised depends largely on the exercise price (or prices). A low exercise price in combination with a short exercise period can be just as successful as a high exercise price in combination with a long exercise period. (c)
1.
Financial statement information concerning outstanding stock warrants issued to a company’s stockholders should include a description of the stock being offered for sale, the option price, the time period during which the rights may be exercised, and the number of rights needed to purchase a new share.
2.
Financial statement information concerning stock warrants issued to key employees should include the following: status of these plans at the end of each period presented, including the number of shares under option, options exercised and forfeited, the weighted-average option prices for these categories, the weighted-average fair value of options granted during the year, and the average remaining contractual life of the options outstanding.
3.
Financial statement disclosure of outstanding stock warrants that have been issued to purchasers of a company’s bonds should include the prices at which they can be exercised, the length of time they can be exercised, and the total number of shares that can be purchased by the bondholders.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 15.4 (a)
In 2004, FASB issued an accounting standard related to stock compensation plans. Generally, the rule indicates that employee stock options be treated like all other types of compensation and that their value be included in financial statements as part of the costs of employee services. The rule requires that all types of stock options be recognized as compensation based on the fair value of the options. Fair value for public companies would be estimated using an option-pricing model. No adjustments after the grant date would be made for changes in the stock price—either up or down. For both public and nonpublic companies, the value of the award would be charged to expense over the period in which employees provide the related service, which is generally considered the vesting period. Expense is recognized over the service period with adjustment (reversal) of expense for options that do not vest, if employees do not meet the service requirement.
(b)
According to Ciesielski’s commentary, the bill in Congress would only record expense for the options granted to the top five executives. They also are recommending that the SEC conduct further study of the issue and therefore delay the implementation of the new standard. From a comparability standpoint, it is highly unlikely that recording expense on only some options would result in useful information. It will be difficult to compare compensation costs (and income) for companies—some that use stock options extensively and some that pay their employees with cash.
CT 15.4 (Continued) (c)
Here is an excerpt from a presentation given by Dennis Beresford (a former chairman of the FASB) on the concept of neutrality, which says it well. The FASB often hears that it should take a broader view, that it must consider the economic consequences of a new accounting standard. The FASB should not act, critics maintain, if a new accounting standard would have undesirable economic consequences. We have been told that the effects of accounting standards could cause lasting damage to American companies and their employees. Some have suggested, for example, that recording the liability for retiree health care or the costs for stock-based compensation will place U.S. companies at a competitive disadvantage. These critics suggest that because of accounting standards, companies may reduce benefits or move operations overseas to areas where workers do not demand the same benefits. These assertions are usually combined with statements about desirable goals, like providing retiree health care or creating employee incentives. There is a common element in those assertions. The goals are desirable but the means require that the Board abandon neutrality and establish reporting standards that conceal the financial impact of certain transactions from those who use financial statements. Costs of transactions exist whether or not the FASB mandates their recognition in financial statements. For example, not requiring the recognition of the cost of stock options or ignoring the liabilities for retiree health care benefits does not alter the economics of the transactions. It only withholds information from investors, creditors, policy makers, and others who need to make informed decisions and, eventually, impairs the credibility of financial reports. One need only look to the collapse of the thrift industry to demonstrate the consequences of abandoning neutrality. During the 1970s and 1980s, regulatory accounting principles (RAP) were altered to obscure problems in troubled institutions. Preserving the industry was considered a greater good. Many observers believe that the effect was to delay action and hide the true dimensions of the problem. The public interest is best served by neutral accounting standards that inform policy rather than promote it. Stated simply, truth in accounting is always good policy. Neutrality does not mean that accounting should not influence human behavior. We expect that changes in financial reporting will have economic consequences, just as economic consequences are inherent in existing financial reporting practices. Changes in behavior naturally follow from more complete and representationally faithful financial statements. The fundamental question, however, is whether those who measure and report on economic events should somehow screen the information before reporting it to achieve some objective. In FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information (paragraph 102), the Board observed: Indeed, most people are repelled by the notion that some “big brother,” whether government or private, would tamper with scales or speedometers surreptitiously to induce people to lose weight or obey speed limits or would slant the scoring of athletic events or examinations to enhance or decrease someone’s chances of winning or graduating. There is no more reason to abandon neutrality in accounting measurement. The Board continues to hold that view. The Board does not set out to achieve particular economic results through accounting pronouncements. We could not if we tried. Beyond that, it is seldom clear which result we should seek because our constituents often have opposing viewpoints. Governments, and the policy goals they adopt, frequently change.
LO: 3, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 15.5 (a)
Dividends on outstanding preferred stock must be subtracted from net income or added to net loss for the period before computing EPS on the common shares. This generalization will be modified by the various features and different requirements preferred stock may have with respect to dividends. Thus, if preferred stock is cumulative, it is necessary to subtract its current dividend requirements from net income (or to add them to net loss) regardless of whether or not the preferred dividends were actually declared. Where the preferred shares are noncumulative, only preferred dividends actually declared during the current period need be subtracted from net income (or added to net loss) to arrive at the income to be used in EPS calculations. In case the preferred shares are convertible into common stock, when assuming conversion, dividend requirements on the preferred shares are not deducted from net income. This applies when testing for potential dilution to determine whether or not the diluted EPS figures for the period are lower than earnings per common share figures.
(b)
When options and warrants to buy common stock are outstanding and their exercise price (i.e., proceeds the corporation would derive from issuance of common stock pursuant to the warrants and options) is less than the average price at which the company could acquire its outstanding shares as treasury stock, the treasury stock method is generally applicable. In these circumstances, existence of the options and warrants would be dilutive. However, if the exercise price of options and warrants exceeded the average price of the common stock, the cash proceeds from their assumed exercise would provide for repurchasing more common shares than were issued when the warrants were exercised, thereby reducing the number of shares outstanding. In these circumstances assumed exercise of the warrants would be antidilutive, so exercise would not be presumed for purposes of computing diluted EPS.
(c)
In arriving at the calculation of diluted EPS where convertible debentures are assumed to be converted, their interest (net of tax) is added back to net income as the numerator element of the EPS calculation while the weighted-average number of shares of common stock into which they would be convertible is added to the shares outstanding to arrive at the denominator element of the calculation.
LO: 4, 5, Bloom: K, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 15.6 Dear Mr. Dolan: I hope that the following brief explanation helps you understand why your warrants were not included in Rhode’s earnings per share calculations. Earnings per share (EPS) provides income statement users a quick assessment of the earnings that were generated for each common share outstanding over a given period. When a company issues only common and preferred stock, it has a simple capital structure; consequently, the only ratio needed to calculate EPS is the following: (Net Income – Preferred Dividends) ÷ Weighted-average Number of Shares Outstanding However, corporations that have outstanding a variety of other securities—convertible bonds, convertible preferred stock, stock options, and stock warrants—have a complex capital structure. Because these securities could be converted to common stock, they have a potentially “dilutive” effect on EPS.
CT 15.6 (Continued) In order not to mislead users of financial information, the accounting profession insists that EPS calculations be transparent. Thus, a security which might dilute EPS must be figured into EPS calculations as though it had been converted into common stock. Basic EPS assumes a weightedaverage number of common shares outstanding while diluted EPS assumes that any potentially dilutive security has been converted. Some securities, however, might actually inflate the EPS figure rather than dilute it. These securities are considered antidilutive and are excluded from the EPS computation. Take, for example, your warrants. The computations below provide a good example of how options and warrants are treated in diluted EPS. In these computations, we assume that Rhode will purchase treasury stock using the proceeds from the exercise of your warrants. If we assume that 30,000 warrants are exercised at $30 and the average market price is the shares is $25, the company does not simply add 30,000 shares to common stock outstanding; rather, for diluted EPS, Rhode is assumed to purchase and retire 36,000 [(30,000 X $30) ÷ $25] shares of treasury stock at $25 with the proceeds. Therefore, if you add the 30,000 exercised warrants to the common stock outstanding and then subtract the 36,000 shares presumably purchased, the number of shares outstanding would be reduced to 94,000 (100,000 + 30,000 – 36,000). Because the ratio’s denominator would be reduced by this inclusion, it would cause the ratio to increase, which defeats the purpose of the assumed exercise. These warrants are considered antidilutive and, therefore, are not included in EPS calculations. This explanation should address any concerns you may have had about the use of your warrants in EPS calculations. If you have any further questions, please call me. Sincerely, Ms. Smart Student Accountant LO: 5, Bloom: C, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: Professional Demeanor, AICPA FC: Reporting, AICPA PC: Communication
Codification Exercises CE15-1 Master Glossary (a)
The amount of earnings for the period available to each share of common stock outstanding during the reporting period.
(b)
A reduction in EPS resulting from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued upon the satisfaction of certain conditions.
(c)
A security that gives the holder the right to purchase shares of common stock in accordance with the terms of the instrument, usually upon payment of a specified amount.
(d)
The date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award. The employer becomes contingently obligated on the grant date to issue equity instruments or transfer assets to an employee who renders the requisite service. Awards made under an arrangement that is subject to shareholder approval are not deemed to be granted until that approval is obtained unless approval is essentially a formality (or perfunctory), for example, if management and the members of the board of directors control enough votes to approve the arrangement. Similarly, individual awards that are subject to approval by the board of directors, management, or both are not deemed to be granted until all such approvals are obtained. The grant date for an award of equity instruments is the date that an employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares. Paragraph 718-10-25-5 provides guidance on determining the grant date. See Service Inception Date.
LO: 1, 2, 4, 5, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE15-2 According to FASB ASC 260-10-45-7 (Earnings Per Share—Other Presentation Matters): EPS data shall be presented for all periods for which an income statement or summary of earnings is presented. If diluted EPS data are reported for at least one period, they shall be reported for all periods presented, even if they are the same amounts as basic EPS. If basic and diluted EPS are the same amount, dual presentation can be accomplished in one line on the income statement. LO: 4, 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE15-3 According to FASB ASC 260-10-50-1 (Earnings Per Share—Disclosure): For each period for which an income statement is presented, an entity shall disclose all of the following: (a)
A reconciliation of the numerators and the denominators of the basic and diluted per-share computations for income from continuing operations. The reconciliation shall include the individual income and share amount effects of all securities that affect earnings per share (EPS). Example 2 (see paragraph 260-10-55-51) illustrates that disclosure. (See paragraph 260-10-45-3.) An entity is encouraged to refer to pertinent information about securities included in the EPS computations that is provided elsewhere in the financial statements as prescribed by Subtopic 505-10.
(b)
The effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic EPS.
(c)
Securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been antidilutive for the period(s) presented. Full disclosure of the terms and conditions of these securities is required even if a security is not included in diluted EPS in the current period.
LO: 4, 5, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE15-4 According to FASB ASC 260-10-55-12 (Earnings Per Share—Implementation—Restatement of EPS Data): If the number of common shares outstanding increases as a result of a stock dividend or stock split (see Subtopic 505-20) or decreases as a result of a reverse stock split, the computations of basic and diluted EPS shall be adjusted retroactively for all periods presented to reflect that change in capital structure. If changes in common stock resulting from stock dividends, stock splits, or reverse stock splits occur after the close of the period but before issuance of the financial statements, the per-share computations for those and any prior-period financial statements presented shall be based on the new number of shares. If per-share computations reflect such changes in the number of shares, that fact shall be disclosed. LO: 4, 5, Bloom: K, Difficulty: Simple , Time: 5-10, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
Codification Research Case (a) The accounting for stock compensation is addressed in the FASB Codification at FASB ASC 718-10 (Compensation-Stock Compensation). (b) See FASB ASC 718-10-10 (Compensation—Stock Compensation, Overall, Objectives). 10-1 The objective of accounting for transactions under share-based payment arrangements with employees is to recognize in the financial statements the employee services received in exchange for equity instruments issued or liabilities incurred and the related cost to the entity as those services are consumed. This Topic uses the terms compensation and payment in their broadest senses to refer to the consideration paid for employee services. Currently Viewing: 718 Compensation—Stock Compensation 10 Overall 10 Objectives General 10-2 This Topic requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Topic establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee stock ownership plans. (c) See FASB ASC 718-50-25. 25-1 An employee share-purchase plan that satisfies all of the following criteria does not give rise to recognizable compensation cost (that is, the plan is noncompensatory):
Codification Research Case (Continued) 1. The plan satisfies either of the following conditions: (a) The terms of the plan are no more favorable than those available to all holders of the same class of shares. Note that a transaction subject to an employee share-purchase plan that involves a class of equity shares designed exclusively for and held only by current or former employees or their beneficiaries may be compensatory depending on the terms of the arrangement. (b) Any purchase discount from the market price does not exceed the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering. A purchase discount of 5 percent or less from the market price shall be considered to comply with this condition without further justification. A purchase discount greater than 5 percent that cannot be justified under this condition results in compensation cost for the entire amount of the discount. Note that an entity that justifies a purchase discount in excess of 5 percent shall reassess at least annually, and no later than the first share purchase offer during the fiscal year, whether it can continue to justify that discount pursuant to this paragraph. 2. Substantially all employees that meet limited employment qualifications may participate on an equitable basis. 3. The plan incorporates no option features, other than the following: (a) Employees are permitted a short period of time—not exceeding 31 days—after the purchase price has been fixed to enroll in the plan. (b) The purchase price is based solely on the market price of the shares at the date of purchase, and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid (such as those paid by payroll withholdings). LO: 3, Bloom: K, Difficulty: Simple, Time: 25-30, AACSB: Communication, Technology, AICPA BB: Technology, AICPA FC: Measurement, Reporting, Research, Technology, AICPA PC: Communication
CHAPTER 16 Investments Assignment Classification Table (By Topic) Topics 1. Debt securities.
Questions
Brief Exercises Exercises
1, 2, 3, 13
1
(a) Held-to-maturity.
4, 5, 7, 8, 10, 13, 21
1, 3,10
(b) Trading.
4, 6, 7, 8, 10, 21
4
(c)
4, 7, 8, 9, 10, 11, 21
2
2. Bond amortization.
8, 9
1, 2, 3
3. Equity securities.
1, 12, 16
Available-for-sale.
2, 3, 5
Problems
Critical Thinking 6
1, 7 1, 3
4, 9
1, 2, 3, 4,
1, 3
7, 9 3, 4, 5
1, 2, 3
1
6
(a) less than 20%
7, 10, 14,15
5, 6, 8
6, 7, 8, 11, 12, 16, 19, 20
3, 5, 6 , 8 10, 11
1, 2
(b) 20 – 50% (Equity method).
6, 7, 8, 10,
6, 7
12, 13, 14, 15, 16, 17, 19, 20
6, 8
1, 4, 5
9
10
9, 10, 11
10
8, 9, 10, 11
15, 16, 17, 18, 19, 20
4. Comprehensive income.
22
5. Disclosures of investments.
18
6. Fair value option.
26, 27, 28
12, 13
19, 20, 21
7. Impairments.
24, 25
10, 11
18, 22, 23
8. Transfers between categories.
23
*9. Derivatives.
29, 30, 31, 32, 33, 34, 35, 36
*This material is dealt with in an Appendix to the chapter.
3 1, 3, 6
24, 25, 26, 27, 28, 29
12, 13, 14, 15, 16, 17
Assignment Classification Table (By Learning Objective) Learning Objectives Questions 1. Describe the accounting for investments in debt securities.
Brief Exercises
Exercises
Problems
Critical Thinking
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 4
1, 2, 3, 4, 5, 9, 21
1, 2, 3, 4, 7
1, 3
1, 6, 7, 8, 11, 12, 14, 15, 16, 19, 20, 21
3, 5, 6, 8, 9, 10, 11
2
8
4, 5
9, 11
6
2.
Describe the accounting for investments in equity securities.
12, 13, 14, 15
5, 6, 8, 9,
3.
Explain the equity and consolidation methods of accounting.
16, 17, 18, 19, 20
7
4.
Evaluate other major issues related to investments in debt and equity securities.
21, 22, 23, 24, 25, 26, 27, 28
9, 10, 11, 12,13
*5.
Describe the uses of and accounting for derivatives.
29, 30
24, 28
12, 13, 14
*6.
Explain the accounting for hedges.
31, 32, 34, 35
25, 26, 27, 29
15, 16, 17
*7.
Identify special reporting issues for derivatives that cause unique accounting problems.
33, 34, 35, 36
*8.
Describe required fair value disclosures.
12, 13, 16, 17
10, 18, 19, 20, 21, 22, 23
Assignment Characteristics Table Level of Difficulty
Time (minutes)
Moderate Simple Moderate Moderate Moderate Simple Moderate Simple Moderate
5–10 10–15 15–20 10–15 20–30 10–15 10–15 5–10 10–15
E16.10 E16.11 E16.12 E16.13 E16.14 E16.15 E16.16 E16.17 E16.18 E16.19 E16.20 E16.21 E16.22 E16.23 *E16.24 *E16.25 *E16.26 *E16.27 *E16.28 *E16.29
Investment classifications. Entries for held-to-maturity securities. Entries for held-to-maturity securities. Entries for available-for-sale securities. Effective-interest versus straight-line bond amortization. Entries for equity securities. Equity securities entries. Equity securities entries and reporting. Available-for-sale debt securities entries and financial statement presentation. Comprehensive income disclosure. Equity securities entries. Journal entries for fair value and equity methods. Equity method. Equity investment. Equity investments Fair value and equity method compared. Equity method. Impairment of debt securities. Fair value measurement. Fair value measurement issues. Fair value option. Impairment. Impairment. Derivative transaction. Fair value hedge. Cash flow hedge. Fair value hedge. Call option. Cash flow hedge.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate
20–25 20–25 15–20 8–10 8–10 15–20 15–20 10–15 15–20 15–20 15–20 15–20 20–25 20–25 15–20 15–20 15–20 15–20 20–25 25–30
P16.1 P16.2 P16.3 P16.4 P16.5 P16.6 P16.7 P16.8
Debt securities. Available-for-sale debt securities. Debt and equity investments. Debt investments. Equity securities entries and disclosures. Equity securities entries. Available-for-sale and held-to-maturity debt securities entries. Fair value and equity methods.
Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate
20–30 30–40 25–30 25–35 25–35 25–35 25–35 20–30
Item
Description
E16.1 E16.2 E16.3 E16.4 E16.5 E16.6 E16.7 E16.8 E16.9
Assignment Characteristics Table (Continued) Item P16.9 P16.10 P16.11 *P16.12 *P16.13 *P16.14 *P16.15 *P16.16 *P16.17
Description Gain on sale of investments and comprehensive income. Equity investments. Equity securities—statement presentation. Derivative financial instrument. Derivative financial instrument. Free-standing derivative. Fair value hedge interest rate swap. Cash flow hedge. Fair value hedge.
Level of Difficulty Moderate Complex Moderate Moderate Moderate Moderate Complex Moderate Moderate
Time (minutes) 20–30 30–40 20–30 20–25 20–25 20–25 30–40 25–35 25–35
CT16.1 CT16.2 CT16.3 CT16.4 CT16.5 CT16.6
Issues raised about investment securities. Equity securities. Financial statement effect of securities. Investment accounted for under the equity method. Equity investment. Fair value.
Moderate Moderate Moderate Moderate Simple Moderate
25–30 25–30 20–30 15–25 25–35 25–35
Answers to Questions 1.
A debt security is an instrument representing a creditor relationship with an entity. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security. An equity security is described as a security representing an ownership interest such as common, preferred, or other capital stock. It also includes rights to acquire or dispose of an ownership interest at an agreed-upon or determinable price, such as warrants, rights, and call options or put options. Convertible debt securities and redeemable preferred stocks are not treated as equity securities.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
2.
The variety in bond features along with the variability in interest rates permits investors to shop for exactly the investment that satisfies their risk, yield, and marketability desires, and permits issuers to create a debt instrument best suited to their needs.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
3.
Cost of a long-term investment in bonds includes the total consideration to acquire the investment, including brokerage fees and other costs incidental to the purchase.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
4.
The three types of classifications for debt investments are: Held-to-maturity: Debt investments that the company has the positive intent and ability to hold to maturity. Trading: Debt investments bought and held primarily for sale in the near term to generate income on short-term price differences. Available-for-sale: Debt investments not classified as held-to-maturity or trading securities.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
5.
A debt investment should be classified as held-to-maturity only if the company has both: (1) the positive intent and (2) the ability to hold those securities to maturity.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
6.
Debt investments classified as trading are reported at fair value, with unrealized holding gains and losses reported as part of net income. Any discount or premium is amortized.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
7.
Trading and available-for-sale debt securities should be reported at fair value, whereas held-tomaturity debt securities should be reported at amortized cost.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
8.
$3,500,000 × 0.10 = $350,000; $350,000 ÷ 2 = $175,000. Wheeler would make the following entry:
Cash ($4,000,000 × 0.08 × 1/2) ........................................................... Debt Investments ............................................................................... Interest Revenue ($3,500,000 × 0.10 × 1/2) ................................ *To number 9
160,000 15,000* 175,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Questions Chapter 16 (Continued) 9.
Fair Value Adjustment ............................................................................... Unrealized Holding Gain or Loss—Equity [$3,604,000 – ($3,500,000 + $15,000)*] .........................................
89,000 89,000
*See number 8. LO: 1, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: None
10.
Unrealized holding gains and losses for trading debt securities should be included in net income for the current period. Unrealized holding gains and losses for available-for-sale debt securities should be reported as other comprehensive income and as a separate component of stockholders’ equity. Unrealized holding gains and losses are not recognized for held-to-maturity securities.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
11. (a) Unrealized Holding Gain or Loss—Equity ..................................... Fair Value Adjustment ...........................................................
60,000
(b) Unrealized Holding Gain or Loss—Equity ..................................... Fair Value Adjustment ($60,000 + $10,000) ..........................
70,000
60,000 70,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
12. Investments in equity securities can be classified as follows: (a) Holdings of less than 20% (fair value method)—investor has passive interest. (b) Holdings between 20% and 50% (equity method)—investor has significant influence. (c) Holdings of more than 50% (consolidated statements)—investor has controlling interest. If an equity investment is not publicly traded and is nonmarketable, a company values the investment and reports it at cost in periods subsequent to acquisition. This approach is often referred to as the cost approach. Companies recognize dividends when received and only recognize gains and losses when selling the securities. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
13. Investments in stock do not have a maturity date and therefore cannot be classified as held-tomaturity securities. LO: 2, Bloom: K, Difficulty: Simple, Time: 1-3, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
14. Selling price of 10,000 shares at $27.50 ............................................... Less: Brokerage commissions ............................................................. Proceeds from sale ............................................................................... Cost of 10,000 shares........................................................................... Gain on sale of investments.................................................................. Cash ..................................................................................................... Equity Investments ........................................................................ Gain on Sale of Investments .........................................................
$275,000 1,770 273,230 (260,000) $ 13,230 273,230 260,000 13,230
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
15. Marketable equity securities are reported at fair value. Any unrealized holding gain or loss is reported in net income. Nonmarketable securities are reported at cost less impairments. A company is encouraged to adjust for observable price changes subsequent to recording the investment at cost if it can determine prices in orderly transactions for identical investments or from similar investments of the same issuer. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 16 (Continued) 16. Significant influence over an investee may result from representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. An investment (direct or indirect) of 20% or more of the voting stock of an investee constitutes significant influence unless there exists evidence to the contrary. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
17. Under the equity method, the investment is originally recorded at cost, but is adjusted for changes in the investee’s net assets. The investment account is increased (decreased) by the investor’s proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee. LO: 3, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
18. The 20% rule is that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee leads to the presumption that an investor has the ability to exercise significant influence over an investee and the equity method should be used. However, there are other factors, when considered, may indicate that ownership of 20 percent or more may not enable an investor to exercise significant influence. An investor with ownership just below 20% may be able to exercise significant influence based on representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings. Factors that could lead to a conclusion of no significant ownership, when ownership is above 20 percent include: (1) The investee opposes the investor’s acquisition of its stock; (2) The investor and investee sign an agreement under which the investor surrenders significant shareholder rights; (3) The investor’s ownership share does not result in “significant influence” because majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor; (4) The investor tries and fails to obtain representation on the investee’s board of directors. LO: 3, Bloom: K, Difficulty: Simple, Time: 5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
19. Dividends subsequent to acquisition should be accounted for as a reduction in the Equity Investment account. LO: 3, Bloom: C, Difficulty: Simple, Time: 1-2, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
20. Ordinarily, Raleigh Corp. should discontinue applying the equity method and not provide for additional losses beyond the carrying value of $170,000. However, if Raleigh Corp.’s loss is not limited to its investment (due to a guarantee of Borg’s obligations or other commitment to provide further financial support or if imminent return to profitable operations by Borg appears to be assured), it is appropriate for Raleigh Corp. to provide for its entire $186,000 ($620,000 × .30) share of the $620,000 loss. LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
21. Trading securities should be reported at aggregate fair value as current assets. Individual held-tomaturity and available-for-sale securities are classified as current or noncurrent depending upon the circumstances. Held-to-maturity securities generally should be classified as current or noncurrent, based on the maturity date of the individual securities. Debt securities identified as available-for-sale should be classified as current or noncurrent, based on maturities and expectations as to sales and redemptions in the following year. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 16 (Continued) 22. Reclassification adjustments are necessary to ensure that double counting does not result when realized gains or losses are reported as part of net income but also are shown as part of other comprehensive income in the current period or in previous periods. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
23. When a security is transferred from one category to another, the transfer should be recorded at fair value, which in this case becomes the new basis for the security. Any unrealized gain or loss at the date of the transfer increases or decreases stockholders’ equity. The unrealized gain or loss at the date of the transfer to the trading category is recognized in income. LO: 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
24. A debt security is impaired when “it is probable that the investor will be unable to collect all amounts due according to the contractual terms.” When an impairment has occurred, the security is written down to its fair value, which is also the security’s new cost basis. The amount of the write down is debited to Allowance for Doubtful Accounts. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
25. The amount of credit losses (impairment) that can be realized on available-for-sale debt securities is limited to the amount that the fair value is less than amortized cost. In other words, if the credit loss exceeds the amount that the fair value is below amortized cost of these securities, the company can sell the securities thereby avoiding the higher credit loss. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
26. Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is therefore a market-based measure. LO:4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
27. The fair value option gives companies the option to report most financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument-by-instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
28. No. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. LO: 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
*29. An underlying is a specified interest rate, security price, commodity price, index of prices or rates, or other market-related variable. Changes in the underlying determine changes in the value of the derivative. Payment is determined by the interaction of the underlying with the face amount and the number of shares, or other units specified in the derivative contract (these elements are referred to as notional amounts). LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 16 (Continued) *30. See illustration below: Traditional Financial Instrument Feature (e.g., Trading Security) Payment Provision Stock price times the number of shares. Initial Investment Settlement
Investor pays full cost. Deliver stock to receive cash.
Derivative Financial Instrument (e.g., Call Option) Change in stock price (underlying) times number of shares (notional amount). Initial investment is less than full cost. Receive cash equivalent, based on changes in stock price times the number of shares.
For a traditional financial instrument, an investor generally must pay the full cost, while derivatives require little initial investment. In addition, the holder of a traditional security is exposed to all risks of ownership, while most derivatives are not exposed to all risks associated with ownership in the underlying. For example, the intrinsic value of a call option only can increase in value. Finally, unlike a traditional financial instrument, the holder of a derivative could realize a profit without ever having to take possession of the underlying. This feature is referred to as net settlement and serves to reduce the transaction costs associated with derivatives. LO: 5, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
*31. The purpose of a fair value hedge is to offset the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
*32. The unrealized holding gain or loss on inventory should be reported as income when this inventory is designated as a hedged item in a qualifying fair value hedge. If the hedge meets the special hedge accounting criteria (designation, documentation, and effectiveness), the unrealized holding gain or loss is reported as income. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
*33. Entering into an interest rate swap is likely a setting where the company is hedging the fair value of a fixed-rate debt obligation. The fixed payments received on the swap will offset fixed payments on the debt obligation. As a result, if interest rates decline, the value of the swap contract increases (a gain), while at the same time the fixed-rate debt obligation increases (a loss). The swap is an effective risk management tool in this setting because its value is related to the same underlying (interest rates) that will affect the value of the fixed-rate bond payable. Thus, if the value of the swap goes up, it offsets the loss in the value of the debt obligation. LO: 7, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
*34. A cash flow hedge is used to hedge exposures to cash flow risk, which is exposure to the variability in cash flows. The cash flows received on the hedging instrument (derivative) will offset the cash flows received on the hedged item. Generally, the hedged item is a transaction that is planned sometime in the future (an anticipated transaction). LO: 6, 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
*35. Derivatives used in cash flow hedges are accounted for at fair value on the balance sheet but gains or losses are recorded in equity as part of other comprehensive income. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication
*36. A hybrid security is a security that has characteristics of both debt and equity and often is a combination of traditional and derivative financial instruments. A convertible bond is a hybrid security because it is comprised of a debt security, referred to as the host security, combined with an option to convert the bond to shares of common stock, the embedded derivative. LO: 7, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting:, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 16.1 January 1, 2025 (a) Debt Investments ..................................................... Cash ................................................................... December 31, 2025 (b) Cash ($80,000 × 0.09) ................................................ Debt Investments ...................................................... Interest Revenue ($74,086 × 0.11) ....................
74,086 74,086 7,200 949 8,149
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.2 January 1, 2025 (a) Debt Investments ...................................................... Cash ...................................................................
74,086
December 31, 2025 (b) Cash ($80,000 × 0.09) ................................................ Debt Investments ...................................................... Interest Revenue ($74,086 × 0.11) ....................
7,200 949
December 31, 2025 (c) Fair Value Adjustment ............................................. Unrealized Holding Gain or Loss—Equity [($74,086 + $949) – $75,500] ..........................
74,086
8,149 465 465
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision MakingPC: Decision Making
Brief Exercise 16.3 January 1, 2025 (a) Debt Investments ...................................................... Cash ................................................................... June 30, 2025 (b) Cash ($60,000 × 0.08 × 6/12) ....................................... Debt Investments .............................................. Interest Revenue ($65,118 × 0.06 × 6/12) ............
65,118 65,118 2,400 446 1,954
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.4 (a) Debt Investments .................................................... Cash .................................................................
50,000
(b) Cash......................................................................... Interest Revenue .............................................
2,000
(c) Unrealized Holding Gain or Loss—Income ........... Fair Value Adjustment ($50,000 – $47,400) ......................................
2,600
50,000 2,000
2,600
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.5 (a) Equity Investments ................................................. Cash .................................................................
13,200
(b) Cash......................................................................... Dividend Revenue (400 × $3.25) .....................
1,300
(c) Fair Value Adjustment ............................................ Unrealized Holding Gain or Loss—Income [(400 × $34.50) – $13,200] ............................
600
13,200 1,300
600
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.6 (a) Equity Investments ................................................ Cash .................................................................
13,200
(b) Cash......................................................................... Dividend Revenue (400 × $3.25) .....................
1,300
13,200 1,300
(c) No adjustment to fair value is reported because the equity security is nonmarketable. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.7 Equity Investment........................................................... Cash .........................................................................
300,000
Equity Investment........................................................... Investment Income (.30 × $180,000) ......................
54,000
Cash ................................................................................ Equity Investment (.30 × $60,000) ..........................
18,000
300,000 54,000 18,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.8 Fair Value Adjustment Bal. 200 500 Bal. 700* *$4,000 − $3,300 Fair Value Adjustment ............................................ Unrealized Holding Gain or Loss—Income ...
500 500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.9 (a)
Other comprehensive loss for 2025 of $10.9 million.
(b) Comprehensive income for 2025: $1,234.8 million or ($1,245.7 – $10.9). (c)
Accumulated other comprehensive income: $46.3 million or ($57.2 – $10.9).
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.10 Allowance for Doubtful Accounts ($70,000 − $60,000) ... Debt Investments ......................................................
10,000 10,000
In this case, an impairment has occurred and the individual security should be written down. The new cost basis of the investment in debt securities is $60,000 and will not change unless additional impairment occurs. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Brief Exercise 16.11
Case 1 The impairment loss is $10,000 ($40,000 - $30,000). The loss is limited by the lower of amortized cost or fair value Case 2 No impairment results, because the fair value is greater than amortized cost. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Brief Exercise 16.12 (a)
January 1, 2025 Debt Investments ................................................ 10,000,000 Cash .............................................................. 10,000,000 December 31, 2025 Interest Receivable ($10,000,000 × 0.05) ............ Interest Revenue ......................................... Fair Value Adjustment ($10,600,000 - $10,000,000) ............................. Unrealized Holding Gain or Loss—Equity ..
(b)
500,000 500,000 600,000 600,000
January 1, 2025 Debt Investments ................................................ 10,000,000 Cash .............................................................. 10,000,000 December 31, 2025 Interest Receivable ($10,000,000 × 0.05) ............ Interest Revenue .........................................
500,000
Debt Investment ($10,600,000 - $10,000,000) ..... Unrealized Holding Gain or Loss—Income
600,000
500,000 600,000
Brief Exercise 16.12 (Continued) Note: One difference here relates to the third entry. Under the fair value option, the specific investment is adjusted (under general available-for-sale guidance, fair value adjustments are recorded on a portfolio basis – an allowance account, Fair Value Adjustment, is used). In addition, under the fair value option, unrealized gains and losses are recorded in income. LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 16.13 (a)
December 31, 2025 Interest Receivable ($2,000,000 × 0.06) ............. Interest Revenue .........................................
120,000 120,000
December 31, 2027 Interest Receivable ($2,000,000 × 0.06) ............. Interest Revenue .........................................
120,000 120,000
(b) December 31, 2025 Interest Receivable ($2,000,000 × 0.06) ............. Interest Revenue .........................................
120,000
Debt Investments ($2,050,000 − $2,000,000) ..... Unrealized Holding Gain or Loss— Income ................................................
50,000
120,000
50,000
December 31, 2027 Interest Receivable ($2,000,000 × 0.06) ............. Interest Revenue .........................................
120,000
Unrealized Holding Gain or Loss—Income ....... Debt Investments ($2,020,000 − $2,000,000).....................
20,000
120,000
20,000
Note: The Debt Investments account is adjusted because the company is using the fair value option. LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Solutions to Exercises Exercise 16.1 (5–10 minutes) (a) 1.
(b) 4.
(c) 1.
(d) 2.
(e) 4.
(f) 3.
LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.2 (10–15 minutes) (a)
January 1, 2025 Debt Investments .............................................. Cash ...........................................................
(b)
300,000 300,000
December 31, 2025 Interest Receivable ........................................... Interest Revenue (0.06 × 300,000) ............
(c)
18,000 18,000
January 1, 2026 Cash................................................................... Interest Receivable ..................................
18,000 18,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Exercise 16.3 (15–20 minutes) (a)
January 1, 2025 Debt Investments .............................................. Cash ...........................................................
322,744.44 322,744.44
Exercise 16.3 (Continued) (b)
Schedule of Interest Revenue and Bond Premium Amortization Effective-Interest Method 12% Bonds Sold to Yield 10% Date 1/1/25 1/1/26 1/1/27 1/1/28 1/1/29 1/1/30
Cash Received — $36,000* 36,000 36,000 36,000 36,000
Interest Revenue — $32,274.44** 31,901.89 31,492.08 31,041.29 30,545.86***
Premium Amortized — $3,725.56 4,098.11 4,507.92 4,958.71 *5,454.14
Carrying Amount of Bonds $322,744.44 319,018.88 314,920.77 310,412.85 305,454.14 300,000.00
*$300,000 × 0.12 **$322,744.44 × 0.10 ***Rounded by 45¢. (c)
December 31, 2025 Interest Receivable ............................................ Debt Investments ........................................ Interest Revenue .........................................
(d)
36,000 3,725.56 32,274.44
December 31, 2026 Interest Receivable ............................................ Debt Investments ........................................ Interest Revenue .........................................
36,000 4,098.11 31,901.89
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.4 (10–15 minutes) (a)
January 1, 2025 Debt Investments ................................................ Cash .............................................................
322,744.44 322,744.44
Exercise 16.4 (Continued) (b)
December 31, 2025 Interest Receivable ............................................. Debt Investments ......................................... Interest Revenue ($322,744.44 × 0.10) ........
36,000
Fair Value Adjustment ....................................... Unrealized Holding Gain or Loss—Equity ($320,500.00 – $319,018.88) ......................
1,481.12
(c)
3,725.56 32,274.44
1,481.12
December 31, 2026 Unrealized Holding Gain or Loss—Equity ......... Fair Value Adjustment ................................ Amortized Cost Available-for-sale bonds Previous fair value adjustment—Dr. Fair value adjustment—Cr.
7,401.89 7,401.89
Fair Value
Unrealized Gain (Loss)
$314,920.77 $309,000.00
$(5,920.77) 1,481.12 $(7,401.89)
LO: 1, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.5 (20–30 minutes) (a)
Schedule of Interest Revenue and Bond Discount Amortization Straight-Line Method 9% Bond Purchased to Yield 12% Date 1/1/25 1/1/26 1/1/27 1/1/28
Cash Received — $18,000 18,000 18,000
Interest Bond Discount Carrying Amount Revenue Amortization of Bonds — — $185,589 $22,804 *$4,804* 190,393 22,804 4,804 195,197 22,803** 4,803 200,000
**($200,000 – $185,589) ÷ 3 = $4,804 **Rounded by $1.
Exercise 16.5 (Continued) (b)
Schedule of Interest Revenue and Bond Discount Amortization Effective-Interest Method 9% Bond Purchased to Yield 12% Date 1/1/25 1/1/26 1/1/27 1/1/28
Cash Received — $18,000 18,000 18,000
Interest Bond Discount Carrying Amount Revenue Amortization of Bonds — — $185,589.00 $22,270.68* $4,270.68 189,859.68 22,783.16 4,783.16 194,642.84 23,357.16** 5,357.16 200,000.00
**$185,589 × 0.12 = $22,270.68 **Rounded by $.02. (c)
December 31, 2026 Interest Receivable .................................................. 18,000.00 Debt Investments ..................................................... 4,804.00 Interest Revenue .............................................. 22,804.00
(d)
December 31, 2026 Interest Receivable .................................................. 18,000.00 Debt Investments ..................................................... 4,783.16 Interest Revenue .............................................. 22,783.16
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.6 (10–15 minutes) (a) Fair Value Adjustment ($70,000 − $65,000) ............ Unrealized Holding Gain or Loss—Income ....
5,000 5,000
(b) The Unrealized Holding Gain or Loss—Income account is reported in the income statement under Other Revenues and Gains. The Fair Value Adjustment account is added to the cost of the Equity Investment account to arrive at fair value. LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.7 (10–15 minutes) (a) December 31, 2025 Unrealized Holding Gain or Loss—Income ............ Fair Value Adjustment ....................................
1,400
(b) During 2026 Cash.......................................................................... Loss on Sale of Investments .................................. Equity Investments .........................................
9,400 600
1,400
10,000
(c) December 31, 2026 Securities Clemson Corp. stock Buffaloes Co. stock Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.
Cost $20,000 20,000 $40,000
Fair Value $19,100 20,500 $39,600
Fair Value Adjustment ............................................... Unrealized Holding Gain or Loss—Income .......
Unrealized Gain (Loss) ($ (900) ( 500) ( (400) ( (1,400) ($1,000)
1,000 1,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.8 (5–10 minutes) The unrealized gains and losses resulting from changes in the fair value of equity securities are recorded in an Unrealized Holding Gain or Loss-Income account that is reported as part of net income. Therefore, the following adjusting entry should be made at the year-end: Unrealized Holding Gain or Loss—Income ......................... Fair Value Adjustment ($73,000 – $65,000) ..................
8,000 8,000
Unrealized Holding Gain or Loss—Income is reported in the “Other expenses and losses” section of the income statement. The Fair Value Adjustment account is a valuation account to the related equity investment account. LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Exercise 16.9 (10–15 minutes). (a) The portfolio should be reported at the fair value of $54,500. Since the cost of the portfolio is $53,000, the unrealized holding gain is $1,500, of which $400 is already recognized. Therefore, the December 31, 2025 adjusting entry should be: Fair Value Adjustment ................................................... Unrealized Holding Gain or Loss—Equity ............
1,100 1,100
(b) The unrealized holding gain of $1,500 (including the previous balance of $400) should be reported as an addition to stockholders’ equity. The Fair Value Adjustment account balance of $1,500 should be added to the cost of the investment account to report the fair value of the debt investment at $54,500. STEFFI GRAF, INC. Balance Sheet As of December 31, 2025 ____________________________________________________________ Current assets: Debt investments $54,500* Stockholders’ equity: Common stock Additional paid-in capital Retained earnings
xxx,xxx xxx,xxx xxx,xxx
Add: Accumulated other comprehensive income Total stockholders’ equity
1,500 $xxx,xxx
*A portion of the debt investment could be reported as noncurrent, depending on the expected date of collection. The unrealized holding gain could also be disclosed. (c) Computation of realized gain or loss on sale of debt security: Net proceeds from sale of security A $15,100 Cost of security A (17,500) Loss on sale of security A ($ 2,400) January 20, 2026 Cash ........................................................................... Loss on Sale of Investments .................................... Debt Investments ..............................................
15,100 2,400 17,500
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Exercise 16.10 (20–25 minutes) (a)
STEFFI GRAF, INC. Statement of Comprehensive Income For the Year Ended December 31, 2025 _____________________________________________________________ Net income $120,000 Other comprehensive income Unrealized holding gain 1,100 Comprehensive income $121,100
(b)
STEFFI GRAF, INC. Statement of Comprehensive Income For the Year Ended December 31, 2026 _____________________________________________________________ Net income $140,000 Other comprehensive income Unrealized holding gains $40,000 Add: Reclassification adjustment for loss included in net income 2,400 42,400 Comprehensive income $182,400 Accumulated other comprehensive income: Beginning balance, January 1, 2026 Current period other comprehensive income Amount reclassified from accumulated other comprehensive income Unrealized holding gain Ending balance, December 31, 2026
$1,100 $40,000 2,400 42,400 $43,500
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.11 (20–25 minutes) (a) The total purchase price of these investments is: Sanchez: (10,000 × $33.50) + $1,980 = $336,980 Vicario: (5,000 × $52.00) + $3,370 = $263,370 WTA: (7,000 × $26.50) + $4,910 = $190,410 The purchase entries will be: January 15, 2025 Equity Investments ............................................... Cash ...............................................................
336,980 336,980
Exercise 16.11 (Continued) April 1, 2025 Equity Investments ............................................... Cash ...............................................................
263,370 263,370
September 10, 2025 Equity Investments ............................................... Cash ...............................................................
190,410 190,410
(b) Gross selling price of 4,000 shares at $35 Commissions, taxes, and fees Net proceeds from sale Cost of 4,000 shares ($336,980 × 0.4) Gain on sale of investment
$140,000 (3,850) 136,150 (134,792) $ 1,358
May 20, 2025 Cash ........................................................................ Equity Investments ........................................ Gain on Sale of Investments .........................
136,150 134,792 1,358
(c) Securities Sanchez Co. Vicario Co. WTA Co. Total portfolio value Previous fair value adjustment balance Fair value adjustment—Cr.
Cost Fair Value $202,188* $180,000(1) 263,370 275,000(2) 190,410 196,000(3) $655,968 $651,000
*$336,980 × 0.6 = $202,188. (1) (2) (6,000 × $30) (5,000 × $55)
Unrealized Gain (Loss) $(22,188) (11,630 5,590 (4,968) 0 $ (4,968)
(3)
(7,000 × $28)
December 31, 2025 Unrealized Holding Gain or Loss—Income ........... Fair Value Adjustment ....................................
4,968 4,968
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.12 (15–20 minutes) Situation 1: Journal entries by Conchita Cosmetics: To record purchase of 20,000 (200,000 × 10%) shares of Martinez Fashion at a cost of $13 per share: March 18, 2025 Equity Investments (20,000 × $13) ................................ Cash.........................................................................
260,000 260,000
To record the dividend revenue from Martinez Fashion: June 30, 2025 Cash .................................................................................. Dividend Revenue ($75,000 × .010)..........................
7,500 7,500
To record the investment at fair value: December 31, 2025 Fair Value Adjustment ...................................................... Unrealized Holding Gain or Loss—Income ..............
40,000 40,000*
*($15 – $13) × 20,000 shares = $40,000 Situation 2: Journal entries by Monica, Inc.: To record the purchase of 30% of Seles Corporation’s common stock: January 1, 2025 Equity Investment (Seles Corp.)....................................... Cash [(30,000 × 0.30) × $9] ........................................
81,000 81,000
Since Monica, Inc. obtained significant influence over Seles Corp., Monica, Inc. now employs the equity method of accounting. To record the receipt of cash dividends from Seles Corporation: June 15, 2025 Cash ($36,000 × 0.30) ........................................................ Equity Investment (Seles Corp.) ............................... Exercise 16.12 (Continued)
10,800 10,800
To record Monica’s share (30%) of Seles Corporation’s net income of $85,000: December 31, 2025 Equity Investment (Seles Corp.) ...................................... (0.30 × $85,000) Investment Income .................................................
25,500 25,500
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Exercise 16.13 (8–10 minutes) (a) (b) (c) (d)
$110,000, the increase to the Investment account. Total net income of Sub Company is $440,000 ($110,000 ÷ 0.25). If the dividend payment ratio is 40%, then total dividends = $176,000 ($440,000 × 0.40). Parent receives dividends of $44,000 ($176,000 × 0.25).
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 8-10, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Exercise 16.14 (8–10 minutes) 1. 2.
3.
Equity Investments ................................................ Cash (200 shares × $40) .............................
8,000
Cash (100 shares × $45) .......................................... Gain on Sale of Investments ...................... Equity Investments (100 × $40) ..................
4,500
Unrealized Holding Gain or Loss—Income ........... Fair Value Adjustment ($40 - $35) × 100 ....
500
8,000 500 4,000 500
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 8-10, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.15 (15–20 minutes) (a) Unrealized Holding Gain or Loss—Income .............. Fair Value Adjustment ($313,500 − $305,600) ..
7,900
(b) Cash [(1,500 × $45) – $1,200] .................................... Loss on Sale of Investments .................................... Equity Investments ............................................
66,300 7,200
(c) Equity Investments [(700 × $75) + $1,300] ............... Cash ....................................................................
53,800
7,900
73,500 53,800
(d) Securities
Cost
Fair Value
Wallace Corp., Common Earnhart Corp., Common Martin Inc., Preferred Total portfolio Previous fair value adjustment—Cr. Fair value adjustment—Cr.
$180,000 53,800 60,000 $293,800
$175,000 50,400 58,000 $283,400
Unrealized Holding Gain or Loss—Income ..... Fair Value Adjustment .............................
Unrealized Gain (Loss) $ (5,000) (3,400) (2,000) (10,400) (7,900) $ (2,500)
2,500 2,500
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.16 (15–20 minutes) (a)
December 31, 2025 Equity Investments ........................................... Cash ...........................................................
1,200,000 1,200,000
June 30, 2026 Cash (50,000 × $0.85)........................................ Dividend Revenue .....................................
42,500 42,500
December 31, 2026 Cash (50,000 × $0.85)........................................ Dividend Revenue .....................................
42,500 42,500
Exercise 16.16 (Continued) Fair Value Adjustment ..................................... Unrealized Holding Gain or Loss— Income................................................... *$27 × 50,000 = $1,350,000 *$1,350,000 – $1,200,000 = $150,000 (b)
150,000* 150,000
December 31, 2025 Equity Investment (Kulikowski) ............................. 1,200,000 Cash .................................................................
1,200,000
June 30, 2026 Cash (50,000 × $0.85) .............................................. Equity Investment (Kulikowski Inc.) ..............
42,500 42,500
December 31, 2026
(c)
Cash (50,000 × $0.85) .............................................. Equity Investment (Kulikowski Inc.) ..............
42,500
Equity Investment (Kulikowski Inc.) ...................... Investment Income (0.20 × $730,000) .............
146,000
42,500
Fair Value Method Investment amount (balance sheet) $1,350,000 Dividend revenue (income statement) 85,000 Unrealized holding gain (income statement) 150,000 Investment income (income statement)
146,000 Equity Method *$1,261,000* 0 146,000
*$1,200,000 + $146,000 – $42,500 – $42,500 LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.17 (10–15 minutes) Equity Investment (Edwards Co.) .......................... Cash .................................................................
180,000
Cash ($20,000 × 0.30).............................................. Equity Investment (Edwards Co.) ..................
6,000
Equity Investment (Edwards Co.) .......................... Investment Income ($80,000 × 0.30)...............
24,000
180,000 6,000 24,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.18 (15–20 minutes) (a) Bad Debt Expense ($800,000 – $720,000) .......................................... Allowance For Doubtful Accounts .................
80,000 80,000
(b) The new carrying value is $720,000. GAAP indicates that under current credit expected loss model (CECL), the allowance will be evaluated in subsequent periods. (c) No entry needed as held-to-maturity investments are not adjusted for fair value changes. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Exercise 16.19 (15-20 Minutes) (a) Unrealized Holding Gain or Loss—Income ($100,000 – $80,000) ............................................ Equity Investment (Arroyo Company) ...........
20,000 20,000
Exercise 16.19 (Continued) (b) Fair Value Adjustment ........................................... Unrealized Holding Gain or Loss—Income .. * Investments Lee Corporation stock Wood Inc. stock Total of portfolio
Cost $250,000 180,000 $430,000
Fair Value $300,000 190,000 $490,000
Previous fair value adjustment .................................... Fair value adjustment....................................................
60,000* 60,000 Unrealized Holding Gain (Loss) $50,000 10,000 $60,000 0 $60,000
Note: For both parts (a) and (b) the change in fair value is reported as Unrealized Holding Gain or Loss—Income. However, in part (a) Lilly does not use the Fair Value Adjustment account because the accounting for the fair value option is on an investment-by-investment basis rather than a portfolio basis. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.20 (15-20 minutes) (a) Net income before security gains or losses ............ Sale of Investment in Woods Inc. stock ($195,000 – $180,000) .............................................. Investment in Arroyo Company stock ($140,000 – $80,000)................................................ Net income ................................................................. (b) Equity Investment (Arroyo Company) ($140,000 – $80,000)................................................ Unrealized Holding Gain or Loss—Income ......
$905,000 15,000 60,000 $980,000 60,000 60,000
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.21 (15-20 minutes) (a) Net income before security gains and losses .......... Investment in debt securities ($41,000 – $40,000) .... Investment in Chen Company stock ($910,000 – $800,000) .............................................. Net income .................................................................. (b) Bonds Payable ............................................................ Unrealized Holding Gain or Loss—Equity ($220,000 – $195,000) .......................................
$100,000 1,000 110,000 $211,000 25,000 25,000
Note to instructor: Fair Value Option for liabilities is discussed in Chapter 13. LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.22 (20–25 minutes) (a)
December 31, 2026 Bad Debt Expense ($3,300,000 – $2,500,000) ........... 800,000 Allowance for Doubtful Accounts ...........................
(b)
800,000
December 31, 2027 Fair Value Adjustment ($1,400,000 – $1,100,000)......................................... 300,000 Unrealized Holding Gain or Loss—Income .......
300,000
No entry for held-to maturity debt investment. (c)
December 31, 2026 Bad Debt Expense ($3,300,000 – $2,500,000) .......... 800,000 Allowance for Doubtful Accounts .....................
800,000
The available-for-sale debt investment credit loss (impairment) is limited to the amount that the fair value is less than the expected credit loss. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 16.23 (20-25 minutes) (a)
(b)
The amount of the credit loss should be $10,000 ($50,000 - $40,000). The credit loss is limited to the amount that the fair value is less than amortized cost. Morley makes the following journal entry to record this transaction Bad Debt Expense ................................................. Allowance for Doubtful Accounts ..................
10,000 10,000
(c)
Morley would not recognize a credit loss in this situation because the fair value is more than the amortized cost.
(d)
Morley makes the following entry to record this transaction Fair Value Adjustment........................................... Unrealized Holding Gain or Loss--Equity ($53,000 – $50,000) .......................................
3,000 3,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 16.24 (15–20 minutes) (a) Call Option............................................................... Cash .................................................................
300
(b) Unrealized Holding Gain or Loss—Income ........... Call Option ($300 – $200) ................................
100
Call Option............................................................... Unrealized Holding Gain or Loss—Income (1,000 × $3) ...................................................
3,000
300
100
3,000
(c) Unrealized Holding Gain: $2,900 ($3,000 – $100) LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 16.25 (15–20 minutes) (a)
6/30/25 $100,000 × 0.03 3,000 (3,000) $ 0
Fixed-rate debt Fixed rate (0.06 ÷ 2) Semiannual debt payment Swap fixed receipt Net income effect Swap variable rate 0.057 × 1/2 × $100,000 0.067 × 1/2 × $100,000 Net interest expense
$ $
(b)
2,850 0 2,850
12/31/25 $100,000 × 0.03 3,000 (3,000) $ 0
$ $
3,350 3,350
Note to instructor: An interest rate swap in which a company changes its interest payments from fixed to variable is a fair value hedge because the changes in fair value of both the derivative and the hedged liability offset one another. LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 16.26 (15–20 minutes) (a) Variable-rate debt Variable rate Debt payment
12/31/25 (b) 12/31/26 $10,000,000 $10,000,000 × 0.058 × 0.066 $ 580,000 $ 660,000
Debt payment Swap variable received Net income effect Swap payable—fixed ($10,000,000 × 0.06)
$
Net interest expense
$
580,000 (580,000) 0
$
600,000 600,000
660,000 (660,000) 0 600,000
$
600,000
Note to instructor: An interest swap in which a company changes its interest payments from variable to fixed is a cash flow hedge because interest costs are always the same. LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 16.27 (15–20 minutes) (a) Interest Expense ....................................................... Cash ($1,000,000 × 0.075) .................................
75,000
(b) Cash ........................................................................... Interest Expense................................................
13,000
(c) Swap Contract........................................................... Unrealized Holding Gain or Loss—Income .....
48,000
(d) Unrealized Holding Gain or Loss—Income ............. Notes Payable....................................................
48,000
75,000 13,000 48,000 48,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 16.28 (20–25 minutes) (a)
(b)
August 15, 2024 Call Option...................................................................... Cash ........................................................................ September 30, 2024 Call Option...................................................................... Unrealized Holding Gain or Loss—Income .......... ($8 × 400) Unrealized Holding Gain or Loss—Income .................. Call Option ($360 – $180) .......................................
(c)
December 31, 2024 Unrealized Holding Gain or Loss—Income .................. Call Option ($2 × 400) ............................................. Unrealized Holding Gain or Loss—Income .................. Call Option ($180 – $65) .........................................
360 360
3,200 3,200 180 180
800 800 115 115
*Exercise 16.28 (Continued) (d)
January 15, 2025 Unrealized Holding Gain or Loss—Income .................. Call Option ($65 – $30) ........................................... Cash (400 × $7) .............................................................. Gain on Settlement of Call Option* ....................... Call Option** ...........................................................
35 35 2,800 370 2,430
**Computation of Gain: $370 (400 shares × $1) – $30 **Value of Call Option at settlement: Call Option 360 3,200
180 800 115 35
2,430 LO: 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 16.29 (25–30 minutes) (a)
May 1, 2025 Memorandum entry to indicate entering into the futures contract.
(b)
June 30, 2025 Futures Contract ..................................................... Unrealized Holding Gain or Loss—Equity [($520 – $500) × 200 ounces] ......................
(c)
4,000 4,000
September 30, 2025 Futures Contract ..................................................... Unrealized Holding Gain or Loss—Equity [($525 – $520) × 200 ounces] ......................
1,000 1,000
*Exercise 16.29 (Continued) (d)
October 5, 2025 Inventory ................................................................ Cash ($525 × 200 ounces) ..............................
105,000
Cash ........................................................................ Futures Contract ............................................ [($525 – $500) × 200 ounces]
5,000
105,000 5,000
Note to instructor: In practice, futures contracts are settled on a daily basis; for our purposes, we show only one settlement for the entire amount. (e)
(f)
December 15, 2025 Cash ........................................................................ Sales Revenue ................................................
250,000
Cost of Goods Sold ............................................... Inventory (Finished goods) ...........................
140,000
Unrealized Holding Gain or Loss—Equity ........... Cost of Goods Sold ($4,000 + $1,000) ...........
5,000
250,000 140,000 5,000
HART GOLF CO. Partial Income Statement For the Quarter Ended December 31, 2025 Sales revenue Cost of goods sold Gross profit
$250,000 135,000* $115,000
*Cost of inventory Less: Futures contract adjustment Cost of goods sold
$140,000 5,000 $135,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Time and Purpose of Problems Problem 16.1 (Time 20–30 minutes) Purpose—the student is required to prepare journal entries and adjusting entries covering a three-year period for debt investments first classified as held-to-maturity and then classified as available-for-sale. Bond premium amortization is also involved. Problem 16.2 (Time 30–40 minutes) Purpose—The student is required to prepare journal entries and adjusting entries for available-for-sale debt investments, along with an amortization schedule. Problem 16.3 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the differentiation in accounting treatments for debt and equity security investments. The student is required to prepare the necessary journal entries to properly reflect transactions relating to available-for-sale debt and equity investments. Problem 16.4 (Time 25–35 minutes) Purpose—the student is required to distinguish between the existence of a bond premium or discount. The student is also required to prepare the adjusting entries at two year-ends for available-for-sale debt investments. Problem 16.5 (Time 25–35 minutes) Purpose—the student is required to prepare journal entries for the sale and purchase of equity investments along with the year-end adjusting entry for unrealized holding gains or losses and to discuss the financial statement presentation. Problem 16.6 (Time 25–35 minutes) Purpose—the student is required to prepare during-the-year and year-end entries for equity investments. Problem 16.7 (Time 25–35 minutes) Purpose—the student is required to prepare during-the-year and year-end entries for available-for-sale debt investments and to explain how the entries would differ if the securities were classified as held-tomaturity. Problem 16.8 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the fair value and equity methods. The student is required to apply the fair value method to both classes of securities and describe how they would be reflected in the body and notes to the financial statements. There is also a requirement involving the equity method. Problem 16.9 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to prepare entries for available-for-sale transactions and to report the results in a comprehensive income statement and a balance sheet.
Time and Purpose of Problems (Continued) Problem 16.10 (Time 30–40 minutes) Purpose—to provide the student with an understanding of the reporting problems associated with equity investments. Description and amounts that should be reported on a company’s comparative financial statements are then required. Problem 16.11 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the reporting problems associated with equity investments. Description and amounts that should be reported on a company’s comparative financial statements are then required. *Problem 16.12 (Time 20–25 minutes) Purpose—the student is required to prepare the entries at purchase, throughout the life, and at expiration for a stand-alone derivative (call option). *Problem 16.13 (Time 20–25 minutes) Purpose—the student is required to prepare the entries at purchase, throughout the life, and at expiration for a stand-alone derivative (put option). *Problem 16.14 (Time 20–25 minutes) Purpose—the student is required to prepare the entries at purchase, throughout the life, and at expiration for a stand-alone derivative (put option). *Problem 16.15 (Time 30–40 minutes) Purpose—the student is provided with an opportunity to prepare the entries for a fair value hedge in the context of an interest rate swap, including how the effects of the swap will be reported in the financial statements. *Problem 16.16 (Time 25–35 minutes) Purpose—the student is provided with an opportunity to prepare the entries for a cash flow hedge in the context of an option contract on the purchase of inventory, including how the effects of the hedge will be reported in the financial statements. *Problem 16.17 (Time 25–35 minutes) Purpose—the student is provided with an opportunity to prepare the entries for a fair value hedge in the context of the use of a put option to hedge inventory, including how the effects for the hedging instrument and hedged item will be reported in the financial statements.
Solutions to Problems Problem 16.1
(a)
(b)
(c)
(d)
(e)
December 31, 2023 Debt Investments .......................................... Cash ...................................................... December 31, 2024 Cash ............................................................... Debt Investments ................................. Interest Revenue .................................. December 31, 2026 Cash ............................................................... Debt Investments ................................. Interest Revenue .................................. December 31, 2023 Debt Investments .......................................... Cash ...................................................... December 31, 2024 Cash ............................................................... Debt Investments .................................. Interest Revenue .................................. Unrealized Holding Gain or Loss—Equity ($107,093 – $106,500) ................................. Fair Value Adjustment ...................
108,660 108,660 7,000 1,567 5,433 7,000 1,728 5,272 108,660 108,660 7,000 1,567 5,433 593 593
Problem 16.1 (Continued) (f)
December 31, 2026 Cash ................................................................. Debt Investments ................................... Interest Revenue ....................................
7,000 1,728 5,272
Debt Investments (available-for-sale)
Spangler Company, 7% bonds Previous fair value adjustment—Dr. ($107,500 – $105,447) Fair value adjustment—Cr.
Amortized Cost $103,719
Fair Value $105,650
Unrealized Holding Gain or Loss—Equity ................. Fair Value Adjustment ..........................................
Unrealized Gain (Loss) $1,931 2,053 $ (122) 122 122
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 16.2 (a) January 1, 2025 purchase entry: Debt Investments ................................................... Cash .................................................................
369,114 369,114
(b) The amortization schedule is as follows: Schedule of Interest Revenue and Bond Discount Amortization—Effective-Interest Method 8% Bonds Purchased to Yield 10%
Date 1/1/25 7/1/25 1/1/26 7/1/26 1/1/27 7/1/27 1/1/28 7/1/28 1/1/29 7/1/29 1/1/30 Total
Cash Received
Interest Revenue
Bond Discount Amortization
16,000* 16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 $160,000
$ 18,456** 18,579 18,707 18,843 18,985 19,134 19,291 19,455 19,628 19,808*** $190,886
$ 2,456 2,579 2,707 2,843 2,985 3,134 3,291 3,455 3,628 3,808 $30,886
Carrying Amount of Bonds $369,114 371,570 374,149 376,856 379,699 382,684 385,818 389,109 392,564 396,192 400,000
*($400,000 × 0.08) ÷ 2. **($369,114 × 0.10) ÷ 2. ***$2 difference due to rounding. (c) Interest entries: July 1, 2025 Cash......................................................................... Debt Investments .................................................... Interest Revenue .............................................
16,000 2,456 18,456
Problem 16.2 (Continued) December 31, 2025 Interest Receivable ................................................. Debt Investments .................................................... Interest Revenue .............................................
16,000 2,579 18,579
(d) December 31, 2026 adjusting entry: Securities Aguirre (total portfolio * value) Previous fair value adjustment—Dr. Fair value adjustment— Cr.
Available-for-Sale Portfolio Cost
Fair Value
Unrealized Gain (Loss)
$379,699*
$372,726
$ (6,973) 3,375 $(10,348)
*This is the amortized cost of the bonds on December 31, 2026. See (b) schedule. December 31, 2026 Unrealized Holding Gain or Loss—Equity ........... Fair Value Adjustment ...................................
10,348 10,348
(e) January 1, 2027 sale entry: Selling price of bonds ........................................... Less: Amortized cost (see schedule from (b)) .... Realized loss on sale of investment ....................
$370,726 (379,699) $ (8,973)
January 1, 2027 Cash ........................................................................ Loss on Sale of Investments ................................. Debt Investments ...........................................
370,726 8,973 379,699
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Problem 16.3
(a) Debt Investments .................................................... Equity Investments ................................................. Interest Revenue ($50,000 × 0.12 × 4/12) ............... Investments .....................................................
162,000* 37,400 2,000 201,400
*[$110,000 + ($50,000 × 1.04)] (Note to instructor: Some students may debit Interest Receivable at date of purchase instead of Interest Revenue. This procedure is correct, assuming that when the cash is received for the interest, an appropriate credit to Interest Receivable is recorded.) (b)
December 31, 2025 Interest Receivable ................................................. Debt Investments ............................................ Interest Revenue ............................................. [Accrued interest [ $50,000 × 0.12 × 10/12 = $5,000 [Premium amortization [ 6/236 × $2,000 = (51) [Accrued interest [ $110,000 × 0.11 × 3/12 = 3,025 $7,974
(c)
8,025 51 7,974
December 31, 2025 Available-for-Sale Debt Portfolio Securities U.S. government bonds McGrath Company bonds Total Previous fair value adjustment balance Fair value adjustment—Dr. *($50,000 × 1.04) – $51
Cost $110,000 51,949* $161,949
Fair Value $124,700 58,600 $183,300
Unrealized Gain (Loss) $14,700 6,651 21,351 0 $21,351
Problem 16.3 (Continued)
(d)
Fair Value Adjustment .......................................... Unrealized Holding Gain or Loss—Equity ...
21,351
Unrealized Holding Gain Loss – Income ............ Fair Value Adjustment ($37,400 - $31,800) ..
5,600
21,351 5,600
July 1, 2026 Cash ($119,200 + $3,025) ...................................... Debt Investments .......................................... Interest Revenue ($110,000 × 0.11 × 3/12) ... Gain on Sale of Investments ........................
122,225 110,000 3,025 9,200
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 16.4
(a) The bonds were purchased at a discount. That is, they were purchased at less than their face value because the bonds’ amortized cost increased from $491,150 to $550,000. (b)
December 31, 2025 Fair Value Adjustment ............................................... Unrealized Holding Gain or Loss—Equity ........
4,850* 4,850
Available-for-Sale Portfolio
Debt Investment Previous fair value adjustment—Dr. Fair value adjustment—Dr. (c)
Amortized Cost
Fair Value
Unrealized Gain (Loss)
$491,150
$497,000
$5,850 1,000 $4,850*
December 31, 2026 Unrealized Holding Gain or Loss—Equity ............... Fair Value Adjustment ......................................
16,292 16,292
Available-for-Sale Portfolio
Debt Investment Previous fair value adjustment—Dr. Fair value adjustment—Cr. needed to bring balance to $10,442 Cr.
Amortized Cost
Fair Value
Unrealized Gain (Loss)
$519,442
$509,000
$(10,442) 5,850* ($16,292)
*$1,000 + $4,850 LO: 1, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Problem 16.5 (a) Gross selling price of 3,000 shares at $22 ............. Commissions, taxes, and fees ................................ Net proceeds from sale ........................................... Cost of 3,000 shares ................................................ Gain on sale of investments ...................................
$66,000 (2,150) 63,850 (58,500) $ 5,350
January 15, 2026 Cash .......................................................................... Equity Investments .......................................... Gain on Sale of Investments ...........................
63,850 58,500 5,350
(b) The total purchase price is: (1,000 × $33.50) + $1,980 = $35,480 The purchase entry will be: April 17, 2026 Equity Investments .................................................. Cash .................................................................. (c)
35,480 35,480
Equity Securities Portfolio—December 31, 2026 Securities
Fair Value
Unrealized Gain (Loss)
$610,000* 240,000** 29,000*** $879,000
($30,000 (15,000) (6,480) ( 8,520
Cost
Munter Ltd. King Co. Castle Co. Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.
$580,000 255,000 35,480 $870,480
(10,100) $18,620
***$61 10,000 ***$40 6,000 ***$29 1,000 December 31, 2026 Fair Value Adjustment ............................................. Unrealized Holding Gain or Loss—Income ....
18,620 18,620
Problem 16.5 (Continued) (d) The unrealized holding gains or losses should be reported on the income statement in the “Other revenues and gains” section. On the balance sheet, the equity securities are classified as noncurrent given that management intends to hold these securities for more than one year. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Problem 16.6
(1)
October 10, 2025 Cash (5,000 × $54) .......................................... Gain on Sale of Investments .................. Equity Investments .................................
(2)
270,000 55,000 215,000
November 2, 2025 Equity Investments ....................................... Cash (3,000 × $54.50)..............................
163,500 163,500
(3) At September 30, 2025, McElroy had the following fair value adjustment: Equity Securities Portfolio—September 30, 2025 Securities Horton, Inc. common Monty, Inc. preferred Oakwood Corp. common Total of portfolio Previous fair value adjustment Balance Fair value adjustment—Cr.
Cost
Fair Value
Unrealized Gain (Loss)
$215,000 133,000 180,000 $528,000
$200,000 140,000 179,000 $519,000
($(15,000) ( 7,000) ( (1,000) ((9,000) ( 0) ($ (9,000)
Problem 16.6 (Continued) At December 31, 2025, McElroy had the following fair value adjustment: Securities Portfolio—December 31, 2025 Securities Monty, Inc. preferred Oakwood Corp. common Patriot common Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Cr.
Cost
Fair Value
Unrealized Gain (Loss)
$133,000 $106,000 180,000 193,000 163,500 132,000 $476,500 $431,000
($(27,000) 13,000) ( (31,500) (45,500) (9,000) ($(36,500)
The entry on December 31, 2025 is therefore as follows: Unrealized Holding Gain or Loss—Income ...... Fair Value Adjustment ...............................
36,500 36,500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 25-35, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 16.7
(a)
February 1 Debt Investments ..................................................... Interest Revenue (4/12 × 0.10 × $300,000) .............. Cash ..................................................................
300,000 10,000 310,000
(Note to instructor: Some students may debit Interest Receivable at date of purchase instead of Interest Revenue. This procedure is correct, assuming that when the cash is received for the interest, an appropriate credit to Interest Receivable is recorded.) April 1 Cash .......................................................................... Interest Revenue ($300,000 × 0.10 × 6/12) ......
15,000 15,000
July 1 Debt Investments ..................................................... Interest Revenue (1/12 × 0.09 × $200,000) .............. Cash ..................................................................
200,000 1,500 201,500
September 1 Cash [($60,000 × 0.99) + ($60,000 × 0.10 × 5/12)] ... Loss on Sale of Investments .................................. Debt Investments ............................................. Interest Revenue (5/12 × 0.10 × $60,000 = $2,500) ...................
61,900 600 60,000 2,500
October 1 Cash [($300,000 – $60,000) × 0.10 × 6/12] ............... Interest Revenue ..............................................
12,000 12,000
December 1 Cash ($200,000 × 0.09 × 6/12) .................................. Interest Revenue ..............................................
9,000 9,000
Problem 16.7 (Continued) December 31 Interest Receivable ................................................. Interest Revenue ............................................. (3/12 × $240,000 × 0.10 = $6,000) (1/12 × $200,000 × 0.09 = $1,500) ($6,000 + $1,500 = $7,500)
7,500 7,500
December 31 Unrealized Holding Gain or Loss—Equity ............ Fair Value Adjustment ....................................
26,000 26,000
Available-for-Sale Portfolio Security Gibbons Co. Sampson, Inc. Total
Cost
Fair Value
Unrealized Gain (Loss)
$240,000 200,000 $440,000
$228,000* 186,000** $414,000
$(12,000) (14,000) $(26,000)
*$240,000 × 0.95 **$200,000 × 0.93 (b) All the entries would be the same, except held-to-maturity securities would be carried at amortized cost and not valued at fair value at yearend, so the last entry would not be made. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Problem 16.8
(a)
Fair Value Adjustment ........................................... 645,000 Unrealized Holding Gain or Loss—Income .. 645,000 Computations: Computations of Unrealized Gain or Loss in 2025
Cost
Fair Value
Unrealized Gain (Loss)
$ 1,400,000 1,000,000 22,500,000
$1,600,000 720,000 22,225,000
($(200,000 ( (280,000) (275,000)
$24,900,000 Previous Fair Value Adjustment (Cr) Fair Value Adjustment (Dr)
$24,545,000
(($355,000) (1,000,000)* $ 645,000
Security Delaney Motors Patrick Electric Norton Ind.
* Computations of Unrealized Gain or Loss in 2024 Security
Cost
Fair Value
Unrealized Gain (Loss)
Norton Ind.
$22,500,000
$21,500,000
($1,000,000)
Problem 16.8 (Continued) (b) The unrealized holding loss on the valuation of the equity securities is reported on the income statement. The gain would appear in the “Other revenues and gains” section of the income statement. The Fair Value Adjustment is a valuation account and it will be used to show the reduction in the fair value of the equity securities. The equity securities portfolio is disclosed in the balance sheet as an asset and reported at its fair value. The asset is probably noncurrent in nature (or maybe current, based on intent of management). The disclosure for these securities includes the change in net unrealized holding gains or losses which was included in earnings. (c) Equity Investment (Norton Industries) ...................... Investment Income ($500,000 × 0.25) .................
125,000
Cash ($100,000 × 0.25)............................................... Equity Investment (Norton Industries)................
25,000
125,000 25,000
With 25% ownership, Brooks has significant influence and should apply the equity method. No fair value adjustments are recorded under the equity method. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Problem 16.9
(a)
January 1, 2025 Fair value of available-for-sale securities ............... Accumulated other comprehensive income ........... Cost basis of available-for-sale securities ..............
$240,000 (30,000) $210,000
As indicated, the cost basis at January 1, 2025 is $210,000, At December 31, 2025, the cost basis of the available-for-sale debt securities was given at $140,000. As a result, the cost basis of the debt securities sold is $70,000 ($210,000 - $140,000). The gain on the sale of the investment during 2025 is given on the income statement as $30,000. Therefore, the cash received on the sale is computed as follow: Cost basis of asset sold ........................................... Gain on the sale of the investment ......................... Cash received ...........................................................
$70,000 30,000 $100,000
The entry to record the sale is as follows. Cash ........................................................................... Debt Investments .............................................. Gain on the Sale of Investment ........................
100,000 70,000 30,000
(b) The computation of the unrealized holding gain or loss in 2025 is computed as follows: Accumulated comprehensive income at December 31, 2025 ($190,000 − $140,000) = $50,000 Accumulated comprehensive income at January 1, 2025 (given) = 30,000 Unrealized holding gain or loss in 2025 $20,000 The entry to record the unrealized gain in 2025 is as follows Fair value Adjustments ................................................... Unrealized Holding Gain or Loss – Equity .............
$20,000 $20,000
Problem 16.9 (Continued) (c)
ACKER INC. Statement of Comprehensive Income For the Year Ended December 31, 2025 Net income .................................................................... Other comprehensive income Unrealized holding gain ....................................... Comprehensive income ............................................... Acker will provide the following disclosure for Accumulated other comprehensive income: Beginning balance, January 1, 2025 Current period other comprehensive income Amount reclassified from accumulated other comprehensive income Unrealized holding gain Ending balance, December 31, 2025
$35,000 20,000 $55,000
$30,000 $50,000**
**Accumulated other comprehensive income 12/31/25 ....................................................... Accumulated other comprehensive income 1/1/25 ........................................................... Increase in unrealized holding gain ......................... Realized holding gain ................................................ Total holding gains arising during period ...............
30,000 20,000 $50,000 $50,000 (30,000) 20,000 30,000 $50,000
Problem 16.9 (Continued) (d)
ACKER INC. Balance Sheet As of December 31, 2025
Assets Cash Debt investments (available-for-sale) Total assets
$155,000* 190,000 $345,000
Stockholders’ Equity Common stock Retained earnings Accumulated other comprehensive income Total
*Beginning balance ................................................................. Dividend revenue ................................................................... Cash proceeds on sale ..........................................................
$260,000 35,000 50,000 $345,000 $ 50,000 5,000 100,000 $155,000
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 16.10 (a)
March 1, 2025 Cash .......................................................................... Dividend Revenue (900 × $2) ......................... April 30, 2025 Cash (300 × $11) ....................................................... Gain on Sale of Investments.......................... Equity Investments ........................................ *[300 × ($11 – $9)] May 15, 2025 Equity Investments .................................................. Cash (100 × $16) ............................................. December 31, 2025 Fair Value Adjustment ............................................. Unrealized Holding Gain or Loss—Income ......................................... Security
Cost
Evers Comp. ($15,000 + $1,600) $16,600 Rogers Comp. 18,000 Chance Comp. ($4,500 – $2,700) 1,800 Total of portfolio $36,400 Previous fair value adjustment bal.—Cr. Fair value adjustment—Dr. (1)
[(1,000 + 100) × $17]
(2)
(900 × $19)
1,800 1,800 3,300 600* 2,700
1,600 1,600 8,500 8,500
Unrealized Fair Value Gain (Loss) $18,700(1) 17,100(2) 1,600(3) $37,400
$ 2,100 (900) (200) $ 1,000 (7,500) $ 8,500
[(500 – 300) × $8]
(3)
February 1, 2026 5. Cash (200 × $8)......................................................... Loss on Sale of Investments [200 × ($8 – $9)] ....... Equity Investments ........................................
1,600 200 1,800
March 1, 2026 6. Cash .......................................................................... Dividend Revenue ..........................................
1,800 1,800
Problem 16.10 (Continued) December 21, 2026 7. Dividend Receivable ................................................ Dividend Revenue (1,100 × $3) ......................
3,300
December 31, 2026 8. Fair Value Adjustment ............................................. Unrealized Holding Gain or Loss—Income...
4,200
Security
(1)
(b)
(1,100 × $19)
(2)
4,200
Unrealized Fair Value Gain (Loss)
Cost
Evers Comp. Rogers Comp. Total of portfolio Previous fair value adjustment bal.—Dr. Fair value adjustment—Dr.
3,300
$20,900(1) 18,900(2) $39,800
$16,600 18,000 $34,600
$4,300 900 $5,200 1,000 $4,200
(900 × $21)
Partial Balance Sheet as of
December 31, 2025
December 31, 2026
Current Assets Dividend receivable
$
0
$ 3,300
Investments Equity investments, at fair value
37,400
39,800
LO: 2, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 16.11 (a)
Balance Sheet at December 31, 2025 Equity investments, at fair value .......................................... (Reported as current or noncurrent based on intent)
$123,000
Income Statement for year ended December 31, 2025 Unrealized Holding Loss ...................................................... (See Schedule A)
$
4,000
Recognize unrealized holding loss in “Other expenses and losses” section of the income statement. (b)
Balance Sheet at December 31, 2026 Equity investments, at fair value .......................................... (Reported as current or noncurrent based on intent)
$94,000
Income Statement for year ended December 31, 2026 Other Expenses and Losses Loss on Sale of investments .................................... Unrealized Holding Loss (see Schedule A) .............
$1,800* 38,000
*The entry made to recognize the loss on sale is as follows: Cash ..................................................................... Loss on Sale of Investments .............................. Equity Investments ....................................
38,200 1,800 40,000
Problem 16.11 (Continued) (c)
Balance Sheet at December 31, 2027 Equity investments, at fair value .......................................... (Reported as current or noncurrent based on intent)
$88,000
Income Statement for year ended December 31, 2027 Other expenses and losses Loss on Sale of Investments ($8,100 + $2,700) .......... Unrealized holding gain (see Schedule A)…………….
$10,800 50,000
The entry made to record the sale of Lindsay Jones’ stock was: Cash ........................................................................ Loss on Sale of Investments ................................. Equity Investments ($15,000 + $33,000) ......
39,900 8,100 48,000
The entry to record the sale of the Duff Company Investment was: Cash ........................................................................ Loss on Sale of Investments ................................. Equity Investments ($16,000 − $8,000) ........
5,300 2,700 8,000
Schedule A: Unrealized Holding Gains or Losses
Portfolio Year 12/31/25 12/31/26 12/31/27
Cost $127,000 136,000 80,000
Fair Value $123,000 94,000 88,000
Unrealized Holding Gain Previous Gain (Loss): Fair Value (Loss) in FV Adj. Adjustment Income ($4,000) $0 ($4,000) (42,000) (4,000) (38,000) 8,000 (42,000) 50,000
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 20-30, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 16.12 (a)
(b)
July 7, 2025 Call Option .............................................................. Cash .................................................................. September 30, 2025 Call Option .............................................................. Unrealized Holding Gain or Loss—Income ($7 × 200) ....................................................... Unrealized Holding Gain or Loss—Income........... Call Option ($240 – $180).................................
(c)
December 31, 2025 Unrealized Holding Gain or Loss—Income........... Call Option ($2 × 200) ...................................... Unrealized Holding Gain or Loss—Income........... Call Option ($180 – $65)...................................
(d)
January 4, 2026 Call Option ($1 × $200) ........................................... Unrealized Holding Gain or Loss—Income ....
240 240 1,400 1,400 60 60 400 400 115 115 200 200
Unrealized Holding Gain or Loss—Income........... Call Option ($65 – $30).....................................
35
Cash (200 × $6) ....................................................... Loss on Settlement of Call Option ........................ Call Option* ......................................................
1,200 30
35
1,230
*Value of Call Option at Settlement: Call Option 240 1,400 60 200 400 115 35 1,230 LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 16.13
(a)
(b)
(c)
(d)
July 7, 2025 Put Option ................................................................ Cash ...................................................................
240
September 30, 2025 Unrealized Holding Gain or Loss—Income ............ Put Option ($240 – $125)...................................
115
December 31, 2025 Unrealized Holding Gain or Loss—Income ............ Put Option ($125 – $50).....................................
75
January 31, 2026 Loss on Settlement of Put Option .......................... Put Option ($50 – $0) ........................................
50
240
115
75
50
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 16.14 (a)
(b)
January 7, 2025 Put Option ............................................................... Cash .................................................................. March 31, 2025 Put Option ............................................................... Unrealized Holding Gain or Loss—Income ($5 × 400) ....................................................... Unrealized Holding Gain or Loss—Income........... Put Option ($360 – $200) .................................
(c)
June 30, 2025 Unrealized Holding Gain or Loss—Income........... Put Option [($82 – $80) × 400] ......................... Unrealized Holding Gain or Loss—Income........... Put Option ($200 – $90) ...................................
(d)
July 6, 2025 Put Option [($82 – $77) × $400] .............................. Unrealized Holding Gain or Loss—Income ....
360 360 2,000 2,000 160 160 800 800 110 110 2,000 2,000
Unrealized Holding Gain or Loss—Income........... Put Option ($90 – $25) .....................................
65
Cash (400 × $8) ....................................................... Loss on Settlement of Put Option ......................... Put Option* .......................................................
3,200 25
65
3,225
*Value of Put Option at settlement: Put Option 360 2,000 160 2,000 800 110 65 3,225 LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 16.15
(a)
(1) No entry necessary at the date of the swap because the fair value of the swap at inception is zero. (2)
(3)
June 30, 2026 Interest Expense ................................................. Cash ($10,000,000 × 0.08 × 1/2) .....................
400,000
June 30, 2026 Cash ..................................................................... Interest Expense ............................................
50,000*
400,000
50,000
Interest Received (Paid) Swap receivable ($10,000,000 × 0.08 × 1/2) ................... $ 400,000 Payable at LIBOR (10,000,000 × 0.07 × 1/2) ...................(350,000) Cash settlement .............................................................. $ 50,000* (4)
(5)
(b)
June 30, 2026 Notes Payable ..................................................... Unrealized Holding Gain or Loss—Income ..
200,000
June 30, 2026 Unrealized Holding Gain or Loss—Income ....... 200,000 Swap Contract................................................
Financial statement presentation as of December 31, 2025 Balance Sheet Liabilities Notes payable $10,000,000 Income Statement No effect
200,000
200,000
*Problem 16.15 (Continued) (c)
Financial statement presentation as of June 30, 2026 Balance Sheet Liabilities Notes payable $ 9,800,000 Swap contract 200,000 Income Statement Interest expense Unrealized holding gain— notes payable Unrealized holding loss— swap contract Total
(d)
$
350,000 ($400,000 – $50,000)
$
200,000 (200,000) $ 350,000
Financial statement presentation as of December 31, 2026 Balance Sheet Assets Swap contract $ 60,000 Liabilities Notes payable 10,060,000 Income Statement Interest expense First six months Next six months Total
$
Unrealized holding gain— swap contract Unrealized holding loss— notes payable Total **Swap receivable ($10,000,000 × 0.08 × 1/2) Payable at LIBOR ($10,000,000 × 0.075 × 1/2) Cash settlement Interest expense unadjusted June 30–December 31, 2026 Cash settlement
350,000 [as shown in (c)] 375,000** (see below) 725,000 60,000 (60,000) $725,000 400,000
$ $ $
(375,000) 25,000 400,000 (25,000) 375,000
LO: 6, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 16.16
(a)
April 1, 2025 Memo entry to indicate entering into the futures contract.
(b)
June 30, 2025 Futures Contract ..................................................... Unrealized Holding Gain or Loss— Equity [($310 – $300) × 500 ounces] ............
(c)
(d)
September 30, 2025 Futures Contract ..................................................... Unrealized Holding Gain or Loss— Equity [($315 – $310) × 500 ounces] ............ October 10, 2025 Inventory ................................................................. Cash ($315 × 500 ounces)................................ Cash ......................................................................... Futures Contract [($315 – $300) × 500 ounces] ........................
(e)
December 20, 2025 Cash ......................................................................... Sales Revenue ..................................................
5,000 5,000 2,500 2,500 157,500 157,500 7,500 7,500
350,000 350,000
Cost of Goods Sold ................................................ Inventory ...........................................................
200,000
Unrealized Holding Gain or Loss—Equity ............ Cost of Goods Sold ($5,000 + $2,500) .............
7,500
200,000 7,500
*Problem 16.16 (Continued) (f)
LEW JEWELRY COMPANY Partial Balance Sheet At June 30, 2025 Current Assets Futures contract.................................................................
$5,000
Stockholders’ Equity Accumulated other comprehensive income ....................
$5,000
There are no income effects associated with this anticipated transaction in the quarter ended June 30, 2025. (g)
LEW JEWELRY COMPANY Income Statement For the Quarter Ended December 31, 2025 Sales revenue ..................................................................... Cost of goods sold............................................................. Gross profit ........................................................................
$350,000 192,500* $157,500
*Cost of inventory .............................................................. Less: Futures contract adjustment................................... Cost of goods sold.............................................................
$200,000 7,500 $192,500
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 16.17
(a)
(1)
October 15, 2025 Inventory .......................................................... Cash (4,000 × $60)....................................... Put Option......................................................... Cash .............................................................
(2)
(3)
October 31, 2025 Unrealized Holding Gain or Loss—Income .... Put Option ($300 – $175) ............................
240,000 240,000 300 300 125 125
Unrealized Holding Gain or Loss—Income .... Allowance to Reduce Inventory to Market [($60 – $58) × 4,000] .................................
8,000
Put Option......................................................... Unrealized Holding Gain or Loss—Income [($60 – $58) × 4,000] .................................
8,000
8,000
8,000
November 30, 2025 Unrealized Holding Gain or Loss—Income .... Put Option ($175 – $105) ............................
70
Unrealized Holding Gain or Loss—Income .... Allowance to Reduce Inventory to Market [($58 – $57) × 4,000] .................................
4,000
Put Option......................................................... Unrealized Holding Gain or Loss—Income [($58 – $57) × 4,000] .................................
4,000
70
4,000
4,000
*Problem 16.17 (Continued) (4)
December 31, 2025 Unrealized Holding Gain or Loss—Income .... Put Option ($105 – $40) ..............................
65d
Unrealized Holding Gain or Loss—Income .... Allowance to Reduce Inventory to Market [($57 – $54) × 4,000] .................................
12,000
65
Put Option ........................................................ 12,000 Unrealized Holding Gain or Loss—Income [($57 – $54) × 4,000]
(b)
12,000a
12,000c
OIL PRODUCTS COMPANY Partial Balance Sheet At November 30, 2025 Assets Inventory ($240,000 − $8,000 − $4,000) ................... Put option ($300 − $125 + $8,000 − $70 + $4,000) ..
$228,000 12,105
OIL PRODUCTS COMPANY Income Statement For the Month Ended November 30, 2025 Other Income (Loss) Unrealized holding loss (Inventory) ................... Unrealized holding gain—put option .................. (c)
$(4,000) $ 3,930 $ (70)
OIL PRODUCTS COMPANY Partial Balance Sheet At December 31, 2025 Assets Inventory ($228,000 − $12,000) ................................ Put option ($12,105 − $65 + $12,000) ......................
$216,000 24,040*
*Problem 16.17 (Continued) OIL PRODUCTS COMPANY Income Statement For the Month Ended December 31, 2025 Other Income (Loss) Unrealized Holding Loss (Inventory) ................. Unrealized Holding Gain—put option ................. c$ 12,000 − d$65 = $11,935b
$(12,000)a $11,935b
*Put Option 300 125 8,000 70 4,000 12,000 65 24,040 LO: 6, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Decision Making
UYJ 16.1 Financial Reporting Problem (a)
P&G sold its available-for-sale investments in 2020. No other investments are reported on the balance sheet. In its summary of significant accounting policies (note 1), P&G states:
Investments Investment securities have primarily consisted of readily marketable debt securities. Unrealized gains or losses from debt securities classified as trading, if any, are charged to earnings. Unrealized gains or losses on debt securities classified as available-for-sale are recorded in OCI. If an available-for-sale security is other than temporarily impaired, the loss is charged to either earnings or OCI depending on our intent and ability to retain the security until we recover the full cost basis and the extent of the loss attributable to the creditworthiness of the issuer. Debt securities are included as Available-for-sale investment securities and Other noncurrent assets in the Consolidated Balance Sheets. In addition to debt securities, we hold minor equity investments in certain companies over which we exert significant influence, but do not control the financial and operating decisions. These are accounted for as equity method investments. Other equity investments that are not controlled, and over which we do not have the ability to exercise significant influence, and for which there is a readily determinable market value, are recorded at fair value, with gains and losses recorded through net earnings. Equity investments without readily determinable fair values are measured at cost, less impairments, plus or minus observable price changes. Equity investments are included as Other noncurrent assets in the Consolidated Balance Sheets. (b)
Per P&G’s summary of significant accounting policies (note 1):
Fair Values of Financial Instruments Certain financial instruments are required to be recorded at fair value. Changes in assumptions or estimation methods could affect the fair value estimates; however, we do not believe any such changes would have a material impact on our financial condition, results of operations or cash flows. Other financial instruments, including cash equivalents, certain investments and short-term debt, are recorded at cost, which approximates fair value. The fair values of long-term debt and financial instruments are disclosed in Note 9. Note 9 Excerpt - Fair Value Hierarchy Accounting guidance on fair value measurements for certain financial assets and liabilities requires that financial assets and liabilities carried at fair value be classified and disclosed in one of the following categories: • Level 1: Quoted market prices in active markets for identical assets or liabilities. • Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data. • Level 3: Unobservable inputs reflecting the reporting entity's own assumptions or external inputs from inactive markets. When applying fair value principles in the valuation of assets and liabilities, we are required to maximize the use of quoted market prices and minimize the use of unobservable inputs. The Company has not changed its valuation techniques used in measuring the fair value of any financial assets or liabilities during the year. When active market quotes are not available for financial assets and liabilities, we use industrystandard valuation models. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including credit risk, interest rate curves and forward and spot prices for currencies. In circumstances where market-based observable inputs are not available, management judgment is used to develop assumptions to estimate fair value. Generally, the fair value of our Level 3 instruments is estimated as the net present value of expected future cash flows based on external inputs.
UYJ 16.1 Financial Reporting Problem (Continued)
Assets and Liabilities Measured at Fair Value Other investments had a fair value of $67 and $169 as of June 30, 2020 and 2019, respectively, and are presented in Other noncurrent assets. During the year ended June 30, 2020, the Company sold all of its existing U.S. government securities and corporate bond securities. Such securities had fair values of $3.6 billion and $2.4 billion, respectively, and were presented in Available-for-sale investment securities at June 30, 2019. The Company's investments measured at fair value are generally classified as Level 2 within the fair value hierarchy. Cash equivalents were $14.6 billion and $3.0 billion as of June 30, 2020 and 2019, respectively and are classified as Level 1 within the fair value hierarchy. There are no other material investment balances classified as Level 1 or Level 3 within the fair value hierarchy, or using net asset value as a practical expedient. Fair values are generally estimated based upon quoted market prices for similar instruments. The fair value of long-term debt was $29.0 billion and $25.4 billion as of June 30, 2020 and 2019, respectively. This includes the current portion of long-term debt instruments ($2.5 billion and $3.4 billion as of June 30, 2020 and 2019, respectively). Certain long-term debt (debt designated as a fair value hedge) is recorded at fair value. All other long-term debt is recorded at amortized cost, but is measured at fair value for disclosure purposes. We consider our debt to be Level 2 in the fair value hierarchy. Fair values are generally estimated based on quoted market prices for identical or similar instruments. (c) P&G discusses risk management, including the role of derivatives in note 9: NOTE 9 RISK MANAGEMENT ACTIVITIES AND FAIR VALUE MEASUREMENTS As a multinational company with diverse product offerings, we are exposed to market risks, such as changes in interest rates, currency exchange rates and commodity prices. We evaluate exposures on a centralized basis to take advantage of natural exposure correlation and netting. To the extent we choose to manage volatility associated with the net exposures, we enter into various financial transactions that we account for using the applicable accounting guidance for derivative instruments and hedging activities. These financial transactions are governed by our policies covering acceptable counterparty exposure, instrument types and other hedging practices. If the Company elects to do so and if the instrument meets certain specified accounting criteria, management designates derivative instruments as cash flow hedges, fair value hedges or net investment hedges. We record derivative instruments at fair value and the accounting for changes in the fair value depends on the intended use of the derivative, the resulting designation and the effectiveness of the instrument in offsetting the risk exposure it is designed to hedge. We generally have a high degree of effectiveness between the exposure being hedged and the hedging instrument. Specific risk management areas are discussed in more detail. LO: 1, 2, 3, 4, 5, 6, Bloom: AN, Difficulty: Moderate, Time: 50-60, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication, Decision Making
UYJ 16.2 Comparative Analysis Case THE COCA-COLA COMPANY and PEPSICO, INC. (a) (1) (2)
Cash used in investing activities Other comprehensive income (loss)
(3)
Unrealized gains and losses-OCI
Coca-Cola $(1,477) $(6,558) $ (47)
PepsiCo $(11,619) $(5,999) $(1)
(b) Coca-Cola reported the $19,273 million of equity investments on its December 31, 2020 balance sheet. (c)
Cost method investments for Coca-Cola (note 4) For equity securities without readily determinable fair values, we have elected the measurement alternative under which we measure these investments at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Management assesses each of these investments on an individual basis. For investments in non-publicly traded companies, management's assessment of fair value is based on valuation methodologies including discounted cash flows, estimates of sales proceeds and appraisals, as appropriate. We consider the assumptions that we believe market participants would use in evaluating estimated future cash flows when employing the discounted cash flow or estimates of sales proceeds valuation methodologies. The ability to accurately predict future cash flows, especially in emerging and developing markets, may impact the determination of fair value. In the event the fair value of an investment declines below our cost basis, management is required to determine if the decline in fair value is other than temporary. If management determines the decline is other than temporary, an impairment charge is recorded. Management's assessment as to the nature of a decline in fair value is based on, among other things, the length of time and the extent to which the market value has been less than our cost basis; the financial condition and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication, Decision Making
UYJ 16.3 Financial Statement Analysis Case UNION PLANTERS (a) While banks are primarily in the business of lending money, they also need to balance their asset portfolio by investing in other assets. For example, a bank may have excess cash that it has not yet loaned, which it wants to invest in very short-term liquid assets. Or it may believe that it can earn a higher rate of interest by buying long-term bonds than it can currently earn by making new loans. Or it may purchase investments for short-term speculation because it believes these investments will appreciate in value. (b) Trading securities are shown on the balance sheet at current fair value, and any unrealized gains and losses resulting from reporting them at fair value are reported as part of income. Available-for-sale securities are reported on the balance sheet at their fair value, and any unrealized gains and losses resulting from reporting them at fair value are reported as other comprehensive income and as a separate component of stockholders’ equity until realized. Held-to-maturity securities are reported at their amortized cost; that is, they are not reported at fair value. Note that Union Planters has no held-to-maturity securities. (c) Securities are reported in three different categories because these three different categories reflect the likelihood that any unrealized gains and losses will eventually be realized by the company. That is, trading securities are held for a short period; thus, if the bank has an unrealized gain on its trading security portfolio, it is likely that these securities will be sold soon and the gain will be realized. On the other hand, available-for-sale securities are not going to be sold for a longer period of time; thus, unrealized gains on these securities may not be realized for several years. If securities were all grouped into a single category, the investor would not be aware of these differences in the probability of realization.
UYJ 16.3 Financial Statement Analysis Case (Continued) (d) The answer to this involves selling your “winner” bonds in your availablefor-sale portfolio at year-end. Union Planters could have increased reported net income by $108 million (clearly, a material amount when total reported income was $224 million). Management chose not to sell these securities because at the time it must have felt that either the securities had additional room for price appreciation, or it didn’t want to pay the additional taxes that would be associated with a sale at a gain, or it wanted to hold the securities because they were needed to provide the proper asset balance in its management of its total asset portfolio, or it would prefer to report the gain in the following year. LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, Reflective Thinking, AICPA BC: Strategic Perspective, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 16.4 Accounting, Analysis, and Principles Accounting (a)
1. Instar’s investment in Dorsel Corp. bonds should be classified as held-to-maturity because they have a specific maturity date and Instar has the intent and ability to hold them until the maturity date. They should be recorded at amortized cost. 2. Instar’s investment of idle cash in equity securities should be at fair value with gains and losses reported through income. 3. Instar’s investment in its supplier should be classified as an equity investment and reported at fair value with gains and losses reported though income. 4. Instar’s investment in Slobbaer Co. common stock should be classified as an equity method investment because its holdings are greater than 20% and Instar exerts significant influence over Slobbaer.
(b)
(1) No entry needed (2) Fair Value Adjustment ......................................... 120,000 Unrealized Holding Gain or Loss—Income ..... 120,000 [To record the increase in value of the securities, ($920,000 – $800,000)] (3) Fair Value Adjustment .......................................... 350,000 Unrealized Holding Gain or Loss—Income ..... 350,000 (To record the increase in the value of the investment in the supplier, $1,550,000 – $1,200,000)
UYJ 16.4 Accounting, Analysis, and Principles (Continued) (4)
Equity Investment (Slobbaer) .................................... Investment Income ............................................ (To record income under the equity method, $300,000 × 0.25 = $75,000)
75,000
Cash ............................................................................ Equity Investment (Slobbaer) ........................... (To record dividends received from equity-method investee, $100,000 × 0.25 = $25,000)
25,000
75,000
25,000
Analysis The total effect on net income is $120,000 + $350,000 + $75,000 = $545,000. Note that the equity method dividends received reduce the balance sheet value of the investment and are not recorded as revenue or income. Principles The rationale for reporting held-to-maturity securities at amortized cost is that if management intends to hold the securities to maturity, fair values are not relevant for evaluating the cash flows associated with these securities. On the other hand, if the debt securities are trading or available-for-sale, they may be sold before maturity or have such short maturities that information on their fair value is relevant for determining future cash flows. When a company exercises significant influence over the operations of another company, it is argued that the investor company should use the equity method of accounting. The rationale for this measurement basis is that the investor company should report the net income at the time the investee company earns it. Under the fair value method, the company does not report income until it receives a dividend or sells the security. LO: 1, 2, 4, Bloom: SYN, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
Time and Purpose of Critical Thinking Cases CT 16.1 (Time 25–30 minutes) Purpose—To provide the student with an opportunity to discuss the issues raised by FASB in determining the accounting for investments in certain debt and equity securities. For example, the proper accounting for the reclassification of securities from trading to available-for-sale must be discussed. Four other situations involving debt and equity securities investments must be addressed. CT 16.2 (Time 25–30 minutes) Purpose—To provide the student with an opportunity to discuss the justification for using fair value as a basis for reporting equity securities. In addition, a number of computations are necessary to determine whether the company properly applied the reporting provisions for investments in certain debt and equity securities. CT 16.3 (Time 20–30 minutes) Purpose—To provide the student with an understanding of the accounting applications dealing with investments in equity securities. This case involves three independent situations for which the student is required to discuss the effects upon classification, carrying value, and earnings. CT 16.4 (Time 15–25 minutes) Purpose—To allow the student to discuss the equity method of accounting for investments and to provide rationale for this method of accounting. CT 16.5 (Time 25–35 minutes) Purpose—To provide the student with an opportunity to discuss the equity method of accounting and provide rationale in a memorandum. CT 16.6 (Time 25–35 minutes) Purpose—To provide the student an opportunity to examine the ethical issues related to fair value accounting.
Solutions to Critical Thinking Cases CT 16.1 Situation 1
GAAP requires that debt securities which are classified as trading securities be reported on the balance sheet at their fair value amount. Any changes in the fair value of trading debt securities from one period to another are included in earnings. Therefore, the $4,200 decrease will be reported on the income statement as an unrealized holding loss.
Situation 2
The security should be reported in the available-for-sale category at the current fair value. The transfer of the security affects earnings because the unrealized loss at the date of transfer is recognized in the income statement.
Situation 3
The reclassification does not affect earnings and the available-for-sale debt security will continue to be reported at its fair value.
Situation 4
When a reduction in the fair value of a debt security classified as held-to-maturity is considered to be an impairment, the new cost basis of the security is its fair value. The security is written down to the fair value amount and the loss is included in earnings. In this case, the fair value of the security at the end of the prior year is the new cost basis.
Situation 5
The equity securities would be classified as a current asset. These securities are reported on the balance sheet at the fair value. The unrealized holding loss of $7,700 in the income statement is reported in the “Other expenses and losses” section.
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
CT 16.2 (a)
The reporting of equity securities at fair value provides the financial statement user with more relevant financial information. The fair value of the securities is essentially the present value of the securities’ future cash flows and so this helps investors and creditors assess the entity’s liquidity. Also, the fair value of the securities helps the financial statement user to assess the entity’s investment strategies. The financial statements of the entity will reflect which investments have increased in fair value and which investments have decreased in fair value. Changes in the fair value of equity securities are included in earnings because these investments can be sold at any time.
CT 16.2 (Continued) (b)
Lexington Company should record the following journal entry and then report the following amounts on its balance sheet. December 31, 2025 Unrealized Holding Gain or Loss—Income ................................... Fair Value Adjustment ($49,500 − $48,400) ........................
1,100 1,100
Balance Sheet—December 31, 2025 Investments Equity investments, at cost.................................................. Less: Fair value adjustment ............................................... Equity investments, at fair value ..........................................
$49,500 1,100 $48,400
Investments classified as equity securities should initially be recorded at their acquisition price. The valuation of these investments is subsequently reported at their fair value. Any changes in the fair value of the investments are recorded in an unrealized holding gain or loss account, which is included in earnings. (c)
No, Lexington Company did not properly account for the sale of the Summerset Company stock. The cost basis of the Summerset stock is still $9,500. Therefore, Lexington should have recorded a $300 ($9,200 – $9,500) loss on investments as follows: Cash ............................................................................................. Loss on Sale of Investments ......................................................... Equity Investments .............................................................
(d)
9,200 300 9,500
December 31, 2026 Fair Value Adjustment ................................................................. Unrealized Holding Gain or Loss—Income ..........................
1,500 1,500
Equity securities are reported at their fair value. Therefore, an adjusting entry must be made to show the $400 excess of fair value over cost in the portfolio (as shown below). Securities Greenspan Corp. stock Tinkers Company stock Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.
Cost $20,000 20,000 $40,000
Fair Value $19,900 20,500 $40,400
Unrealized Gain (Loss) ($ (100) ( 500) $ 400 ( (1,100) ($1,500
LO:2, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
CT 16.3 Situation 1
The carrying value of the trading debt investment will be the fair value on the date of the transfer. The unrealized holding loss, the difference between the current fair value and the cost, will be recognized immediately.
Situation 2
When a decrease in the fair value is permanent, it indicates an impairment in the value of the security has occurred. As a result, the security is written down to the fair value and this becomes the new cost basis of the security. The security is reported on the balance sheet at its current fair value. The amount of the write-down is included in earnings as a realized loss.
Situation 3
Both the portfolio of trading debt securities and the portfolio of available-for-sale debt securities are reported at their fair value. The $13,500 decrease in fair value of the trading portfolio is recorded in the unrealized holding loss account and is included in earnings for the period. The $28,600 increase in fair value of the available-for-sale portfolio is recorded in the unrealized holding gain account and is not included in earnings for the period. Instead, the unrealized holding gain is shown as other comprehensive income and as a separate component of stockholders’ equity.
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
CT 16.4 Since Fontaine Company purchased 40% of Knoblett Company’s outstanding stock, Fontaine is considered to have significant influence over Knoblett Company. Therefore, Fontaine will account for this investment using the equity method. The investment is reported on the December 31 balance sheet as a long-term investment. The account balance includes the initial purchase price plus 40% of Knoblett’s net income since the acquisition date of July 1, 2026. The investment account balance will be reduced by 40% of the cash dividends paid by Knoblett’s. The cash dividends represent a return of Fontaine’s investment and, therefore, the investment account is reduced. The income statement will report 40% of Knoblett’s net income as investment income. Equity Investment (Knoblett Co.) 40% of cash dividends Cost of investment received from Knoblett 40% of Knoblett’s income since 7/1/26 LO: 3, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
CT 16.5 Memo on accounting treatment to be accorded Investment in Spoor Corporation: Selig Company should follow the equity method of accounting for its investment in Spoor Corporation because Selig Company is presumed to be able to exercise significant influence over the operating and financial policies of Spoor Corporation due to the size of its investment (30%). In 2025, Selig Company should report its interest in Spoor Corporation’s outstanding common stock as a long-term investment. Following the equity method of accounting, Selig Company should record the cash purchase of 30 percent of Spoor Corporation stock at acquisition cost. Thirty percent of Spoor Corporation’s total net income from July 1, 2025, to December 31, 2025, should be added to the carrying amount of the investment in Selig Company’s balance sheet and shown as revenue in its income statement to recognize Selig Company’s share of the net income of Spoor Corporation after the date of acquisition. This amount should reflect adjustments similar to those made in preparing consolidated statements, including adjustments to eliminate intercompany gains and losses. The cash dividends paid by Spoor Corporation to Selig Company should reduce the carrying amount of the investment in Selig Company’s balance sheet and have no effect on Selig Company’s income statement. LO: 3, Bloom: AN, Difficulty: Simple, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: Strategic Perspective, AICPA AC: Reporting, AICPA PC: Communication, Decision Making
CT 16.6 (a)
Classifying the securities as they propose will indeed have the effect on net income that they say it will. Classifying all the gains as from trading securities will cause all the gains to flow through the income statement this year and classifying the losses as held-to-maturity will defer the losses from this year’s income statement. Classifying the gains and losses in the opposite manner will have the opposite effect.
(b)
What each proposes is unethical since it is knowingly not in accordance with GAAP. The financial statements are fraudulently, not fairly, stated. The affected stakeholders are other members of the company’s officers and directors, company employees, the independent auditors (who may detect these misstatements), the stockholders, and prospective investors.
(c)
The act of selling certain securities (those with gains or those with losses) is management’s choice and is not per se unethical. Generally accepted accounting principles allow the sale of selected securities so long as the inventory method of assigning cost adopted by the company is consistently applied. If the officers act in the best interest of the company and its stakeholders, and in accordance with GAAP, and not in their self-interest, their behavior is probably ethical. Knowingly engaging in unsound and poor business and accounting practices that waste assets or that misstate financial statements is unethical behavior.
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, Reflective Thinking, AICPA AC: Reporting, AICPA PC: Communication, Decision Making, Professional Behavior
Codification Exercises CE16.1 Master Glossary (a)
Trading securities are securities that are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period of time. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.
(b)
A holding gain or loss is the net change in fair value of a security. The holding gain or loss does not include dividend or interest income recognized but not yet received or write-downs for otherthan-temporary impairment.
(c)
A cash flow hedge is a hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.
(d)
A fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk.
LO: 1, 2, 6, 7, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Critical Thinking, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication, Decision Making
CE16.2 According to FASB ASC 235-10-S99-1 (Notes to Financial Statements—SEC Materials): (n)
Accounting policies for certain derivative instruments. Disclosures regarding accounting policies shall include descriptions of the accounting policies used for derivative financial instruments and derivative commodity instruments and the methods of applying those policies that materially affect the determination of financial position, cash flows, or results of operation. This description shall include, to the extent material, each of the following items: (1) A discussion of each method used to account for derivative financial instruments and derivative commodity instruments; (2) The types of derivative financial instruments and derivative commodity instruments accounted for under each method; (3) The criteria required to be met for each accounting method used, including a discussion of the criteria required to be met for hedge or deferral accounting and accrual or settlement accounting (e. g., whether and how risk reduction, correlation, designation, and effectiveness tests are applied); (4) The accounting method used if the criteria specified in paragraph (n)(3) of this section are not met; (5) The method used to account for terminations of derivatives designated as hedges or derivatives used to affect directly or indirectly the terms, fair values, or cash flows of a designated item;
CE16.2 (Continued) (6) The method used to account for derivatives when the designated item matures, is sold, is extinguished, or is terminated. In addition, the method used to account for derivatives designated to an anticipated transaction, when the anticipated transaction is no longer likely to occur; and (7) Where and when derivative financial instruments and derivative commodity instruments, and their related gains and losses, are reported in the statements of financial position, cash flows, and results of operations. Instructions to paragraph 4-08(n). 1. For purposes of this paragraph (n), derivative financial instruments and derivative commodity instruments (collectively referred to as “derivatives”) are defined as follows: (i) Derivative financial instruments have the same meaning as defined by generally accepted accounting principles (see Financial Accounting Standards Board (“FASB”), Statement of Financial Accounting Standards No. 119, “Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments,” (“FAS 119”) paragraphs 5–7, (October 1994)), and include futures, forwards, swaps, options, and other financial instruments with similar characteristics. (ii) Derivative commodity instruments include, to the extent such instruments are not derivative financial instruments, commodity futures, commodity forwards, commodity swaps, commodity options, and other commodity instruments with similar characteristics that are permitted by contract or business custom to be settled in cash or with another financial instrument. For purposes of this paragraph, settlement in cash includes settlement in cash of the net change in value of the derivative commodity instrument (e. g., net cash settlement based on changes in the price of the underlying commodity). 2. For purposes of paragraphs (n)(2), (n)(3), (n)(4), and (n)(7), the required disclosures should address separately derivatives entered into for trading purposes and derivatives entered into for purposes other than trading. For purposes of this paragraph, trading purposes has the same meaning as defined by generally accepted accounting principles (see, e. g., FAS 119, paragraph 9a (October 1994)). 3. For purposes of paragraph (n)(6), anticipated transactions means transactions (other than transactions involving existing assets or liabilities or transactions necessitated by existing firm commitments) an enterprise expects, but is not obligated, to carry out in the normal course of business (see, e. g., FASB, Statement of Financial Accounting Standards No. 80, “Accounting for Futures Contracts,” paragraph 9, (August 1984)). 4. Registrants should provide disclosures required under paragraph (n) in filings with the Commission that include financial statements of fiscal periods ending after June 15, 1997. [45 FR 63669, Sept. 25, 1980, as amended at 46 FR 56179, Nov. 16, 1981; 50 FR 25215, June 18, 1985; 50 FR 49532, Dec. 3, 1985; 51 FR 3770, Jan. 30, 1986; 57 FR 45293, Oct. 1, 1992; 59 FR 65636, Dec. 20, 1994; 62 FR 6063, Feb. 10, 1997] LO: 5, Bloom: K, Difficulty: Moderate, Time: 10-15, AACSB: Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication, Decision Making
CE16.3 According to FASB ASC 323-10-35-20 (Investments—Equity Method and Joint Ventures—Subsequent Measurement): The investor ordinarily shall discontinue applying the equity method if the investment (and net advances) is reduced to zero and shall not provide for additional losses unless the investor has guaranteed obligations of the investee or is otherwise committed to provide further financial support for the investee. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication
CE16.4 According to FASB ASC 815-10-45-4 (Derivatives and Hedging—Other Presentation Matters—Balance Sheet Netting); Unless the conditions in paragraph 210-20-45-1 are met, the fair value of derivative instruments in a loss position shall not be offset against the fair value of derivative instruments in a gain position. Similarly, amounts recognized as accrued receivables shall not be offset against amounts recognized as accrued payables unless a right of setoff exists. LO: 5, Bloom: K, Difficulty: Simple , Time: 3-5, AACSB: None, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication, Decision Making
Codification Research Case (a)
According to FASB ASC 320-10: 15-5
The guidance in the Investments—Debt and Equity Securities Topic establishes standards of financial accounting and reporting for both of the following: a.
Investments in equity determinable fair values
securities
that
have
readily
b.
All investments in debt securities, including debt instruments that have been securitized.
Readily Determinable Fair Value (FASB ASC 320-10-20 Glossary) An equity security has a readily determinable fair value if it meets any of the following conditions: a. The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by Pink Sheets LLC. Restricted stock meets that definition if the restriction terminates within one year. b. The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparable to one of the U.S. markets referred to above. c. The fair value of an investment in a mutual fund is readily determinable if the fair value per share (unit) is determined and published and is the basis for current transactions.
Codification Research Case (Continued) (b)
See FASB ASC 320-10-25 25-14 Sales of debt securities that meet either of the following conditions may be considered as maturities for purposes of the classification of securities and the disclosure requirements under this Subtopic: 1. The sale of a security occurs near enough to its maturity date (or call date if exercise of the call is probable) that interest rate risk is substantially eliminated as a pricing factor. That is, the date of sale is so near the maturity or call date (for example, within three months) that changes in market interest rates would not have a significant effect on the security’s fair value. 2. The sale of a security occurs after the entity has already collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition due either to prepayments on the debt security or to scheduled payments on a debt security payable in equal installments (both principal and interest) over its term. For variable-rate securities, the scheduled payments need not be equal.
Codification Research Case (Continued) (c)
See FASB ASC 320-10-50 50-10 For any sales of or transfers from securities classified as heldto-maturity, an entity shall disclose all of the following in the notes to the financial statements for each period for which the results of operations are presented: 1. The net carrying amount of the sold or transferred security 2. The net gain or loss in accumulated other comprehensive income for any derivative that hedged the forecasted acquisition of the held-to-maturity security 3. The related realized or unrealized gain or loss 4. The circumstances leading to the decision to sell or transfer the security. (Such sales or transfers should be rare, except for sales and transfers due to the changes in circumstances identified in paragraph 320-10-25-6(a) through (f).)
LO: 1, 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology, AICPA PC: Communication, Decision Making
CHAPTER 17 Revenue Recognition Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises
1. Current Environment; 5-Step Model.
1, 2, 3, 4, 5, 6
2. Contracts.
7
1, 2, 3, 4
3. Performance Obligations
9, 10, 11
5, 19, 20
4. Transaction Price
8, 12, 18
6, 7, 8
Problems
Critical Thinking
8
1, 2, 3
1, 2, 3
1, 2
1
4, 6, 7
4, 5
1
3, 4, 6, 7, 8
5
Exercises
5. Variable Consideration; 8, 13, 14, Time value; Non-Cash 15, 16, 17 consideration, consideration paid to customer
5, 6, 7, 8, 9, 4, 5, 8, 9, 10, 11, 12 10, 11,12
6. Allocate transaction price to 11, 12, 18, performance obligations. 19
13, 14, 15
1, 2, 3, 4, 5
7. Satisfying Performance Obligations – transfer control: Returns; repurchases; Bill and Hold; Principal-agent; consignments; Warranties; Upfront fees.
5, 20, 21, 22, 23, 24, 25, 26, 27, 28, 29
13, 14, 15, 16, 17, 18, 16, 17, 18, 19, 20 , 21, 19, 20 22, 23, 24, 25, 26, 27
8. Presentation, Contract modifications Contract Costs, Collectibility.
30, 31, 32, 33
19, 21
28, 29, 30, 31, 32
*9. Long-Term Contracts
34, 35, 36, 37
22, 23, 24
33, 34, 35, 36, 37
9, 10, 11
*10. Franchising.
38, 39
25
38, 39
12
*This material is dealt with in an Appendix to the chapter.
1, 2, 3, 5, 6, 7, 8
3, 4, 6, 7, 8
6, 7
9
Assignment Classification Table (By Learning Objective) Questions
Brief Exercises
Exercises
1. Discuss the fundamental concepts related to revenue recognition and measurement.
1, 2, 3, 4
1, 2,
1, 2, 3
2. Explain and apply the five-step revenue recognition process.
4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22
3, 4, 5, 6, 7, 8, 9, 10, 11, 12
2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15
1, 2, 3, 4, 5, 6, 7, 8, 9, 10
2, 3, 4, 8
3. Apply the five-step process to major revenue recognition issues.
23, 24, 25, 26, 27, 28, 29
13, 14, 15, 16, 17, 18, 19, 20
8, 9, 16, 17, 18, 19, 20, 21, 22, 23, 24, 25, 26, 27
1, 2, 3, 4, 5, 6, 7, 8
5, 6, 7
4. Describe presentation and disclosure regarding revenue.
30, 31, 32, 33
21
16, 17, 18, 28, 29, 30, 31, 32
*5. Apply the percentage-ofcompletion method for long-term contracts.
34, 35, 36
22
33, 34, 35, 36, 37
9, 10, 11
*6. Apply the costrecovery method for long-term contracts.
34, 35
23
33, 36, 37
9, 10, 11
*7. Identify the proper accounting for losses on longterm contracts.
37
24
*8. Explain revenue recognition for franchises.
38, 39
25
Learning Objectives
1
6, 7
10, 11
38, 39
Critical Thinking
Problems
12
9
Assignment Characteristics Table Item
Description
E17.1 E17.2 E17.3 E17.4 E17.5 E17.6 E17.7 E17.8 E17.9 E17.10 E17.11 E17.12 E17.13 E17.14 E17.15 E17.16 E17.17 E17.18 E17.19 E17.20 E17.21 E17.22 E17.23 E17.24 E17.25 E17.26 E17.27 E17.28 E17.29 E17.30 E17.31 E17.32 *E17.33 *E17.34 *E17.35 *E17.36 *E17.37
Fundamentals of Revenue Recognition Fundamentals of Revenue Recognition Existence of a Contract. Determine Transaction Price Determine Transaction Price Determine Transaction Price Determine Transaction Price Determine Transaction Price Determine Transaction Price. Allocate Transaction Price. Allocate Transaction Price. Allocate Transaction Price. Allocate Transaction Price. Allocate Transaction Price. Allocate Transaction Price. Sales with Returns Sales with Returns Sales with Allowances Sales with Returns. Sales with Returns. Sales with Returns. Sales with Repurchase. Repurchase Agreement Bill and Hold. Consignment Sales. Warranty Arrangement. Warranties. Existence of a Contract. Contract Modification. Contract Modification Contract Costs. Contract Costs, Collectibility. Recognition of Profit on Long-Term Contracts. Analysis of Percentage-of-Completion Financial Statements. Gross Profit on Uncompleted Contract. Recognition of Revenue on Long-Term Contract and Entries. Recognition of Profit and Balance Sheet Amounts for LongTerm Contracts. Franchise Entries. Franchise Fee, Initial Down Payment. Allocate Transaction Price, Upfront Fees. Allocate Transaction Price, Modification of Contract.
*E17.38 *E17.39 P17.1 P17.2
Level of Time Difficulty (minutes) Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Simple Moderate Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate Simple Moderate Moderate Moderate
10-15 10-15 10–15 20-25 20-25 20-25 15–20 15–20 20–25 25-30 20-25 10-15 25-30 25-30 10-15 20-25 15-20 20-25 15–20 25-30 15–20 20–25 10–15 10–15 5–10 10–15 15–20 10–15 20–25 20–25 10–15 20–25 20–25 10–15 10–15 15–20 15–25
Moderate Moderate Moderate Moderate
20–25 15–20 30–35 20–25
Assignment Characteristics Table (Continued) Item P17.3
Description Allocate Transaction Price, Discounts, Time Value.
Level of Difficulty Moderate
Time (minutes)
P17.4
Allocate Transaction Price, Discounts, Time Value.
Complex
35–40
P17.5
Allocate Transaction Price, Returns, and Consignments
Complex
35–40
P17.6
Warranty, Customer Loyalty Program.
Moderate
25–30
P17.7
Customer Loyalty Program
Moderate
30–35
P17.8
Time Value, Gift cards, Discounts.
Moderate
30–35
*P17.9 *P17.10 *P17.11 *P17.12
Recognition of Profit on Long-Term Contract. Long-Term Contract with Interim Loss. Long-Term Contract with an Overall Loss. Franchise Revenue.
Complex Moderate Complex Moderate
30–40 20–25 40–50 35–45
CT17.1 CT17.2 CT17.3 CT17.4 CT17.5 CT17.6 CT17.7 CT17.8 *CT17.9
Five-Step Revenue Process. Satisfying Performance Obligations. Recognition of Revenue—Theory. Recognition of Revenue—Theory. Discounts Recognition of Revenue from Subscriptions. Revenue Recognition—Bonus Points. Revenue Recognition—Membership Fees. Long-term Contract—Percentage-of-Completion.
Moderate Moderate Moderate Moderate Complex Complex Moderate Moderate Moderate
20–30 20–30 25–30 25–30 20–25 35–45 25–30 20–25 20–25
30–35
Answers to Questions 1.
Most revenue transactions pose few problems for revenue recognition. This is because, in many cases, the transaction is initiated and completed at the same time. However, due to the complexity of some transactions, many believe the revenue recognition process is increasingly complex to manage, more prone to error, and more material to financial statements compared to any other area of financial reporting. In addition, even with the many standards, no comprehensive guidance was provided for service transactions. As a result, the FASB has indicated that the present state of reporting for revenue is unsatisfactory and the Board issued a standard, “Revenue from Contracts with Customers”. This standard provides a new approach for how and when companies should report revenue. The standard is comprehensive and applies to all companies. As a result, comparability and consistency in reporting revenue should be enhanced.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
2.
GAAP had numerous standards related to revenue recognition, but many believed the standards were often inconsistent with one another. The FASB decided the asset-liability approach brings more discipline to the measurement of revenue.
LO: 1, Bloom: K, Difficulty: Simple, Time: 1, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
3.
The revenue recognition principle indicates that revenue is recognized in the accounting period when a performance obligation is satisfied. That is, a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.
LO: 1, Bloom: K, Difficulty: Simple, Time: 1, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
4.
The five steps in the revenue recognition process are: 1. 2. 3. 4. 5.
Identify the contract(s) with customers. Identify the separate performance obligations in the contract. Determine the transaction price. Allocate the transaction price to the separate performance obligations. Recognize revenue when each performance obligation is satisfied.
LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 1, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
5.
Change in control is the deciding factor in determining when a performance obligation is satisfied. Control is transferred when the customer has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control is also indicated if the customer has the ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
6.
Revenues are generally recognized as follows: (a) Revenue from selling products—date of delivery to customers. (b) Revenue from services performed—when the services have been performed (performance obligation satisfied). (c) Revenue from permitting others to use company assets—as time passes or as the assets are used. (d) Revenue from disposing of assets other than products—at the date of sale.
LO: 2, Bloom: C, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Questions Chapter 17 (Continued) 7.
The first step in the revenue recognition process is the identification of a contract or contracts with the customer. A contract is an agreement between two or more parties that creates enforceable rights or obligations. That is, the contract identifies the performance obligations in a revenue arrangement. Contracts can be written, oral, or implied from customary business practice. In some cases, there may be multiple contracts related to the transaction, and accounting for each contract may or may not occur, depending on the circumstances. These situations often develop when not only a product is provided but some type of service is performed as well.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
8.
No entry is required on October 10, 2025, because neither party has performed on the contract. That is, neither party has an unconditional right as of October 10, 2025. On December 15, 2025, Executor delivers the product and therefore should recognize revenue on that date as it satisfied its performance obligation on that date. The journal entry to record the sales revenue and related cost of goods sold is as follows: December 15, 2025 Notes Receivable ............................................... Cash .................................................................. Sales Revenue ........................................
5,000 5,000
Cost of Goods Sold ............................................ Inventory..................................................
6,500
10,000 6,500
LO: 2, Bloom: AP, Difficulty: Simple, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
9.
A performance obligation is a promise in a contract to provide a product or service to a customer. This promise may be explicit, implicit, or possibly based on customary business practice. To determine whether a performance obligation exists, the company must determine whether the customer can benefit from the good or service on its own or together with other readily available resources.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
10.
To determine whether a performance obligation exists, the company must provide a distinct product or service to the customer. To determine whether a company has to account for multiple performance obligations, the company’s promise to sell the good or service to the customer must be separately identifiable from other promises within the contract (that is, the good or service must be distinct within the contract). In other words, the objective is to determine whether the nature of a company’s promise is to transfer individual goods and services to the customer or to transfer a combined item (or items) for which individual goods or services are inputs.
LO: 2, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
11.
In this situation, it appears that Engelhart has two performance obligations: (1) one related to providing the tractor and (2) the other related to the GPS services. Both are distinct (they can be sold separately) and are not interdependent.
LO: 2, Bloom: C, Difficulty: Moderate, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Questions Chapter 17 (Continued) 12.
The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods and services. The transaction price in a contract is often easily obtained because the customer agrees to pay a fixed amount to the company over a short period of time. In other contracts, companies must consider the following factors: (1) Variable consideration, (2) Time value of money, (3) Noncash consideration, and (4) Consideration paid or payable to customer.
LO: 2, Bloom: K, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
13.
Variable consideration (when the price of a good or service is dependent on future events), includes such elements as price or volume discounts, rebates, credits, performance bonuses, or royalties. A company estimates the amount of variable consideration it will receive from the contract to determine the amount of revenue to recognize. Companies use either (1) the expected value, which is a probability-weighted amount, or (2) the most likely amount in a range of possible amounts to estimate variable consideration. Companies select among these two methods based on which approach better predicts the amount of consideration to which a company is entitled.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
14.
The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration. In this situation: 25% chance of $421,000 if by February 1 [.25 X ($400,000 + $21,000)] = $ 105,250 25% chance of $414,000 if by February 8 [.25 X ($421,000 - $7,000)] = 103,500 25% chance of $407,000 if by February 15 [.25 X ($414,000 - $7,000)] = 101,750 25% chance of $400,000 if after February 15 [.25 X ($407,000 - $7,000)] = 100,000 $ 410,500 Thus, the total transaction price is $410,500 based on the probability-weighted estimate.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
15.
Allee should only allocate variable consideration to the performance obligation if it is reasonably assured that it will be entitled to that amount. In this case, it does not have experience with similar contracts and is not able to estimate the cumulative amount of revenue. Allee should not recognize revenue at this time. Allee is constrained in recognizing variable consideration as there might be a significant reversal of revenue previously recognized.
LO: 2, Bloom: AP, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
16.
In measuring the transaction price, companies make the following adjustment for: (a) Time value of money - When a sales transaction involves a significant financing component (that is, interest is accrued on consideration to be paid over time), the fair value (transaction price) is determined either by measuring the consideration received or by discounting the payment using an imputed interest rate. The imputed interest rate is the more clearly determinable of either (1) the prevailing rate for a similar instrument of an issuer with a similar credit rating, or (2) a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or services. The company will report the effects of the financing either as interest expense or interest revenue.
Questions Chapter 17 (Continued) (b) When noncash consideration is involved, revenue is generally recognized on the basis of the fair value of what is received. If the fair value cannot be determined, then the company should estimate the selling price of the goods delivered or services performed and recognize this amount as revenue. In addition, companies sometimes receive contributions (donations, gifts). A contribution is often some type of asset (such as securities, land, buildings or use of facilities) but it could be the forgiveness of debt. Similarly, this consideration should be recognized as revenue based on the fair value of the consideration received. LO: 2, Bloom: K, Difficulty: Simple, Time: 1, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
17.
Any discounts or volume rebates should reduce consideration received and reduce revenue recognized.
LO: 2, Bloom: K, Difficulty: Simple, Time: 1, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
18.
If an allocation of transaction price to various performance obligations is needed, the allocation is based on what the company could sell the good or service on a standalone basis (referred to as the standalone selling price). If this information is not available, companies should use their best estimate of what the good or service might sell for as a standalone unit. The three approaches for estimating standalone selling price are: (1) Adjusted market assessment approach; (2) Expected cost plus a margin approach, and (3) Residual approach.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
19.
Since each element sells separately and has a separate standalone selling price, the equipment, installation, and training are three separate performance obligations. The total revenue of $80,000 should be allocated to the three performance obligations based on their relative standalone selling price. Thus, the total estimated selling price is $100,000 ($90,000 + $7,000 + $3,000). The allocation is as follows: Equipment ($90,000 ÷ $100,000) X $80,000 = $72,000. Installation ($7,000 ÷ $100,000) X $80,000 = $5,600. Training ($3,000 ÷ $100,000) X $80,000 = $2,400.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
20.
A company satisfies its performance obligation when the customer obtains control of the good or service. Indications that the customer has obtained control are: 1. 2. 3. 4. 5.
The company has a right to payment for the asset. The company transferred legal title to the asset. The company transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer has accepted the asset.
LO: 2, Bloom: K, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Questions Chapter 17 (Continued) 21.
Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following three criteria is met: 1. 2. 3.
The customer receives and consumes the benefits as the seller performs. The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property). The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer’s specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.
LO: 2, Bloom: K, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
22.
A company recognizes revenue from a performance obligation over time by measuring the progress toward completion. The method selected for measuring progress should depict the transfer of control from the company to the customer. The most common are the cost-to-cost and units-of-delivery methods. The objective of these methods is to measure the extent of progress in terms of costs, units, or value-added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (costs incurred, labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed) track results. Neither is universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances. The most popular input measure used to determine the progress toward completion is the cost-tocost basis. Under this basis, a company measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
23.
To account for sales with rights of return, (and for some services that are provided subject to a refund), companies generally recognize all of the following: a.
b.
Revenue for the transferred products in the amount of consideration to which seller is reasonably assured to be entitled considering the products expected to be returned or allowances granted. An asset (and corresponding adjustment to cost of goods sold) for its right to recover inventory from the customer. If the company is unable to reliably estimate the level of returns, it should not report revenue until the returns are predictable.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
24.
If a company sells a product in one period and agrees to buy it back in the next period, legal title may have transferred, but the economic substance of the transaction is that the seller retains the risks of ownership. When companies enter into repurchase agreements, they are allowed to transfer an asset to a customer but have an unconditional (forward) obligation or unconditional right (call option) to repurchase the asset at a later date. In these situations, the question is whether the company sold the asset. Generally, companies report these transactions as a financing (borrowing). That is, if the company has a forward obligation or call option to repurchase the asset for an amount greater than or equal to its selling price, then the transaction is a financing transaction.
LO: 3, Bloom: K, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Questions Chapter 17 (Continued) 25.
Bill-and-hold sales result when the buyer is not yet ready to take delivery, but the buyer takes title and accepts billing. Revenue is recognized at the time title passes if all of the following criteria are met and the control provisions related to revenue recognition are met: (a) (b) (c) (d)
The reason for the bill-and-hold arrangement must be substantive. The product must be identified separately as belonging to the customer. The product currently must be ready for physical transfer to the customer. The seller cannot have the ability to use the product or to direct it to another customer.
LO: 3, Bloom: K, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
26.
In a principal-agent relationship, the principal’s performance obligation is to provide goods or perform services for a customer. The agent’s performance obligation is to arrange for the principal to provide these goods or services to a customer. In a principal-agent relationship, amounts collected on behalf of the principal are not revenue of the agent. The revenue for the agent is the amount of the commission it receives (usually a percentage of the selling price or total revenue).
LO: 3, Bloom: K, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
27.
A sale on consignment is the shipment of merchandise from a manufacturer (or wholesaler) to a dealer (or retailer) with title to the goods and the risk of sale being retained by the manufacturer who becomes the consignor. The consignee (dealer) is expected to exercise due diligence in caring for the merchandise and the dealer has full right to return the merchandise. The consignee receives a commission upon the sale and remits the balance of the cash collected to the consignor. The consignor recognizes a sale and the related revenue upon notification of sale from the consignee and receipt of the cash. The consigned goods are carried in the consignor’s inventory, not the consignee’s, until sold.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
28.
The two types of warranties are: a.
Warranties that the product meets agreed-upon specifications in the contract at the time the product is sold. This type of warranty is included in the sale price of the company’s product and is often referred to as an assurance-type warranty.
b.
Warranties that provide an additional service beyond the assurance-type warranty. This warranty is not included in the sale price of the product and is referred to as a service-type (extended) warranty.
Companies do not record a separate performance obligation for assurance-type warranties. These types of warranties are nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These types of obligations should be expensed in the period the goods are provided or services performed. In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur after sale and that are incident to the correction of defects or deficiencies required under the warranty provisions. Warranties that provide the customer with service beyond fixing defects that existed at the time of sale represent a separate service and are an additional performance obligation. As a result, companies should allocate a portion of the transaction price to this performance obligation. The company recognizes revenue in the period that the service type warranty is in effect. LO: 3, Bloom: K, Difficulty: Moderate, Time: 5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Questions Chapter 17 (Continued) 29.
The total transaction price is $420 [$300 + ($5 X 24 months)]. That is, Campus Cellular is providing a service in the second year without receiving an upfront fee. Thus, the upfront fee should be recognized as revenue over two periods. As a result, Campus Cellular recognizes revenue of $210 ($420 ÷ 2) in both years 1 and year 2.
LO: 3, Bloom: K, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
30.
Under the asset-liability model for recognizing revenue, companies recognize assets and liabilities according to the definitions of assets and liabilities in a revenue arrangement. For example, when a company has a right to consideration for meeting a performance obligation, it has a right to consideration from the customer and therefore has a contract asset. A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received consideration from the customer. Thus, if the customer performs first, by prepaying for the product, then the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheet. Contract assets are of two types: (a) Unconditional rights to receive consideration because the company has satisfied its performance obligation with the customer, and (b) Conditional rights to receive consideration because the company has satisfied one performance obligation, but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet (e.g., unbilled receivables) should be reported separately as contract assets.
LO: 4, Bloom: K, Difficulty: Simple, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
31.
A contract modification occurs if a company changes the contract terms during the term of the contract. When a contract is modified, the company must determine whether a new performance obligation has occurred or whether it is a modification of the existing performance obligation. If it is a modification of an existing performance obligation, then the change is generally reported prospectively or as a cumulative effect adjustment to revenue, depending on the circumstances. If the modification results in a separate performance obligation, then this performance obligation should be accounted for separately.
LO: 4, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
32.
(a) Companies divide fulfillment costs (contract acquisition costs) into two categories: (1) those that give rise to an asset, and (2) those that are expensed as incurred. Companies recognize an asset for the incremental costs if these costs are incurred to obtain a contract with a customer. In other words, incremental costs are costs that a company would not incur if the contract had not been obtained (for example, selling commissions). Other examples are: (a) Direct labor, direct materials, and allocation of costs that relate directly to the contract (such as costs of contract management and supervision, insurance, and depreciation of tools and equipment), and (b) Costs that generate or enhance resources of the company that will be used in satisfying performance obligations in the future. Costs include intangible design or engineering costs that will continue to benefit in the future. Companies capitalize costs that are direct, incremental, and recoverable (assuming that the contract period is more than one year).
Questions Chapter 17 (Continued) LO: 4, Bloom: K, Difficulty: Moderate, Time: 6-8, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
33.
The disclosure requirements for revenue recognition are designed to help financial statement users understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. To achieve that objective, companies disclose qualitative and quantitative information about all of the following: • Contracts with Customers - These disclosures include the disaggregation of revenue, presentation of opening and closing balances in contract assets and contract liabilities, and significant information related to their performance obligations. • Significant judgments. These disclosures include judgments and changes in these judgments that affect the determination of the transaction price, the allocation of the transaction price, and the determination of the timing of revenue. • Assets recognized from costs incurred to fulfill a contract. These disclosures include the closing balances of assets recognized to obtain or fulfill a contract, the amount of amortization recognized, and the method used for amortization.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*34.
For the most part, companies recognize revenue at the point of sale because that is when the performance obligation is satisfied. Under certain circumstances, companies recognize revenue over time. The most notable context in which revenue is recognized over time is long-term construction contract accounting. Long-term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. A company satisfies a performance obligation and recognizes revenue over time if at least one of the following three criteria is met: 1. The customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs. 2. The company’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced; or 3. The company’s performance does not create an asset with an alternative use. For example, the asset cannot be used by another customer. In addition to this alternative use element, at least one of the following criteria must be met: (a) Another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer. (b) The company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised.
Questions Chapter 17 (Continued) Therefore, if criterion 1 or 2 is met, then a company recognizes revenue over time if it can reasonably estimate its progress toward satisfaction of the performance obligations. That is, it recognizes revenues and gross profits each period based upon the progress of the construction— referred to as the percentage-of-completion method. The rationale for using percentage-ofcompletion accounting is that under most of these contracts the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer’s ownership interest. As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression. The right to payment for performance completed to date does not need to be for a fixed amount. However, the company must be entitled to an amount that would compensate the company for performance completed to date (even if the customer can terminate the contract for reasons other than the company’s failure to perform as promised). Alternatively, if the criteria for recognition over time are not met (e.g., the company does not have a right to payment for work completed to date), the company recognizes revenues and gross profit at a point in time; that is, when the contract is completed. This approach is referred to as the cost-recovery method. LO: 5, 6, Bloom: K, Difficulty: Moderate, Time: 5-8, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*35. Under the percentage-of-completion method, income is reported to reflect more accurately the production effort. Income is recognized periodically on the basis of the percentage of the job completed rather than only when the entire job is completed. The principal disadvantage of the cost-recovery method is that it may lead to distortion of earnings because no attempt is made to reflect current performance when the period of the contract extends into more than one accounting period. The percentage-of-completion method recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long-term contract. To defer recognition of these items until completion of the entire contract is to misrepresent the efforts (costs) and accomplishments (revenues) of the accounting periods during the contract. LO: 5, 6, Bloom: K, Difficulty: Simple, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*36. The methods used to determine the extent of progress toward completion are the cost-to-cost method and units-of-delivery method. Costs incurred and labor hours worked are examples of input measures, while tons produced, stories of a building completed, and miles of highway completed are examples of output measures. LO: 5, Bloom: C, Difficulty: Moderate, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*37. The two types of losses that can become evident in accounting for long-term contracts are: (1) A current period loss involved in a contract that, upon completion, is expected to produce a profit. (2) A loss related to an unprofitable contract. The first type of loss is actually an adjustment in the current period of gross profit recognized on the contract in prior periods. It arises when, during construction, there is a significant increase in the estimated total contract costs, but the increase does not eliminate all profit on the contract. Under the percentage-of-completion method, the estimated cost increase necessitates a current period adjustment of previously recognized gross profit; the adjustment results in recording a current period loss. No adjustment is necessary under the cost-recovery method because gross profit is only recognized upon completion of the contract.
Questions Chapter 17 (Continued) Cost estimates at the end of the current period may indicate that a loss will result upon completion of the entire contract. Under both percentage-of-completion and cost-recovery methods, the entire loss must be recognized in the current period. LO: 7, Bloom: K, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*38.
It is improper to recognize the entire franchise fee as revenue at the date of sale when many of the services of the franchisor are yet to be performed.
LO: 8, Bloom: K, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*39.
Continuing franchise fees should be reported as revenue when the performance obligations related to those fees have been satisfied by the franchisor. These revenues are generally recognized over time as the related product and services are provided. Continuing product sales would be accounted for in the same manner as would any other product sales.
LO: 8, Bloom: K, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Solutions to Brief Exercises Brief Exercise 17.1 (a)
In applying the 5-step process, it appears that a valid contract exists between Leno Computers and Fallon Electronics for the following reasons: 1. The contract has commercial substance—Fallon Electronics has agreed to pay cash for the computers. 2. The parties have approved the contract and are committed to perform—Fallon Electronics has made a commitment to purchase the computers and Leno has approved the selling of the computers. In fact, Leno has delivered the computers to Fallon. 3. The identification of the rights of the parties—Fallon has the right to the computers and Leno has the right to payment. 4. The identification of the payment terms—Fallon has agreed to pay $20,000 within 30 days for the computers. 5. It is probable that the consideration will be collected—although no cash has yet been paid by Fallon. Fallon has a good credit rating which indicates that the consideration will be collected.
(b)
The contract may not be valid if the contract is wholly unperformed and each party can unilaterally terminate the contract without consideration. In addition, if Fallon has a poor credit rating and it is not probable that the consideration will be collected on the contract, a valid contract does not exist.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.2 No entry is required on May 10, 2025, because neither party has performed under the contract and either party may terminate the contract without compensatory damages. On June 15, 2025, Cosmo delivers the product and therefore, should recognize revenue as Cosmo satisfies its performance obligation by delivering the product to Greig.
Brief Exercise 17.2 (Continued) The journal entry to record the sale and related cost of goods sold is as follows. June 15, 2025 Accounts Receivable ....................................................... Sales Revenue ..........................................................
2,000
Cost of Goods Sold .......................................................... Inventory ...................................................................
1,300
2,000
1,300
After receiving the cash payment on July 15, 2025, Cosmo makes the following entry. July 15, 2025 Cash .................................................................................. Accounts Receivable ................................................
2,000 2,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.3 There is one performance obligation in this situation, which is providing of the licensed software and custom support together. Both the software license and the custom customer support services are distinct, but they are not distinct within the contract. It appears that Hillside’s objective is to transfer a combined product. That is, the customer support services are highly interrelated and interdependent with the licensed software and therefore, these customer support services should be combined with the licensed software in determining the performance obligation. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.4 Three performance obligations exist in this contract—manufacture of the 3D printer, installation services and the maintenance services. Destin does clearly have a performance obligation for the manufacture of the 3-D printer. Destin may or may not have a performance obligation for the installation of the 3-D printer as installation can be done by another company. In other words, there is no indication that customization is required by Destin. Also, Destin may or may not have a separate performance obligation for the maintenance agreement, as it can be provided by other companies. In summary, there are three performance obligations related to this contract, some of which may end up being performed by companies other than Destin. LO: 2, Bloom: AP, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Brief Exercise 17.5 Ismail accounts for the bundle of goods and services as a single performance obligation because the goods or services in the bundle are highly interrelated. Ismail also provides a significant service by integrating the goods or services into the combined item (that is, the hospital) for which the customer has contracted. In addition, the goods or services are significantly modified and customized to fulfill the contract. In other words, the company’s objective is to transfer a combined item. Revenue for the performance obligation would be recognized over time by selecting an appropriate measure of progress toward satisfaction of the performance obligation. LO: 2, Bloom: AP, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Brief Exercise 17.6 The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration in this situation: Completion Date August 1 August 8 August 15 After August 15
Probability
Expected Value
70% chance of $1,150,000 = $ 805,000 20% chance of $1,100,000 = 220,000 5% chance of $1,050,000 = 52,500 5% chance of $1,000,000 = 50,000 $1,127,500
Thus, the total transaction price is $ 1,127,500 based on the probabilityweighted estimate. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Brief Exercise 17.7 (a) In this situation, Nair uses the most likely amount as the estimate $1,150,000. (b) When there is limited information with which to develop a reliable estimate of completion, then no revenue related to the incentive should be recognized until the uncertainty is resolved. Therefore, no revenue is recognized until the completion of the contract, with a transaction price of $1,000,000. LO: 2, Bloom: AP, Difficulty: Simple, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Brief Exercise 17.8 (a) Groupo would recognize revenue of $1,000,000 at delivery. (b) Groupo would recognize revenue of $800,000 at the point of sale. (c) Groupo would recognize revenue of $464,000 at the point of sale and recognize interest revenue of $36,000 ($500,000 - $464,000) over the payment period. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Brief Exercise 17.9 January 2, 2025 Notes Receivable...................................................... Discount on Notes Receivable......................... Sales Revenue ..................................................
11,000
Cost of Goods Sold ................................................. Inventory ..........................................................
6,000
1,000 10,000 6,000
Revenue Recognized in 2025 Sales revenue ........................................................... Interest revenue ($11,000 – $10,000)....................... Total revenue ....................................................
$10,000 1,000 $11,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.10 Parnevik should record revenue of $660,000 on March 1, 2025, which is the fair value of the inventory in this case. Parnevik is also financing this purchase and records interest revenue on the note over the 5-year period. In this case, the interest rate is imputed to be 10% ([$660,000/$1,062,937] = .6209, which is the PV of $1 factor for n = 5, i = 10%). Parnevik records interest revenue of $55,000 (.10 X $660,000 X 10/12) at December 31, 2025. (a) The journal entries to record Parnevik’s sale to Goosen Inc. and related cost of goods sold is as follows. March 1, 2025 Notes Receivable .............................................. Discount on Notes Receivable ................. Sales Revenue ...........................................
1,062,937
Cost of Goods Sold .................................... ….. Inventory ....................................................
400,000
402,937 660,000 400,000
Brief Exercise 17.10 (Continued) (b) Parnevik makes the following entry to record interest revenue for 2025. December 31, 2025 Discount on Notes Receivable ........................ Interest Revenue (.10 X $660,000 X 10/12) ........................
55,000 55,000
As a practical expedient, companies are not required to reflect the time value of money to determine the transaction price if the time period for payment is less than a year. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Brief Exercise 17.11 January income ........................................................ February income ($4,000 X .20 X .50) ...................... March income ($4,000 X .20 X .30)........................... April income ($4,000 X .20 X .20) .............................
$ 0 $400 $240 $160
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.12 Manual reduces revenue by $6,600 ($110,000 X .06) because it is probable that it will provide rebates amounting to 6%. As a result, Manual recognizes revenue of $103,400 ($110,000 - $6,600) in the first quarter of the year. LO: 2, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.13 July 10, 2025 (a) Accounts Receivable .............................................. Sales Revenue ................................................. Cost of Goods Sold ................................................. Inventory ..........................................................
700,000 700,000 560,000 560,000
Brief Exercise 17.13 (Continued) October 11, 2025 (b) Sales Returns and Allowances................................ Accounts Receivable ........................................
78,000 78,000
Returned Inventory .................................................. Cost of Goods Sold [($560,000 ÷ $700,000) x $78,000] ................
62,400 62,400
October 31, 2025 No entries are needed as the return period has expired. NOTE TO INSTRUCTOR: Some companies may choose to record sales revenue net. If sales are recorded net, the entries are as follows. July 10, 2025 (a) Accounts Receivable ............................................... Refund Liability (.15 X $700,000) ..................... Sales Revenue ($700,000 - $105,000) ..............
700,000 105,000 595,000
Cost of Goods Sold (.80 X $700,000) ...................... Inventory ...........................................................
560,000
Estimated Inventory Returns (.15 x $560,000) ....... Cost of Goods Sold ......................................
84,000
560,000 84,000
October 11, 2025 (b) Refund Liability ........................................................ Accounts Receivable ........................................ Returned Inventory (.80 X 78,000) ........................... Estimated Inventory Returns ...........................
78,000 78,000 62,400 62,400
Brief Exercise 17.13 (Continued) October 31, 2025 Inventory ($84,000 − $62,400) ................................. Estimated Inventory Returns ..........................
21,600
Refund Liability ($105,000 - $78,000) ..................... Sales Revenue .................................................
27,000
21,600 27,000
To reclassify inventory and close out the refund liability, as the return period has expired. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-12, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.14 Kristin would recognize in its financial statements the following: (a) Net sales of $5,800 comprised of sales, $6,000 ($20 X 300) less sales returns and allowances of $200 ($20 X 10). (b) An estimated liability for refunds for $200 ($20 refund X 10 products expected to be returned) (c) The amount recognized in cost of goods sold for 290 (300 – 10) products is $3,480 ($12 X 290). LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.15 When to recognize revenue in a bill-and-hold arrangement depends on the circumstances. Mills determines when it has satisfied its performance obligation to transfer a product by evaluating when ShopBarb obtains control of that product. For ShopBarb to have obtained control of a product in a bill-and-hold arrangement, all of the following criteria should be met: (a) The reason for the bill-and-hold arrangement must be substantive. (b) The product must be identified separately as belonging to ShopBarb. (c) The product currently must be ready for physical transfer to ShopBarb.
Brief Exercise 17.15 (Continued) (d) Mills cannot have the ability to use the product or to direct it to another customer. In this case, the criteria are assumed to be met. As a result, revenue recognition should be permitted at the time the contract is signed. Mills makes the following entry to record the bill and hold sale. June 1, 2025 Accounts Receivable ............................................... Sales Revenue ..................................................
200,000
Cost of Goods Sold .................................................. Inventory ...........................................................
110,000
200,000
110,000
Mills makes the following entry to record the cash received. September 1, 2025 Cash .......................................................................... Accounts Receivable ........................................
200,000 200,000
If a significant period of time elapses before payment, the accounts receivable is discounted. In addition, if one of the four conditions is violated, revenue recognition should be deferred until the goods are delivered to ShopBarb. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.16 (1) Cash ........................................................................... Accounts Payable (ShipAway Cruise Lines) ....
70,000
Accounts Payable (ShipAway Cruise Lines) ........... Sales Revenue ($70,000 X .06) ........................... Cash ....................................................................
70,000
70,000
(2)
LO: 3, Bloom: AP, Difficulty: Simple, Time: 2, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
4,200 65,800
Brief Exercise 17.17 Cash .................................................................................. Advertising Expense ........................................................ Commission Expense ($21,500 X .10) ............................. Revenue from Consignment Sales ..........................
18,850* 500 2,150 21,500
*[$21,500 – $500 – ($21,500 X .10)] Cost of Goods Sold .......................................................... Inventory on Consignment [.60 X ($20,000 + $2,000)] .......................................
13,200 13,200
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.18 Amounts Reported in Income Sales Revenue ......................................................... $1,000,000 Warranty Expense ................................................... 40,000 Amounts Reported on the Balance Sheet Unearned Service Revenue .................................... Cash ($1,000,000 + $12,000) ................................... Warranty Liability ....................................................
$ 12,000 1,012,000 40,000
Because the transaction takes place at the end of the year, which is a reporting date, warranty expense and warranty liability are reported at their estimated amounts. The company recognizes revenue related to the service type warranty over the two-year period that extends beyond the assurance warranty period (two years). In most cases, the unearned warranty revenue is recognized on a straight-line basis and the costs associated with the service type warranty are expensed as incurred. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.19 No entry is required on May 1, 2025 because neither party has performed on the contract. On June 15, 2025, Eric agreed to pay the full price and therefore, Mount has an unconditional right to those funds on that date. On receiving the cash on June 15, 2025, Mount records the following entry. June 15, 2025 Cash .......................................................................... Unearned Sales Revenue .................................
25,000 25,000
On satisfying the performance obligation on September 30, 2025, Mount records the following entry September 30, 2025 Unearned Sales Revenue......................................... Sales Revenue ..................................................
25,000 25,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.20 The initiation fee may be viewed as a separate performance obligation because it provides a renewal option at a lower price than normally charged. As a result, BlueBox is providing a discounted price in the subsequent years. This should be reflected in the revenue recognized in all four periods. In this situation, the total transaction price is $280 ([($5 X 12) X 3] + $100). In the first year, BlueBox would report revenue of $70 ($280 ÷ 4). The initiation fee is allocated over the entire four-year period. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Brief Exercise 17.21 In evaluating how to account for the modification, Stengel Co. concludes that the remaining services to be provided are distinct from the services transferred on or before the date of the contract modification. In addition, Stengel has the right to receive an amount of consideration that reflects the standalone selling price of the reduced menu of maintenance services. Therefore, Stengel allocates the new transaction price of $80,000 to the third year of service. In effect, Stengel should account for this modification as a termination of the original contract and the creation of a new contract. LO: 4, Bloom: C, Difficulty: Simple, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Brief Exercise 17.22 Construction in Process ......................................... Materials, Cash, Payables. ..............................
1,700,000
Accounts Receivable .............................................. Billings on Construction in Process ..............
1,200,000
Cash ......................................................................... Accounts Receivable .......................................
960,000
Construction in Process (Gross Profit) ($2,000,000 X .34) ....................................... Construction Expenses .......................................... Revenue from Long-Term Contracts ($7,000,000 X .34*) ......................................... *[$1,700,000 ÷ ($1,700,000 + $3,300,000)]
1,700,000 1,200,000 960,000 680,000 1,700,000 2,380,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 8-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Brief Exercise 17.23 Current Assets Accounts receivable ........................................ Inventories Construction in process .......................... Less: Billings ........................................... Costs in excess of billings ..........................
$240,000 $1,715,000 1,000,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 4, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
715,000
*Brief Exercise 17.24 (a) Construction Expenses ......................................... Construction in Process ($265,364 - $285,364) Revenue from Long-Term Contracts .......
285,364
(b) Loss from Long-Term Contracts ..................... Construction in Process ........................... *[$420,000 – ($278,000 + $162,000)]
20,000*
20,000* 265,364** 20,000
**$420,000 X [$278,000/($278,000 + $162,000)] LO: 7, Bloom: AP, Difficulty: Moderate, Time: 4-6, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Brief Exercise 17.25 April 1, 2025 Cash ......................................................................... Notes Receivable ($75,000 – $25,000) .................... Discount on Notes Receivable........................ Unearned Service Revenue (Training) ........... Unearned Franchise Revenue ($25,000 + $41,402 - $2,000) .........................
25,000 50,000 8,598 2,000 64,402
July 1, 2025 Unearned Service Revenue (Training) ................... Unearned Franchise Revenue ................................ Franchise Revenue .......................................... Service Revenue (Training).............................
2,000 64,402
LO: 8, Bloom: AP, Difficulty: Moderate, Time: 8, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
64,402 2,000
Solutions to Exercises Exercise 17.1 (10–15 minutes) (1) Kawaski is in the business of buying and selling both new and used jeeps and this activity should be considered part of its ordinary activities. Customers have entered into a contract to purchase these jeeps and sales revenue should be recognized by Kawaski. Conversely, if Kawaski is selling its corporate headquarters to another party, the transaction would not be a contract with a customer because selling real estate is not an ordinary activity of Kawaski. In this case a gain or loss on sale should be recognized on the transaction. (2) This statement is not correct. This criterion was used in previous GAAP but often proved difficult to implement in practice. In the new standard, indicators that control has passed to the customer include having (1) a present obligation to pay, (2) physical possession, (3) legal title, (4) risks and rewards of ownership, and (5) acceptance of the asset. (3) This statement is not correct. This criterion was used in previous GAAP but proved difficult to implement in practice. See additional answer related to item number 2. (4) This statement is not correct. For a valid contract to exist, the collection of revenue must be probable. (5) The distinction between revenue and gains is important because it is useful to understand how these increases in net income occurred. Sales revenue results from the normal operating activities of the business, and therefore, is generally considered a better measure for predicting the amount, timing, and uncertainty of future cash flows. Gains, on the other hand, are often incidental to the business, and therefore, do not provide as much predictive information. LO: 1, Bloom: C, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.2 (10–15 minutes) (1) A wholly unperformed contract is not recorded until one or both of the parties have performed. The new revenue standard uses an assetliability approach for recognizing revenue. In this model, until one of the parties performs, a net asset or net liability does not exist, and therefore, there is no effect on the company’s financial position. (2) This statement is true. One of the difficulties in the revenue recognition process is identifying the performance obligations in the contract.
Exercise 17.2 (Continued) (3) Elaina should account for this additional option. Whether the option provides for free goods or goods at a discount, the option is a separate performance obligation which affects the current transaction price. Consideration payable to a customer is a reduction of the transaction price unless the payment is for a distinct good or service. (4) Under GAAP, the collectability criterion is designed to prevent companies from applying the revenue model to problematic contracts and recognizing revenue and a large impairment loss at the same time. However, if the company determines that it is probable that it will collect the funds, then the normal risks of nonpayment are not considered at the time the revenue is reported. LO: 1, 2, Bloom: C, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.3 (10–15 minutes) (a)
May 1, 2025 No entry – neither party has performed on May 1, 2025.
(b) May 15, 2025 Cash............................................................................ Unearned Sales Revenue ..................................
900 900
(c) May 31, 2025 Unearned Sales Revenue .......................................... Sales Revenue ....................................................
900
Cost of Goods Sold ................................................... Inventory .............................................................
575
900
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
575
Exercise 17.4 (20–25 minutes) (a) The journal entry to record the sale and related cost of goods sold are as follows: January 2, 2025 Notes Receivable ............................................ Sales Revenue ($610,000 − $10,000) ...
600,000
Cost of Goods Sold ............................................ Inventory ...............................................
500,000
600,000 500,000
The journal entry to record the collection of the note is as follows: January 28, 2025 Cash ............................................................... Notes Receivable ................................. Sales Discounted Forfeited ................. (b)
610,000 600,000 10,000
January 2, 2025 Notes Receivable ............................................ Sales Revenue ......................................
610,000
Cost of Goods Sold ............................................ Inventory ...............................................
500,000
January 28, 2025 Cash ............................................................... Notes Receivable .................................
610,000 500,000 610,000 610,000
Note that the time value of money is not considered because the contract is less than a year. Also, if payment occurs within 5 days, under the net method, the entry would be: Cash ............................................................... Notes Receivable .................................
600,000 600,000
Exercise 17.4 (Continued) If payment occurs within 5 days, under the gross method, the entry would be as follows: Cash ............................................................... 600,000 Sales Discounts ............................................ 10,000 Notes Receivable ................................. 610,000 LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.5 (20-25 Minutes) (a) The transaction price for this contract should be computed as follows: Contract price Expected value of the bonus Transaction price Completion Time
Probability of Completion
$200,000 34,000 $234,000 X Bonus Amounts = Expected Value ($10,000 decrease/week)
On time Within one week Within two weeks Total expected value of bonus
55% 30% 15%
$40,000 30,000 20,000
$22,000 9,000 3,000 $34,000
(b) The transaction price for this contract should be computed as follow: Contract price Expected value of the bonus Transaction price Completion Time
On time Within one week Computation of expected value
$200,000 39,000 $239,000
Probability of Completion X Bonus Amounts = Expected Value ($10,000 decrease/week) 90% 10%
$40,000 30,000
$36,000 3,000 $39,000
NOTE TO INSTRUCTOR: Given just two outcomes, the company could determine the bonus component of the transaction price based on the most likely outcome ($40,000). If reliable, use of probability outcomes is more accurate. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.6 (20-25 minutes) The transaction price that Real Estate Inc. should record is $3,000,000. At this point, it appears that it will be difficult for Real Estate Inc. to argue that it is probable that a significant reversal will not occur related to the 1% of payments based on future sales. Real Estate Inc., for example, has asked for a different method of compensation (sale price of $3,250,000) which is not that much greater than the $3,000,000. However, the $3,250,000 sales price was rejected by the Blackhawk Group. The preferable approach is for Real Estate to record the transaction price at $3,000,000 and record revenue related to the future sales-based arrangement as it occurs. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.7 (15–20 minutes) (a) Because the arrangement only has two possible outcomes (regulatory approval is achieved or not), Blair determines the transaction price based on the most likely approach. Thus, the best measure for the transaction price is $10,000,000. (b)
December 20, 2025 Accounts Receivable ..................................... License Revenue ....................................
10,000,000 10,000,000
January 15, 2026 Cash ................................................................ Accounts Receivable .............................
10,000,000 10,000,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.8 (15–20 minutes) (a) Aaron determines that the transaction price for the 100 policies is $14,500 [($100 X 100) + ($10 X 4.5 X 100)]. (b) Aaron will recognize revenue of $2,636 ($14,500 X 12/66) because on average, customers renew for 4.5 years for an expected policy life of 5.5 years, Aaron includes that amount in its estimate for the transaction price. As circumstances change, Aaron updates its estimate of the transaction price and recognizes revenue (or a reduction of revenue) for those changes in circumstances. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.9 (20–25 minutes) (a)
December 31, 2025 Cash................................................................. Unearned Rent Revenue (2026 slips – 300 X $800) ........................
240,000 240,000
December 31, 2026 Unearned Rent Revenue ................................ Rent Revenue ..........................................
240,000
Cash................................................................. Unearned Rent Revenue [2027 slips – 200 X $800 X (1.00 – .05)]..
152,000
Cash................................................................. Unearned Rent Revenue [2028 slips – 60 X $800 X (1.00 – .20)]....
38,400
240,000
152,000
38,400
(b) The marina operator should recognize that the 2026 advance rentals generated $190,400 ($152,000 + $38,400) of cash in exchange for the marina’s promise to deliver future services. In effect, this has accelerated payments from boat owners. Also, the price of rental services has effectively been reduced. The current cash bonanza does not reflect current revenue. The future costs of operation must be covered, in part, from this accelerated cash inflow. On a present value basis, the granting of these discounts seems ill-advised unless interest rates were to skyrocket so that interest revenue would offset the discounts provided or because costs for dock repairs is expected to increase significantly. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.10 (25–30 minutes) July 1, 2025 No entry – neither party has performed under the contract. On September 1, 2025, Geraths has two performance obligations: (1) the delivery of the windows and (2) the installation of the windows. Windows Installation Total
$2,000 600 $2,600
Allocation Windows ($2,000 ÷ $2,600) X $2,400 = $1,846* Installation ($600 ÷ $2,600) X $2,400 = 554** Revenue recognized $2,400 (rounded to nearest dollar) Geraths makes the following entries for delivery and installation: September 1, 2025 Cash ......................................................................... Accounts Receivable .............................................. Unearned Service Revenue ............................ Sales Revenue ................................................
2,000 400
Cost of Goods Sold ................................................. Inventory ..........................................................
1,100
554** 1,846*
1,100
(Windows delivered, performance obligation for installation recorded) October 15, 2025 Cash ......................................................................... Unearned Service Revenue .................................... Service Revenue (Installation) ........................ Accounts Receivable .......................................
400 554 554 400
The sale of the windows is recognized once delivered. The installation fee is recognized when the windows are installed. LO: 2, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.11 (20–25 minutes) (a)
July 1, 2025 No entry – neither party has performed under the contract.
On September 1, 2025, Geraths has two performance obligations: (1) the delivery of the windows and (2) the installation of the windows. Windows Installation ($400 + (.20 X $400)] Total
$2,000 480 $2,480
Allocation Windows ($2,000 ÷ $2,480) X $2,400 = $1,935* Installation ($480 ÷ $2,480) X $2,400 = 465** Revenue recognized $2,400 (rounded to nearest dollar) Geraths makes the following entries for delivery and installation: September 1, 2025 Cash .......................................................................... Accounts Receivable ............................................... Unearned Service Revenue ............................. Sales Revenue .................................................
2,000 400
Cost of Goods Sold .................................................. Inventory ...........................................................
1,100
465** 1,935* 1,100
October 15, 2025 Cash .......................................................................... Unearned Service Revenue ..................................... Service Revenue (Installation) ......................... Accounts Receivable ........................................
400 465 465 400
The sale of the windows is recognized once delivered. The installation fee is recognized when the windows are installed.
Exercise 17.11 (Continued) (b) If Geraths cannot estimate the costs for installation, then the residual approach is used. In this approach, the total fair value of the contract is $2,400. Given that the windows have a standalone fair value of $2,000, then $400 ($2,400 – $2,000) is allocated to the installation. Geraths makes the following entries for delivery and installation: September 1, 2025 Cash .................................................................. Accounts Receivable ....................................... Unearned Service Revenue .................... Sales Revenue .........................................
2,000 400
Cost of Goods Sold ......................................... Inventory ...................................................
1,100
400* 2,000**
1,100
(Windows delivered, performance obligation for installation recorded) October 15, 2025 Cash .................................................................. Unearned Service Revenue ............................. Service Revenue (Installation)................. Accounts Receivable ...............................
400 400 400 400
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.12 (10–15 minutes) (a) The entry to record the sale and related cost of goods sold is as follows: January 2, 2025 Accounts Receivable ...................................... Sales Revenue ......................................... Unearned Service Revenue ....................
410,000
Cost of Goods Sold ........................................ Inventory ..................................................
300,000**
(b)
370,000* 40,000 300,000
First Quarter Sales revenue Cost of goods sold Gross profit
$370,000* 300,000** $70,000
The revenue for installation will be recognized in the second quarter. LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.13 (25–30 minutes) (a) The total revenue of $1,000,000 should be allocated to the two performance obligations based on their standalone selling prices. In this case, the standalone selling price of the equipment should be considered $1,000,000 and the standalone selling price of the installation fee is $50,000. The total standalone selling price to consider is $1,050,000 ($1,000,000 + $50,000). The allocation is as follows. Equipment ($1,000,000 / $1,050,000) X $1,000,000 = $952,381 Installation ($50,000 / $1,050,000) X $1,000,000 = $ 47,619
Exercise 17.13 (Continued) (b) Crankshaft makes the following entries: June 1, 2025 Cash ................................................................ Unearned Service Revenue (Installation) ......................... Sales Revenue (Equipment) ..................
1,000,000
Cost of Goods Sold ....................................... Inventory .................................................
600,000
47,619 952,381 600,000
September 30, 2025 Unearned Service Revenue ........................... Service Revenue (Installation)...............
47,619 47,619
The sale of the equipment should be recognized upon delivery, as the customer controls the asset and therefore Crankshaft's performance obligation is met. Service revenue for the installation is recognized on September 30, 2025 - the services have been provided and the performance obligation is satisfied. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.14 (25–30 minutes) (a) The total revenue of $1,000,000 should be allocated to the two performance obligations based on their standalone selling prices. In this case, the standalone selling price of the equipment should be considered $1,000,000 and the standalone selling price of the installation fee, assuming a cost-plus approach is $45,000 [($36,000 + (.25 X $36,000)]. The total standalone selling price to consider is $1,045,000 ($1,000,000 + $45,000). The allocation is as follows: Equipment ($1,000,000 / $1,045,000) X $1,000,000 = $ 956,938* Installation ($45,000 / $1,045,000) X $1,000,000 = $ 43,062** (b) Crankshaft makes the following entries: June 1, 2025 Cash................................................................. Unearned Service Revenue (Installation) .......................... Sales Revenue (Equipment) ...................
1,000,000
Cost of Goods Sold ........................................ Inventory ..................................................
600,000
43,062** 956,938* 600,000
September 30, 2025 Unearned Service Revenue ............................ Service Revenue .....................................
43,062 43,062
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.15 (10–15 minutes) (a) The separate performance obligations are the oven, installation, and maintenance service, since each item has standalone selling price to the customer. (b) Oven Installation Maintenance Total
$ 800/$1,025 X $1,000 = $ 780 $ 50*/$1,025 X $1,000 = $ 49 $ 175**/$1,025 X $1,000 = $ 171 $1,025
*$50 = $850 – $800 **$175 = $975 – $800 LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.16 (20–25 minutes) (a) 1. The journal entries to record sales and related cost of goods sold are as follows: March 10, 2025 Accounts Receivable (200 X $50) ................. Sales Revenue ....................................
10,000
Cost of Goods Sold (200 X $30) ................. Inventory .............................................
6,000
10,000 6,000
2. The journal entries to record sales returns are as follows: March 25, 2025 Sales Returns and Allowances (6 X $50) ..... Accounts Receivable............................
300
Returned Inventory (6 x $30)......................... Cost of Goods Sold ..............................
180
300 180
Exercise 17.16 (Continued) 3. The adjusting journal entries required to record estimated remaining returns are as follows: March 31, 2025 Sales Returns and Allowances [(10 – 6) X $50] ... Refund Liability ..................................
200
Estimated Inventory Returns [(10 – 6) X $30] Cost of Goods Sold ...........................
120
200 120
(b) Financial Statement Presentation Income Statement (Partial) For the Quarter Ended March 31, 2025 Sales revenue (200 × $50) Less: Sales returns and allowances ($300 + $200) Net sales Cost of goods sold ($6,000 − $180 − $120) Gross profit
$10,000 500 9,500 5,700 $ 3,800
Balance Sheet (Partial) At March 31, 2025 Accounts receivable ($10,000 – $300) Returned inventory (including estimated) (10 × $30) Refund liability
$9,700 $ 300 $ 200
NOTE TO INSTRUCTOR: Some companies may choose to record sales revenue net. If sales are recorded net, the entries are as follows: (a) March 10, 2025 Accounts Receivable (200 X $50) ............. Refund Liability (10 X $50)............. Sales Revenue................................
10,000 500 9,500
Exercise 17.16 (Continued) Cost of Goods Sold ..................................... Inventory .............................................
6,000
Estimated Inventory Returns (10 X $30) .... Cost of Goods Sold ............................
300
6,000 300
The journal entries to record the return are as follows: March 25, 2025 Refund Liability (6 X $50) ............................... Accounts Receivable............................
300
Returned Inventory (6 X $30) ....................... Estimated Inventory Returns ...............
180
300 180
March 31, 2025 No entries required. (b) Financial Statement Presentation Income Statement (Partial) For the Quarter Ended March 31, 2025 Net sales revenue Cost of goods sold ($6,000 – $300) Gross profit
$ 9,500 5,700 $ 3,800
Balance Sheet (Partial) At March 31, 2025 Accounts receivable ($10,000 – $300) Returned inventory (including estimated) (10 × $30) Refund liability
$9,700 $ 300 $ 200
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.17 (15–20 minutes) (a) 1. The journal entries to record sales and related cost of goods sold are as follows: March 10, 2025 Cash (200 X $50) ............................................ Sales Revenue.....................................
10,000
Cost of Goods Sold (200 X $30) .................. Inventory ..............................................
6,000
10,000 6,000
2. The journal entries to record sales returns are as follows: March 25, 2025 Sales Returns and Allowances (6 X $50) ...... Accounts Payable..................................
300
Returned Inventory (6 X $30) ......................... Cost of Goods Sold ...............................
180
300 180
3. The adjusting journal entries required to record estimated remaining returns are as follows: March 31, 2025 Sales Returns and Allowances [(10 – 6) X $50] Accounts Payable ...............................
200
Estimated Inventory Returns [(10 – 6) X $30] . Cost of Goods Sold ...........................
120
200 120
Exercise 17.17 (Continued) (b) Financial Statement Presentation Income Statement (Partial) For the Quarter Ended March 31, 2025 Sales revenue (200 × $50) Less: Sales returns and allowances ($300 + $200) Net sales Cost of goods sold ($6,000 – $180 – $120) Gross profit
$10,000 500 9,500 5,700 $ 3,800
Balance Sheet (Partial) At March 31, 2025 Cash (assuming no cash payments to Barr) Returned inventory (including estimated) (10 × $30) Accounts payable ($300 + $200)
$10,000 $ 300 $ 500
NOTE TO INSTRUCTOR: Some companies may choose to record sales revenue net. If sales are recorded net, the entries are as follows: (a) March 10, 2025 Cash (200 X $50) ........................................... Refund Liability (10 X $50) ................. Sales Revenue ....................................
10,000
Cost of Goods Sold (200 X $30) ................. Inventory .............................................
6,000
Estimated Inventory Returns (10 X $30) .... Cost of Goods Sold ..........................
300
500 9,500 6,000 300
Exercise 17.17 (Continued) The journal entries to record the return is as follows: March 25, 2025 Refund Liability (6 X $50) .......................... Accounts Payable.............................
300
Returned Inventory (6 X $30) .................... Estimated Inventory Returns ...........
180
300 180
March 31, 2025 No entries required. (b) Financial Statement Presentation Income Statement (Partial) For the Quarter Ended March 31, 2025 Net sales revenue ([200 × $50] – [10 X $50]) Cost of goods sold ($6,000 – $300) Gross profit
$ 9,500 5,700 $ 3,800
Balance Sheet (Partial) At March 31, 2025 Cash (assuming no cash payments to Barr) Returned inventory (including estimated) (10 × $30)
$10,000 $ 300
Accounts payable Refund liability ($500 - $300)
$ $
300 200
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.18 (20-25 minutes) (a) 1. The journal entries to record sales and related cost of goods sold are as follows: October 2, 2025 Accounts Receivable ................................. Sales Revenue ................................
6,000
Cost of Goods Sold ................................ Inventory ........................................
3,600
6,000 3,600
2. The journal entry to record the allowance is as follows: October 16, 2025 Sales Returns and Allowances ................. Accounts Receivable........................
400 400
3. The adjusting journal entry to record estimated remaining allowances is as follows: October 31, 2025 Sales Returns and Allowances .................. Refund Liability ..............................
250 250
(b) Financial Statement Presentation Income Statement (Partial) For the Quarter Ended October 31, 2025 Sales revenue Less: Sales returns and allowances ($400 + $250) Net sales Cost of goods sold Gross profit
$6,000 650 5,350 3,600 $1,750
Exercise 17.18 (Continued) Balance Sheet (Partial) At October 31, 2025 Accounts receivable ($6,000 – $400) Refund Liability
$5,600 $ 250
NOTE TO INSTRUCTOR: Some companies may choose to record sales revenue net. If sales are recorded net, the entries are as follows: (a) 1.
October 2, 2025 Accounts Receivable (200 X $30) ............. Refund Liability .............................. Sales Revenue................................
6,000
Cost of Goods Sold ................................. Inventory .........................................
3,600
800 5,200 3,600
2. The journal entries to record the allowance is as follows: October 16, 2025 Refund Liability ......................................... Accounts Receivable .......................
400 400
3. The adjusting journal entry to record estimated remaining allowances is as follows: October 31, 2025 Refund Liability ($800 – $400 – $250) ........ Sales Revenue................................
150 150
Exercise 17.18 (Continued) (b) Financial Statement Presentation Income Statement Partial) For the Quarter Ended October 31, 2025 Net sales revenue ($5,200 + $150) Cost of goods sold Gross profit
$5,350 3,600 $1,750
Balance Sheet (Partial) at October 31, 2025 Accounts receivable ($6,000 – $400) Refund liability
$5,600 250
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.19 (15–20 minutes) The journal entries to record sales and related cost of goods sold are as follows: June 3, 2025 Accounts Receivable (Mount) .................. Sales Revenue ................................
8,000
Cost of Goods Sold ................................ Inventory ........................................
6,000
8,000 6,000
The journal entries to record the return is as follows: June 8, 2025 Sales Returns and Allowances ................. Accounts Receivable (Mount).......... Returned Inventory [$300 × ($6,000/$8,000)] .......................... Cost of Goods Sold ..........................
300 300 225 225
Exercise 17.19 (Continued) *Because these goods were flawed they likely will be separated from other inventory. The journal entry to record delivery cost is as follows: June 8, 2025 Delivery Expense ....................................... Cash ...................................................
24 24
July 16, 2025 Cash ($8,000 − $300) ................................. Accounts Receivable (Mount) ..........
7,700 7,700
NOTE TO INSTRUCTOR: Some companies may choose to record sales revenue net. If sales are recorded net, the entries are as follows:
June 3, 2025 Accounts Receivable (Mount) .................. Refund Liability .............................. Sales Revenue................................
8,000
Cost of Goods Sold ................................. Inventory .........................................
6,000
Estimated Inventory Returns ................. Cost of Goods Sold ........................
600*
800 7,200 6,000 600
*[($6,000/ $8,000) X $800] The journal entries to record the return are as follows: June 8, 2025 Refund Liability ........................................ Accounts Receivable (Mount) .........
300 300
Exercise 17.19 (Continued) Returned Inventory [$300 X $6,000/ $8,000)] . Estimated Inventory Returns ...........
225 225
Note: Because these goods were flawed, they likely will be separated from other inventory. The journal entry to record delivery cost is as follows: June 8, 2025 Delivery Expense ....................................... Cash ...................................................
24 24
July 16, 2025 Cash ........................................................... Accounts Receivable (Mount) ..........
7,700 7,700
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.20 (25–30 minutes) (a) Sales reported gross at point of sale. January 2, 2025
(b)
Accounts Receivable................................ Sales Revenue ................................
1,500,000
Cost of Goods Sold ................................ Inventory ........................................
750,000
1,500,000 750,000
March 1, 2025 Sales Returns and Allowances ................. Accounts Receivable........................
100,000
Returned Inventory .................................... Cost of Goods Sold ................. [($750,000 / $1,500,000) X $100,000]
50,000
100,000 50,000
Exercise 17.20 (Continued) March 15, 2025 Cash ($1,500,000 − $100,000) ................... Accounts Receivable ....................... (c)
1,400,000 1,400,000
March 31, 2025 Sales Returns and Allowances ................. Refund Liability ................................
200,000
Estimated Inventory Returns .................... Cost of Goods Sold .......................... [($750,000 / $1,500,000) X $200,000]
100,000
200,000 100,000
NOTE TO INSTRUCTOR: Some companies may choose to record sales revenue net. If sales are recorded net, the entries are as follows: (a)
January 2, 2025 Accounts Receivable ...................................... Refund Liability ($1,500,000 X .20) ......... Sales Revenue .........................................
1,500,000
Cost of Goods Sold ........................................ Inventory ..................................................
750,000
Estimated Inventory Returns ......................... Cost of Goods Sold ................................
150,000*
*[($750,000 /$1,500,000) X $300,000]
300,000 1,200,000 750,000 150,000
Exercise 17.20 (Continued) (b)
March 1, 2025 Refund Liability .............................................. Accounts Receivable .............................
100,000
Returned Inventory (.50* X $100,000) ........... Estimated Inventory Returns ................. * ($750,000 / $1,500,000)
50,000
100,000 50,000
March 15, 2025 Cash ($1,500,000 - $100,000) ......................... Accounts Receivable ............................. (c)
1,400,000 1,400,000
March 31, 2025 Sales Returns and Allowances……………… Accounts Payable .............................
200,000*
Estimated Inventory Returns ........................ Cost of Goods Sold................................
100,000
200,000 100,000
*[($750,000 / $1,500,000) X $200,000] The credit is to Accounts Payable because the customer has paid the account in full. As a result, any subsequent allowances will be settled in cash. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.21 (15–20 minutes) (a) Uddin could recognize revenue at the point of sale based upon the time of shipment because the books are sold f.o.b. shipping point. That is, control has transferred, and its performance obligation is met. Because the returns can be estimated, recognition is at point of sale (shipping point). (b) Based on the available information, the correct treatment is to recognize revenue when the performance obligation is satisfied – in this case at the time of shipment (transfer of title). In addition to legal title, other indicators of control appear to be met (1) Uddin has the right to payment (2) Uddin has transferred the physical possession of the asset (3) the bookstore has significant risks and rewards of ownership, (4) the bookstore has accepted the textbooks, and (5) collection is probable. (c) The entries to record the sale of the textbooks and related cost of goods sold are as follows: July 1, 2025 Accounts Receivable................................ Sales Revenue................................
15,000,000
Cost of Goods Sold ................................. Inventory .........................................
12,000,000
15,000,000 12,000,000
(d) The entries to record the returns, related cost of goods sold, and cash payment are as follows: October 3, 2025 Sales Returns and Allowances ................ Accounts Receivable .....................
1,500,000
Returned Inventory ($1,500,000 X .80*).. Cost of Goods Sold........................
1,200,000
Cash ......................................................... Accounts Receivable .....................
13,500,000
*($12,000,000 / $15,000,000)
1,500,000 1,200,000 13,500,000
Exercise 17.21 (Continued) (e) On October 31, 2025, Uddin prepares financial statements On Uddin’s income statement, the following information is reported: Sales revenue Less: Sales returns and allowances Net sales Cost of goods sold ($12,000,000 - $1,200,000) Net Income
$15,000,000 1,500,000 13,500,000 10,800,000 $ 2,700.000
On Uddin’s balance sheet as of October 31, 2025, the following information is reported. Accounts receivable ($15,000,000 - $1,500,000 - $13,500,000) = $0 Returned inventory $1,200,000 As a result, at the end of the reporting period the net sales reflect the amount that Uddin is reasonably expected to collect. NOTE TO INSTRUCTOR: Some companies may choose to record sales revenue net. If sales are recorded net, the entries are as follows: (c) July 1, 2025 Accounts Receivable ..................................... Refund Liability ($15,000,000 X .12) ...... Sales Revenue ........................................
15,000,000
Cost of Goods Sold ....................................... Inventory .................................................
12,000,000
Estimated Inventory Returns ....................... Cost of Goods Sold ................................
1,440,000*
*(.12 X $12,000,000)
1,800,000 13,200,000 12,000,000 1,440,000
Exercise 17.21 (Continued) (d) Inventory Returned on October 3, 2025 Refund Liability ............................................... Accounts Receivable ..............................
1,500,000
Inventory (Returns)......................................... Estimated Inventory Returns* ................
1,200,000
Cash ................................................................ Accounts Receivable ..............................
13,500,000
1,500,000 1,200,000 13,500,000
*[($12,000,000 / $15,000,000) X $1,500,000] (e) On October 31, 2025, Uddin prepares financial statements. As no other returns are expected the following entry is made to close out the allowance: Refund Liability ............................................... Sales Revenue .........................................
300,000
Cost of Goods Sold……………………………. Estimated Inventory Returns…………...
240,000
300,000 240,000
As a result, at the end of the reporting period (the return period for these sales has expired), the net sales reflect the amount that Uddin is reasonably expected to collect. On Uddin’s income statement, the following information is reported: Net sales ($13,200,000 + $300,000) 13,500,000 Cost of goods sold ($12,000,000 − $1,200,000) 10,800,000 Net income $ 2,700.000 On Uddin’s balance sheet as of October 31, 2025 the following information is reported: Accounts receivable $0 Returned inventory $1,200,000 LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.22 (20–25 minutes) (a) In this case, due to the agreement to repurchase the equipment, Cramer continues to have control of the asset and therefore this agreement is a financing transaction and not a sale. That is, if the company has an unconditional obligation (forward) or unconditional right (call option) for an amount greater than or equal to its selling price, the transaction is a financing transaction by the company. Thus the asset is not removed from the books of Cramer. The entries to record to financing are as follows: July 1, 2025 Cash ................................................................ Liability to Enyart Company .................. (b)
40,000 40,000
December 31, 2025 Interest Expense ............................................ Liability to Enyart Company ($40,000 X .06 X 6/12) ..........................
1,200 1,200
*An interest rate of 6% is imputed from the agreement ($2,400 ÷ $40,000). (c)
June 30, 2026 Interest Expense ............................................ Liability to Enyart Company ($40,000 X .06 X 6/12) .......................... Liability to Enyart Company.......................... ($40,000 + $1,200 + $1,200) Cash .......................................................
1,200 1,200 42,400
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
42,400
Exercise 17.23 (10–15 minutes) Because Zagat has an unconditional obligation (forward) to repurchase the ingots at an amount greater than the selling price, the transaction is treated as a financing. (a)
March 1, 2025 The selling price of the ingots is $200,000. Zagat would record the following entry when it receives the consideration from the customer: Cash................................................................. Liability to Werner Metal Company .......
(b)
200,000 200,000
May 1, 2025 Interest Expense ($200,000 X .02).................. Liability to Werner Metal Company ............... Cash .........................................................
4,000 200,000 204,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Exercise 17.24 (10–15 minutes) (a) This transaction is a bill-and-hold situation. Delivery of the counters is delayed at the buyer’s request, but the buyer takes title and accepts billing. Thus, the agreement must be evaluated to determine if revenue can be recognized before delivery. (b) Revenue is reported at the time title passes if the following conditions are met: (1) The reason for the bill-and-hold arrangement must be substantive. (2) The product must be identified separately as belonging to the customer. (3) The product currently must be ready for physical transfer to the customer, and (4) The seller cannot have the ability to use the product or to direct it to another customer.
Exercise 17.24 (Continued) (c) Cash ................................................................ Accounts Receivable ..................................... Sales Revenue ........................................
300,000 1,700,000 2,000,000
LO: 3, Bloom: K, AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.25 (5–10 minutes) (a) Inventoriable costs: 80 units shipped at cost of $500 each ............ Freight ............................................................... Total inventoriable cost............................
$40,000 840 $40,840
Cost of 40 units sold (40/80 X $40,840) ...........
$20,420
(b) Computation of consignment profit: Consignment sales (40 X $750) ....................... Cost of units sold (40/80 X $40,840) ................ Commission charged by consignee (.06 X $30,000) ............................................... Advertising cost ............................................... Installation costs .............................................. Profit on consignment sales ................................... (c) Remittance of consignee: Consignment sales .................................................. Less: Commissions ................................................ Advertising .................................................... Installation .................................................... Remittance from consignee ....................................
$30,000 (20,420) (1,800) (200) (320) $ 7,260 $30,000 $1,800 200 320
2,320 $27,680
Note: Since the installation costs related only to goods sold, the installation costs are not part of the inventory cost but are a selling expense. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.26 (10–15 minutes) (a)
January 2, 2025 Cash............................................................................ Sales Revenue ....................................................
(b)
50,000 50,000
During 2025 Warranty Expense ..................................................... Cash, Labor, Parts .............................................
900
December 31, 2025 Warranty Expense ..................................................... Warranty Liability ...............................................
650
900
650
January 2, 2025 Cash ($50,000 + $800)................................................ Sales Revenue .................................................... Unearned Warranty Revenue (Service-type) ....
50,800 50,000 800
During 2025 Warranty Expense ..................................................... Cash, Labor, Parts .............................................
900
December 31, 2025 Warranty Expense ..................................................... Warranty Liability ...............................................
650
900
650
Grando recognizes $400 ($800 X 1/2) of revenue on the service-type warranty in 2027 and 2028. Warranty costs in the extended warranty period will be expensed as incurred. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, AICPA PC: Decision Making
Exercise 17.27 (15–20 minutes) (a)
October 1, 2025
To record sales revenue, warranties, and related cost of goods sold Cash (or Accounts Receivable) ............................... Sales Revenue ................................................... Unearned Warranty Revenue (Service-type) ...
3,600
Cost of Goods Sold .................................................. Inventory ............................................................
1,440
3,200 400 1,440
To record warranty expense on October 25, 2025 Warranty Expense..................................................... Cash, Parts, Labor.............................................
200 200
(b) Celic recognizes warranty expenses associated with the assurance-type warranty as actual warranty costs are incurred during the first 90 days after the customer receives the computer. Celic recognizes the Unearned Service Revenue associated with the service-type warranty as revenue during the extended warranty period and recognizes the costs associated with providing the service-type warranty as they are incurred. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.28 (10–15 minutes) (a)
No entry – neither party has performed on the contract on January 1, 2025.
(b)
The entries to record the sale and related cost of goods sold of the wiring base is as follows: February 5, 2025 Contract Asset .......................................................... Sales Revenue ...................................................
1,200
Cost of Goods Sold .................................................. Inventory ............................................................
700
1,200
700
Exercise 17.28 (Continued) (c) The entries to record the sale and related cost of goods sold of the shelving unit is as follows: February 25, 2025 Cash................................................................ Contract Asset ....................................... Sales Revenue ........................................
3,000
Cost of Goods Sold ....................................... Inventory .................................................
320
1,200 1,800
320
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.29 (20–25 minutes) (a) Cash................................................................. Sales Revenue (90 X $100) .....................
9,000
Cost of Goods Sold ........................................ Inventory (90 X $54) ................................
4,860
(b) Cash................................................................. Sales Revenue (10 X $100) .....................
1,000
Cost of Goods Sold ........................................ Inventory (10 X $54) ................................
540
9,000 4,860 1,000 540
In this situation, the contract modification for the additional 45 products is, in effect, a new and separate contract for future products that does not affect the accounting for the previously existing contract. (c) In this case, because the new price does not reflect a stand-alone selling price, Gaertner allocates a modified transaction price (less the amounts allocated to products transferred at or before the date of the modification) to all remaining products to be transferred.
Exercise 17.29 (Continued) Under the prospective approach, Gaertner determines the transaction price for subsequent sales ($97.86) as follows: Consideration for products not yet delivered under original contract ($100 X 60) Consideration for products to be delivered under the contract modification ($95 X 45) Total remaining revenue Revenue per remaining unit ($10,275 105) = $97.86.
$ 6,000 4,275 $10,275
As indicated, the numerator includes products not yet transferred under original contract ($100 X 60) plus products to be transferred under the contract modification ($95 X 45), which is divided by the remaining 105 products. The journal entries to record subsequent sales and related cost of goods sold for 10 units is as follows: Cash (10 X $97.86) ......................................... Sales Revenue ........................................
978.60
Cost of Goods Sold ....................................... Inventory .................................................
540.00
978.60 540.00
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.30 (20–25 minutes) (a)
January 1, 2025 Cash ................................................................ Unearned Service Revenue ...................
10,000 10,000
December 31, 2025 Unearned Service Revenue ........................... Service Revenue.....................................
10,000 10,000
Exercise 17.30 (Continued) January 1, 2026 Cash................................................................. Unearned Service Revenue ....................
10,000 10,000
December 31, 2026 Unearned Service Revenue ............................ Service Revenue ..................................... (b)
10,000 10,000
January 1, 2027 Cash ($8,000 + $20,000).................................. Unearned Service Revenue ....................
28,000 28,000
December 31, 2027 Unearned Service Revenue ($28,000 ÷ 4)...... Service Revenue .....................................
7,000 7,000
In this case, the modification of the contract does not result in new performance obligation. As a result, the remaining service revenue is recognized evenly over the remaining four years. (c) Given the change in services in the extended contract period, the services are distinct; the modification should not be considered as part of the original contract. Tyler recognizes revenue on the remaining services at different rates. Tyler will recognize $6,667 ($20,000 ÷ 3) per year in the extended period (2028–2030). For 2027, Tyler makes the following entry: January 1, 2027 Cash ($8,000 + $20,000).................................. Unearned Service Revenue ....................
28,000 28,000
Exercise 17.30 (Continued) December 31, 2027 Unearned Service Revenue ........................... Service Revenue.....................................
8,000 8,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.31 (10–15 minutes) (a) The $2,000 commission costs related to obtaining the contract are recognized as an asset. The design services ($3,000), controllers ($6,000), testing and inspection fees ($2,000) should be capitalized as well, as they are specific to the contract. The $27,000 cost for the receptacles and loading equipment appear to be independent of the contract, as Rex will retain these and likely use them in other projects. (b) Companies only capitalize costs that are direct, incremental, and recoverable (assuming that the contract period is more than one year. General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract) and wasted materials and labor are not eligible for capitalization and should be expensed as incurred. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Exercise 17.32 (20–25 minutes) (a) If the contract is for less than 1 year, Rex can use the practical expedient and recognize the incremental costs of obtaining a contract as an expense when incurred. (b) The collectibility of the contract payments will not affect the amount of revenue recognized. That is, the amount recognized is not adjusted for customer credit risk. Rather, Rex should report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an expense in the income statement. If there is significant doubt at contract inception about collectibility, this may indicate that the parties to the contract are not committed to perform their respective obligations to the contract (i.e., existence of a contract may not be met). No revenue is recognized until the issue of significant doubt is resolved. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 17.33 (20–25 minutes) (a) Gross profit recognized in: 2025 Contract price Costs: Costs to date Estimated costs to complete Total estimated profit Percentage completed to date Total gross profit recognized Less: Gross profit recognized in previous years
$1,600,000 $400,000 600,000
Gross profit recognized in current year
*
2026
*$400,000 ÷ $1,000,000 = 40%
2027
$1,600,000 $825,000
1,000,000 600,000 X
.40*
275,000
$1,600,000 $1,070,000
1,100,000 500,000 X
.75**
0
1,070,000 530,000 X
1.00
240,000
375,000
530,000
0
240,000
375,000
$ 240,000
$ 135,000
$ 155,000
**$825,000 ÷ $1,100,000 = 75%
*Exercise 17.33 (Continued) (b) 2026 Construction in Process ($825,000 – $400,000) .... Materials, Cash, Payables...............................
425,000
Accounts Receivable ($900,000 – $300,000) ......... Billings on Construction in Process ..............
600,000
Cash ($810,000 – $270,000) .................................... Accounts Receivable ......................................
540,000
Construction Expenses ($825,000 – $400,000) ..... Construction in Process (see part (a)) .................. Revenue from Long-Term Contracts .............
425,000 135,000
425,000 600,000 540,000
560,000
(c) Gross profit recognized in: Gross profit
2025 $–0–
2026 $–0–
2027 $530,000*
*($1,600,000 – $1,070,000) LO: 5, 6, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 17.34 (10–15 minutes) (a) Contract billings to date ......................................... Less: Accounts receivable 12/31/25 ..................... Portion of contract billings collected .................... (b)
$61,500 18,000 $43,500
$19,500 = 30% $65,000 (The ratio of gross profit to revenue recognized in 2025.) $1,000,000 X .30 = $300,000 (The initial estimated total gross profit before tax on the contract.)
LO: 5, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 17.35 (10–15 minutes) DOUGHERTY INC. Computation of Gross Profit to be Recognized on Uncompleted Contract Year Ended December 31, 2025 Total contract price Estimated contract cost at completion ($800,000 + $1,200,000) ............................................... Fixed fee ............................................................................ Total ........................................................................... Total estimated cost ......................................................... Gross profit............................................................................... Percentage of completion ($800,000 ÷ $2,000,000) ........ Gross profit to be recognized .................................................
$2,000,000 450,000 2,450,000 (2,000,000) 450,000 X .40 $ 180,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 17.36 (15–20 minutes) (a)
2025:
$640,000 X $2,200,000 = $880,000 $1,600,000
2026: $2,200,000 (contract price) minus $880,000 (revenue recognized in 2025) = $1,320,000 (revenue recognized in 2026). (b) $1,560,000 ($2,200,000 - $640,000) of the contract price is recognized as revenue in 2026. (c) Using the percentage-of-completion method, the following entries would be made: Construction in Process ........................................ Materials, Cash, Payables ..............................
640,000
Accounts Receivable .............................................. Billings on Construction in Process ..............
420,000
Cash......................................................................... Accounts Receivable ......................................
350,000
Construction in Process ........................................ Construction Expenses .......................................... Revenue from Long-Term Contracts [from (a)] ......................................................
240,000* 640,000
640,000 420,000 350,000
880,000
*Exercise 17.36 (Continued) *[$2,200,000 – ($640,000 + $960,000)] X [($640,000 / $1,600,000)] (Using the cost-recovery method, all the same entries are made except for the last entry. No gross profit is recognized until the contract is completed.) LO: 5, 6, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 17.37 (15–25 minutes) (a) Computation of Gross Profit to Be Recognized under Cost-Recovery Method. No computation necessary. No gross profit to be recognized prior to completion of contract. Computation of Billings on Uncompleted Contract in Excess of Related Costs under Cost-Recovery Method. Construction costs incurred during the year.................. Partial billings on contract (.25 X $6,000,000) .................
$ 1,185,800 (1,500,000) $ (314,200)
(b) Contract price ..............................................
$6,000,000
Costs to date ................................................ Estimated costs to complete ...................... Total ......................................................
$1,185,800 4,204,200
Estimated profit ($6,000,000 – $5,390,000) ....... % of completion ........................................... Gross profit...........................................
$610,000 X .22*
5,390,000
$ 134,200
*($1,185,800 / $5,390,000) LO: 5, 6, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 17.38 (20–25 minutes) (a)
May 1, 2025 Cash............................................................................ Notes Receivable ($70,000 – $28,000) ...................... Discount on Notes Receivable [$42,000 – (2.48685* X $14,000)] ..................... Unearned Franchise Revenue [$28,000 + ($42,000 – $7,184)].........................
28,000 42,000 7,184 62,816
July 1, 2025 Unearned Franchise Revenue .................................. Franchise Revenue ........................................... (b)
62,816 62,816
May 1, 2025 Cash............................................................................ Notes Receivable ($70,000 – $28,000) ...................... Discount on Notes Receivable [$42,000 – (2.48685* X $14,000)] ..................... Unearned Franchise Revenue [$28,000 + ($42,000 – $7,184)].........................
28,000 42,000 7,184 62,816
December 31, 2025 Unearned Franchise Revenue .................................. 10,469** Franchise Revenue ...........................................
10,469
*Present value factor for 10%, 3-year ordinary annuity. **($62,816 ÷ 3) X 6/12 (c)
May 1, 2025 Cash............................................................................ Notes Receivable ($70,000 – $28,000) ...................... Discount on Notes Receivable [$42,000 – (2.48685* X $14,000)] ..................... Unearned Service Revenue (Training) .............. Unearned Franchise Revenue ($28,000 $2,400 + $42,000 – $7,184) ..............................
28,000 42,000 7,184 2,400 60,416
*Exercise 17.38 (Continued) July 1, 2025 Unearned Service Revenue (Training)..................... Unearned Franchise Revenue .................................. Franchise Revenue ........................................... Service Revenue (Training) ..............................
1,200*** 60,416 60,416 1,200
***$2,400 ÷ 2 September 1, 2025 Unearned Service Revenue (Training)..................... Service Revenue ...............................................
1,200* 1,200
(Calculations rounded) *Present value of ordinary annuity 3 years at 10%. LO: 8, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Exercise 17.39 (15–20 minutes) (a)
January 1, 2025 Cash ........................................................................... Notes Receivable ($50,000 – $10,000) ..................... Discount on Notes Receivable ......................... Unearned Franchise Revenue ($10,000 + $29,567) .........................................
10,000 40,000 10,433 39,567
*Down payment made on 4/1/25............................... Present value of an ordinary annuity ($8,000 X 3.69590*) ......................................... Total revenue recorded by Campbell and total acquisition cost recorded by Lesley Benjamin ............................................. April 1, 2025 Unearned Franchise Revenue .................................. Franchise Revenue ...........................................
$10,000 29,567 $39,567 39,567 39,567
*Present value factor for 11%, 5-year ordinary annuity.
*Exercise 17.39 (Continued) December 31, 2025 Discount on Notes Receivable.................................. Interest Revenue ................................................ *($40,000 – $10,433) X .11 (b)
3,252* 3,252
January 1, 2025 Cash............................................................................ Notes Receivable ($50,000 – $10,000) ...................... Discount on Notes Receivable .......................... Unearned Service Revenue (Training) .............. Unearned Franchise Revenue ...........................
10,000 40,000 10,433 3,600 35,967
April 1, 2025 Unearned Service Revenue (Training) ..................... Unearned Franchise Revenue .................................. Franchise Revenue ............................................ Service Revenue (Training) ($3,600 X 3/12) ......
900 35,967 35,967 900
December 31, 2025 Unearned Service Revenue (Training) ..................... Discount on Notes Receivable.................................. Service Revenue ($3,600 X 9/12) ....................... Interest Revenue [($40,000 – $10,433) X .11] .......... (c)
2,700 3,252 2,700 3,252
January 1, 2025 Cash............................................................................ Notes Receivable ($50,000 – $10,000) ...................... Discount on Notes Receivable .......................... Unearned Franchise Revenue ($10,000 + $29,567) Down payment made on 1/1/25 ................................. Present value of an ordinary annuity (from part a) Total revenue recorded by Campbell and total acquisition cost recorded by Lesley Benjamin ..............................................
10,000 40,000 10,433 39,567 $10,000 29,567 $39,567
*Exercise 17.39 (Continued) December 31, 2025 Unearned Franchise Revenue .................................. Franchise Revenue ...........................................
7,913** 7,913
**($39,567 ÷ 5) Discount on Notes Receivable ................................. Interest Revenue [($40,000 – $10,433) X .11] .............................
3,252
LO: 8, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
3,252
Time and Purpose of Problems Problem 17.1 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for upfront fees. Problem 17.2 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for a contract modification. Problem 17.3 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for discounts and time value. Problem 17.4 (Time 35–40 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for discounts and time value. Problem 17.5 (Time 35–40 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for returns and consignment sales. Problem 17.6 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to account for warranty and customer loyalty programs. Problem 17.7 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the criteria and applications utilized in the determination revenue recognition for a bonus point program. The student is required to allocate the transaction price to the bonus points and sales revenue for the products and then prepare entries for bonus point redemptions. Problem 17.8 (Time 30–35 minutes) Purpose—to provide the student with an understanding of and an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for time value, gift cards, and discounts. *Problem 17.9 (Time 30–40 minutes) Purpose—to provide the student with an understanding of both the percentage-of-completion and costrecovery methods of accounting for long-term construction contracts. The student is required to compute the estimated gross profit that would be recognized during each year of the construction period under each of the two methods. *Problem 17.10 (Time 20–25 minutes) Purpose—to provide the student with a long-term construction contract problem that requires the recognition of a loss during an interim year on a contract that is profitable overall. This problem requires application of both the percentage-of-completion method and the cost-recovery method to an interim loss situation. *Problem 17.11 (Time 40–50 minutes) Purpose—to provide the student with a long-term construction contract problem that requires the recognition of a loss during an interim year on an unprofitable contract overall. This problem requires application of both the percentage-of-completion method and the cost-recovery method to this unprofitable contract.
*Problem 17.12 (Time 35–45 minutes) Purpose—to provide the student with an understanding of the accounting treatment accorded franchising operations. The student is required to discuss the alternative types of franchise fees – initial franchise fee and continuing franchise fees – and determine when fees should be recognized, at a point in time or over time.
Solutions to Problems Problem 17.1 (a) The total revenue of $50,000 (100 contracts X $500) should be allocated to the two performance obligations based on their relative standalone selling prices. In this case, the standalone selling price of each tablet is $250 and the standalone selling price of the internet service is $300. The total standalone selling price to consider is $550 ($250 + $300) for each contract. The allocation for each contract is as follows: Tablet ($250 / $550) X $500 = $227 Internet Service ($300 / $550) X $500 = $273 January 2, 2025 Cash ($500 X 100) ...................................................... Unearned Service Revenue (100 X $273) .......... Sales Revenue (100 X $ 227) .............................
50,000
Cost of Goods Sold ($175 X 100) .............................. Inventory .............................................................
17,500
27,300 22,700 17,500
The sale of the tablets (and gross profit) should be recognized once the tablets are delivered on January 2, 2025.
December 31, 2025 Unearned Service Revenue ($27,300 ÷ 3)................. Service Revenue ................................................
9,100 9,100
(To record revenue for internet service provided in 2025)
(b) Bundle B contains three different performance obligations: (1) the tablet, (2) internet service, and (3) tablet service plan.
Problem 17.1 (Continued) The total revenue of $120,000 (200 contracts X $600) should be allocated to the three performance obligations based on their relative standalone selling prices: Tablet Internet service Tablet service plan Total estimated standalone price
$250 300 150 $700
The allocation for a single contract is as follows: Tablet Internet service Tablet service Total revenue
$214 ($250 / $700) X $600 257 ($300 / $700) X $600 129 ($150 / $700) X $600 $600
Tablet Tailors makes the following entries for 200 Tablet Bundle B: July 1, 2025 Cash ($600 X 200) ..................................................... Unearned Service Revenue (Internet) .............. Unearned Service Revenue (Maintenance) ..... Sales Revenue ($214 X 200) .............................
120,000
Cost of Goods Sold ($175 X 200) ............................. Inventory ............................................................
35,000
51,400* 25,800** 42,800 35,000
*200 X $257 **200 X $129 The sale of the tablets (and gross profit) should be recognized once the tablets are delivered on July 1, 2025.
Problem 17.1 (Continued) December 31, 2025 Unearned Service Revenue (Internet) [($51,400 ÷ 3) X 6/12] .............................................. Unearned Service Revenue (Maintenance) [($25,800 ÷ 3) X 6/12] .............................................. Service Revenue ................................................
8,567 4,300 12,867
(To record revenue for internet and maintenance services provided in 2025) (c) Without reliable data with which to estimate the standalone selling price of the internet service Tablet Tailors allocates $250 for each contract to revenue on the tablets, with the residual amount allocated to the Internet service. Tablet Tailors makes the following entries: January 2, 2025 Cash ($500 X 100) ...................................................... Unearned Service Revenue (Internet) ($50,000 − $25,000) ......................... Sales Revenue (Equipment) ($250 X 100).........
50,000
Cost of Goods Sold ($175 X 100) .............................. Inventory .............................................................
17,500
25,000 25,000
17,500
December 31, 2025 Unearned Service Revenue ($25,000 ÷ 3)................. Service Revenue ................................................
8,333 8,333
(To record revenue for internet service provided in 2025) Tablet Tailors will recognize service revenue of $8,333 ($25,000 ÷ 3) in each year of the 3-year contract. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 17.2 Since the services in the extended period are the same as those provided in the original contract period, the services are not distinct; the modification should be considered as part of the original contract. (a) January 2, 2025 Cash (40 X $90) ......................................................... Unearned Service Revenue ..............................
3,600 3,600
(To record cash received for 40 extended internet service contracts) (b) December 31, 2025 Unearned Service Revenue ...................................... Service Revenue ($7,240* ÷ 3) ..........................
2,413
*Original Internet Service Contract (40 X $273) Revenue recognized in first 2 years ($10,920 X 2/3) Remaining Service at original rates Extended service Total Unearned Revenue (3 years of service)
2,413 $10,920 (7,280) 3,640 3,600 $ 7,240
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 17.3 (a) The total revenue of $8,000 ($800 X 10) should be allocated to the two performance obligations based on their relative standalone selling prices. In this case, the standalone selling price of the grills is considered $7,000 ($700 X 10) and the standalone selling price of the installation fee is $1,500 ($150 X 10). The total standalone selling price to consider is therefore $8,500 ($7,000 + $1,500). The allocation is as follows. Equipment ($7,000 / $8,500) X $8,000 = $6,588 Installation ($1,500 / $8,500) X $8,000 = $1,412 Grill Masters makes the following entries: April 20, 2025 Cash............................................................................ Unearned Service Revenue (Installation) ......... Unearned Sales Revenue (Equipment) .............
8,000 1,412 6,588
May 15, 2025 Unearned Service Revenue (Installation)................. Unearned Sales Revenue (Equipment) .................... Service Revenue (Installation) .......................... Sales Revenue (Equipment) ..............................
1,412 6,588
Cost of Goods Sold ................................................... Inventory ($425 X 10) .........................................
4,250
1,412 6,588 4,250
Both the sale of the equipment and the service revenue are recognized once the installation is completed on May 15, 2025. (b)
April 17, 2025 Cash............................................................................ Sales Revenue [($200 X 280) X (1.0 - .06)] ........
52,640
Cost of Goods Sold .................................................. Inventory (280 X $160) .......................................
44,800
52,640 44,800
Problem 17.3 (Continued) In this case, Grill Masters should reduce revenue recognized by $3,360 which is computed as the selling price of the grills $52,640 [($280 X 200) – ($56,000 X .06)], because it is probable (almost certain) that it will provide the discounted price amounting to 6%. (c) 1.
September 1, 2025 Accounts Receivable [($1,000 X 20) – (.03 X $20,000)] ..................... Sales Revenue ........................................... Cost of Goods Sold ........................................... Inventory ($550 X 20) .................................
19,400 19,400 11,000 11,000
September 25, 2025 Cash ................................................................... Accounts Receivable ................................. 2.
19,400 19,400
September 1, 2025 Accounts Receivable [(100 X $20) – (.03 X $20,000)] ........................ Sales Revenue ........................................... Cost of Goods Sold ........................................... Inventory ($550 X 20) .................................
19,400 19,400 11,000 11,000
October 15, 2025 Cash ($1,000 X 20) ............................................. Accounts Receivable ................................. Sales Discounts Forfeited (.03 X $20,000) .........................................
20,000 19,400 600
Problem 17.3 (Continued) (d)
October 1, 2025 Notes Receivable ....................................................... Discount on Notes Receivable .......................... Sales Revenue ($5,324 X .75132*) .....................
5,324
Cost of Goods Sold ................................................... Inventory .............................................................
2,700
1,324 4,000
2,700
*Present value factor for 10%, 3 years December 31, 2025 Discount on Notes Receivable.................................. Interest Revenue (.10 X 3/12 X $4,000)..............
100 100
Grill Masters records revenue of $4,000 on October 1, 2025, which is the value of consideration received, based on the present value of the note. As a practical expedient, companies are not required to reflect the time value of money to determine the transaction price if the time period for payment is less than a year or if it is not a significant financing transaction. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 17.4 (a) The entry to record the sale is as follows: June 1, 2025 Accounts Receivable ....................................... Sales Revenue..........................................
70,000
Cost of Goods Sold ....................................... Inventory ($400 X 100) ...........................
40,000
70,000 40,000
NOTE TO INSTRUCTOR: The entries to record the sale and related cost of goods sold at net amounts is as follows: June 1, 2025 Accounts Receivable ....................................... Refund Liability (.04 X $70,000) ............... Sales Revenue..........................................
70,000
Cost of Goods Sold ....................................... Estimated Inventory Returns (.04 X $40,000) ............................................. Inventory ($400 X 100) ...........................
38,400
(b) 1.
1,600 40,000
May 1, 2025 Cash [.20 X ($1,800 X 300)] ....................... Unearned Sales Revenue..................
2.
2,800 67,200
108,000 108,000
August 1, 2025 Cash [.80 X ($1,800 X 300)] ........................ Unearned Sales Revenue .......................... Sales Revenue ($1,800 X 300) ..........
432,000 108,000
Cost of Goods Sold .................................. Inventory [300 X ($260 + $275 + $400)]
280,500
540,000 280,500
Problem 17.4 (Continued) (c) The introduction of a bonus payment gives rise to a change in the transaction price for the revenue arrangement, to include an adjustment for management’s estimate of the amount of consideration to which Economy will be entitled. With just two possible outcomes, Economy uses the “most-likely-amount” approach, resulting in a transaction price of $594,000 [($1,800 X 300) X 1.10]. May 1, 2025 Cash [.20 X ($1,800 X 300)] ............................. Unearned Sales Revenue ........................
108,000 108,000
July 1, 2025 Cash ($594,000 – $108,000) ............................ Unearned Sales Revenue................................ Sales Revenue .........................................
486,000 108,000
Cost of Goods Sold......................................... Inventory [300 X ($400 + $275 + $260)] ...
280,500
594,000 280,500
(d) This is a bill-and-hold arrangement. It appears that the criteria for Epic to have obtained control of the appliance bundles have been met: (a) The reason for the bill-and-hold arrangement must be substantive. (b) The product must be identified separately as belonging to Epic Rentals. (c) The product currently must be ready for physical transfer to Epic. (d) Economy cannot have the ability to use the product or to direct it to another customer. Economy makes the following entries. February 1, 2025 Cash (.10 X 400 X $1,800) ............................... Unearned Sales Revenue ........................
72,000 72,000
Problem 17.4 (Continued) April 1, 2025 Accounts Receivable ($720,000 – $72,000) ... Unearned Sales Revenue.................................... Sales Revenue (400 X $1,800) .................
648,000 72,000
Cost of Goods Sold ........................................ Inventory [400 X ($400 + $275 + $260)] ..
374,000
720,000 374,000
Thus, Economy has transferred control to Epic; Economy has a right to payment for the appliances and legal title has transferred. LO: 2, 3, Bloom: AP, Difficulty: Complex, Time: 35-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 17.5 (a) If sales with returns are recorded gross at point of sale, the following entries are made. January 1, 2025 Notes Receivable ............................................. Sales Revenue (40 X $1,200) ...................
48,000
Cost of Goods Sold (40 X $800) ..................... Inventory ..................................................
32,000
48,000 32,000
Returns are recorded as they occur, with a debit to Returned Inventory and a credit to Cost of Goods Sold. If any returns are outstanding at the end of the period, an adjusting entry will be required. Note to Instructor: Ritt makes the following entry if the sale is recorded net. January 1, 2025
(b)
Notes Receivable (Mills)................................... Refund Liability (.05 X $48,000)............... Sales Revenue .........................................
48,000
Cost of Goods Sold......................................... Estimated Inventory Returns (40 X $800 X .05)........................................... Inventory (40 X $800) ...............................
30,400
2,400 45,600
1,600 32,000
August 10, 2025 Accounts Receivable (16 X $3,600*) ................ Sales Revenue .........................................
57,600
Cost of Goods Sold......................................... Inventory (16 X $2,000) ............................
32,000
57,600
32,000
*Note: There is no adjustment for the volume discount, because it is not probable that the customer will reach the benchmark.
Problem 17.5 (Continued) (c) This revenue arrangement has 3 different performance obligations: (1) the sale of the dryers, (2) installation, and (3) the maintenance plan. The total revenue of $45,200 should be allocated to the three performance obligations based on their relative standalone selling price: Dryers (3 X $14,000) Installation (3 X $1,000) Maintenance plan Total estimated standalone selling price
$42,000 3,000 1,200 $46,200
The allocation for a single contract is as follows. Dryers Installation Maintenance plan Total revenue
$41,091 ($42,000 / $46,200) X $45,200 2,935 ($3,000 / $46,200) X $45,200 1,174 ($1,200 / $46,200) X $45,200 $45,200
Ritt makes the following entries. June 20, 2025 Cash (.20 X $45,200) ............................................ Accounts Receivable ($45,200 – $9,040) ....... Unearned Service Revenue (Installation).......................................... Unearned Service Revenue (Maintenance Plan) .............................. Unearned Sales Revenue (Dryers) .........
9,040 36,160 2,935 1,174 41,091
Problem 17.5 (Continued) October 1, 2025 Cash (.80 X $45,200)........................................ Accounts Receivable ...............................
36,160
Unearned Service Revenue (Installation) ......... Unearned Sales Revenue (Dryers)................. Service Revenue (Installation) ................ Sales Revenue (Dryers) ...........................
2,935 41,091
Cost of Goods Sold ........................................ Inventory (3 X $11,000) ............................
33,000
36,160
2,935 41,091 33,000
December 31, 2025 Unearned Service Revenue (Maintenance Plans) .................................................................. Service Revenue (Maintenance Plans) ($1,174 X 3/36) .......................................
98 98
(d) Entries for Ritt April 25, 2025 Inventory (Consignments) (100 X $800)............ Finished Goods Inventory .......................
80,000 80,000
June 30, 2025 Cash [(60 X $1,200) – (.10 X 60 X $1,200)] ......... Commission Expense (Consignments) ($72,000 X .10).................................................... Revenue from Consignment Sales ......... (60 X $1,200)
64,800
Cost of Goods Sold (60 X $800) ......................... Inventory (Consignments).......................
48,000
7,200 72,000
48,000
Problem 17.5 (Continued) Entries for Farm Depot April 25, 2025 No entry – Inventory continues to be controlled by Ritt. Summary Entry for Consignment Sales Cash (60 X $1,200)................................................ Payable to Consignor ............................. Commission Revenue ($72,000 X .10) ...
72,000 64,800 7,200
June 30, 2025 Payable to Consignor .......................................... Cash .........................................................
64,800 64,800
LO: 2, 3, Bloom: AP, Difficulty: Complex, Time: 35-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 17.6 (a) Warranty Performance Obligations 1. 2.
To transfer 70 specialty winches to customers with a total transaction price of $21,000. To provide extended warranty services for 20 winches after the assurance warranty period with a value of $8,000 (20 X $400) for 2 years.
With respect to the bonus points program, Hale has a performance obligation for: 1. 2.
Delivery of the products and, Future delivery of products that can be purchased by customers with bonus point earned.
(b) Cash ....................................................................... Unearned Warranty Revenue (20 X $400) ............................................. Sales Revenue .........................................
29,000 8,000 21,000
To reduce inventory and recognize cost of goods sold: Cost of Goods Sold ........................................ Inventory ..................................................
16,000 16,000
Hale records warranty expense over the first two years as the actual warranty costs are incurred. An adjusting entry is recorded at year-end to recognize estimated warranty liabilities to be honored in the future. The company also recognizes revenue related to the service type warranty over the three-year period that extends beyond the assurance warranty period (two years). In most cases, the unearned warranty revenue is recognized on a straight-line basis and the costs associated with the service type warranty are expensed as incurred. (c) Because the points provide a material right to a customer that it would not receive without entering into a contract, the points are a separate performance obligation. Hale allocates the transaction price to the product and the points on a relative standalone selling price basis as follows.
Problem 17.6 (Continued) The standalone selling price: Purchased products: Estimated points to be redeemed Total
$100,000 9,500 $109,500
The allocation is as follows. Products ($100,000 / $109,500) X $100,000 = $91,324 Bonus Points ($9,500 / $109,500) X $100,000 = $ 8,676
To record sales of products subject to bonus points: Cash ................................................................. Liability to Bonus Point Customers ....... Sales Revenue.........................................
100,000
Cost of Goods Sold (1 - 0.45) X $100,000 ...... Inventory ..................................................
55,000
8,676 91,324
55,000
(d) Additional Sales Revenue from bonus point redemptions, if 4,500 points have been redeemed: (4,500 points ÷ 9,500 points X $8,676) = $4,110.
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 17.7 (a) The transaction price is allocated to the products and loyalty points, as follows: Total Standalone Percent Transaction Allocated Selling Prices Allocated Price Amounts Product Purchases Loyalty Points
$300,000 75,000* $375,000
80% 20%
$300,000 300,000
$240,000 60,000 $300,000
*30,000 X $2.50 (b)
July 2, 2025 Cash................................................................. Unearned Sales Revenue……….............. Sales Revenue ……………………… .........
300,000
Cost of Goods Sold ........................................ Inventory…………………………….. ..........
171,000
60,000 240,000 171,000
(c) At July 31, 2025, the revenue recognized as a result of the loyalty points redeemed is $24,000 [$60,000 X (10,000 ÷ 25,000)]. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Problem 17.8 (a) Sales with financing January 1, 2025 Notes Receivable ............................................ Discount on Notes Receivable ............... Sales Revenue ($5,000 X .89*) .......................................
5,000
Cost of Goods Sold ........................................ Inventory ..................................................
4,000
550 4,450 4,000
*Present value factor for 6% and 2 years
Sales revenue Interest revenue (0.06 X $4,450) Total revenue for Colbert
$4,450 267 $4,717
(b) Gift Cards March 1, 2025 Cash ................................................................. Unearned Sales Revenue (20 X $100) ....
2,000 2,000
March 31, 2025 Unearned Sales Revenue ............................... Sales Revenue (.50 X 20 X $100) ............
1,000
Cost of Goods Sold ........................................ Inventory (0.50 X 20 X $80) .....................
800
1,000 800
April 30, 2025 Unearned Sales Revenue ............................... Sales Revenue (0.30 X 20 X $100) ..........
600
Cost of Goods Sold ........................................ Inventory (0.30 X 20 X $80) .....................
480
600 480
Problem 17.8 (Continued) June 30, 2025 Unearned Sales Revenue ............................... Sales Revenue (0.05 X 20 X $100) ...........
100
Cost of Goods Sold ........................................ Inventory (0.05 X 20 X $80) ......................
80
100
80
In addition, an additional entry is made on June 30, 2025 to recognize that 10% of the gift cards (2 cards) will not be redeemed. June 30, 2025 Unearned Sales Revenue ............................... Sales Revenue (0.10 X 20 X $100) ...........
200 200
There is no cost of goods sold related to the last 2 gift cards as they were not redeemed. LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 17.9
(a) Contract price Less estimated cost: Costs to date Estimated cost to complete Estimated total cost Estimated total gross profit
2025 $900,000
2026 $900,000
2027 $900,000
270,000 330,000 600,000 $300,000
450,000 150,000 600,000 $300,000
610,000 — 610,000 $290,000
Gross profit recognized in— 2025: $270,000 X $300,000 = $600,000
$135,000
2026: $450,000 X $300,000 = $600,000 Less 2025 recognized gross profit Gross profit in 2026
$225,000
135,000 $ 90,000
2027: Less 2025–2026 recognized gross profit Gross profit in 2027
225,000 $ 65,000
(b) In 2025 and 2026, no gross profit would be recognized. Total billings...................................... Total cost ........................................... Gross profit recognized in 2027.......
$900,000 (610,000) $290,000
LO: 5, 6, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 17.10 (a)
Computation of Recognizable Profit/Loss Percentage-of-Completion Method 2025 Costs to date (12/31/25) ........................................... Estimated costs to complete .................................. Estimated total costs .......................................
$2,880,000 3,520,000 $6,400,000
Percent complete ($2,880,000 ÷ $6,400,000) ..........
45%
Revenue recognized ($8,400,000 X .45).................. Costs incurred ......................................................... Profit recognized in 2025 ........................................
$3,780,000 (2,880,000) $ 900,000
2026 Costs to date (12/31/26) ($2,880,000 + $2,230,000)..................................... Estimated costs to complete .................................. Estimated total costs ....................................... Percent complete ($5,110,000 ÷ $7,300,000) .......... Revenue recognized in 2026 ($8,400,000 X .70) – $3,780,000 ........................... Costs incurred in 2026 ............................................ Loss recognized in 2026 .........................................
$5,110,000 2,190,000 $7,300,000 70% $2,100,000 (2,230,000) $ (130,000)
2027 Total revenue recognized........................................ Total costs incurred ................................................ Total profit on contract............................................ Deduct profit previously recognized ($900,000 – $130,000) .......................................... Profit recognized in 2027 ........................................
$8,400,000 (7,300,000) 1,100,000 770,000 $ 330,000
Problem 17.10 (Continued) (b) No profit or loss recognized in 2025 and 2026 2027 Contract price .......................................................... Costs incurred ......................................................... Profit recognized......................................................
$8,400,000 7,300,000 $1,100,000
LO: 5, 6, 7, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 17.11 (a)
Computation of Recognizable Profit/Loss Percentage-of-Completion Method 2025 Costs to date (12/31/25) ................................................. Estimated costs to complete ........................................ Estimated total costs .............................................
$ 300,000 1,200,000 $1,500,000
Percent complete ($300,000 ÷ $1,500,000) ...................
20%
Revenue recognized ($1,900,000 X .20)........................ Costs incurred ............................................................... Profit recognized in 2025 ..............................................
$ 380,000 (300,000) $ 80,000
2026 Costs to date (12/31/26) ................................................. Estimated costs to complete ........................................ Estimated total costs ............................................. Contract price ................................................................ Total loss ........................................................................
$1,200,000 800,000 2,000,000 1,900,000 $ 100,000
Total loss ........................................................................ Plus gross profit recognized in 2025 ........................... Loss recognized in 2026 ...............................................
$ 100,000 80,000 $ 180,000
Problem 17.11 (Continued) 2027 Costs to date (12/31/27) ........................................ Estimated costs to complete ............................... Contract price ....................................................... Total loss ............................................................... Total loss ............................................................... Less: Loss recognized in 2026 ........................... $180,000 Gross profit recognized in 2025 ................ (80,000) Loss recognized in 2027.......................................
$2,100,000 0 2,100,000 1,900,000 $ 200,000 $ 200,000 100,000 $ 100,000
(b) No profit or loss in 2025 2026 Contract price ....................................................... Estimated costs .................................................... Loss recognized ...................................................
$1,900,000 (2,000,000) $ 100,000
2027 Contract price ....................................................... Costs incurred ...................................................... Total loss ............................................................... Less: Loss recognized in 2026 ............................ Loss recognized.................................................
$1,900,000 (2,100,000) 200,000 100,000 $ 100,000
LO: 5, 6, 7, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*Problem 17.12 (a) A company recognizes revenue in the accounting period when a performance obligation is satisfied—the revenue recognition principle. A key element of the revenue recognition principle is that a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following two criteria is met. 1.
The customer receives and consumes the benefits as the seller performs.
2.
The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property).
3.
The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer’s specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.
In the case of a franchise, fees related to rights to use the intellectual property generally are recognized at a point in time, usually when the franchise begins operation. That is because at that time, the customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the franchise rights. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. The continuing franchise fees are recognized over time because they are in exchange for products and services transferred to the franchisee during the franchise period.
*Problem 17.12 (Continued) (b) 1.
January 5, 2025 Cash ................................................. Notes Receivable ............................. Discount on Notes Receivable ($100,000 – $75,816*)............... Unearned Franchise Revenue....
20,000 100,000 24,184 95,816
*Present value of future payments ($20,000 X 3.79079) July 1, 2025 2. Unearned Franchise Revenue ........ Franchise Revenue .....................
20,000 20,000
To record revenue from delivery of franchise rights. December 31, 2025 Cash ($260,000 X .02) ...................... Franchise Revenue ................
5,200 5,200
(to recognize continuing franchise fees) Unearned Franchise Revenue ($75,816 ÷ 60 X 6) ......................................... Franchise Revenue .................................
7,582 7,582
(To recognize ongoing fees for brand maintenance) Cash………………………………………………. Discount on Notes Receivable ....................... Interest Revenue ($75,816 X .10) .............. Notes Receivable……………………………
20,000 7,582
(To recognize collection of note and interest revenue)
7,582 20,000
*Problem 17.12 (Continued) (c) In this situation Amigos would recognize the entire franchise fee of $95,816 when the franchise opens. That is, franchise revenue is recognized at a point in time. LO: 8, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
UYJ 17.1 Financial Reporting Problem (a) 2020 Net sales: $70,950 million. (b) P&G’s net sales increased from $67,684 million to $70,950 million or $3,266 million ($70,950 - $67,684) from 2019 to 2020, or 4.8% ($3,266/$67,684). Net sales increased from $66,832 million to $67,684 million or $852 ($67,684 - $66,832) from 2018 to 2019, or 1.3% ($852/$66,832). (c) Our revenue is primarily generated from the sale of finished product to customers. Those sales predominantly contain a single performance obligation and revenue is recognized at a single point in time when ownership, risks and rewards transfer, which can be on the date of shipment or the date of receipt by the customer. A provision for payment discounts and product return allowances is recorded as a reduction of sales in the same period the revenue is recognized. The revenue recorded is presented net of sales and other taxes we collect on behalf of governmental authorities. The revenue includes shipping and handling costs. which generally are included in the list price to the customer. (d) Trade promotions, consisting primarily of customer pricing allowances, merchandising funds and consumer coupons, are offered through various programs to customers and consumers. Sales are recorded net of trade promotion spending, which is recognized as incurred at the time of the sale. Most of these arrangements have terms of approximately one year. Accruals for expected payouts under these programs are included as accrued marketing and promotion in the Accrued and other liabilities line item in the Consolidated Balance Sheets. The policies for trade promotions are consistent with revenue recognition criteria and with accrual accounting concepts. Trade promotion expenses are recorded in the period of the sales, and as a result are matched with the revenue they help generate. Any amounts that benefit future periods are accrued and reported as liabilities to be matched with revenues in future periods when paid out. LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
UYJ 17.2 Comparative Analysis Case (a) For the year 2020, Coca-Cola reported net operating revenues of $33,014 million and PepsiCo reported net revenue of $70,372 million. Coca-Cola’s revenues decreased by $4,252 million ($37,266 - $33,014) or 11.4% ($4,252/$37,266) from 2019 to 2020 while PepsiCo’s revenues increased by $3,211 million ($70,372 - $67,161) or by 4.78% ($3,211/$67,161) from 2019 to 2020. (b) Revenue Recognition Policies Coca-Cola provided the following revenue recognition note (Note 3: p. 79) NOTE 3: REVENUE RECOGNITION (in part) Our Company markets, manufactures and sells: • beverage concentrates, sometimes referred to as "beverage bases," and syrups, including fountain syrups (we refer to this part of our business as our "concentrate business" or "concentrate operations"); and • finished sparkling soft drinks and other nonalcoholic beverages (we refer to this part of our business as our "finished product business" or "finished product operations"). Revenue is recognized when performance obligations under the terms of the contracts with our customers are satisfied. Our performance obligation generally consists of the promise to sell concentrates, syrups or finished products to our bottling partners, wholesalers, distributors or retailers. Control of the concentrates, syrups or finished products is transferred upon shipment to, or receipt at, our customers' locations, as determined by the specific terms of the contract. Upon transfer of control to the customer, which completes our performance obligation, revenue is recognized. Our sales terms generally do not allow for a right of return except for matters related to any manufacturing defects on our part. After completion of our performance obligation, we have an unconditional right to consideration as outlined in the contract. Our receivables will generally be collected in less than six months, in accordance with the underlying payment terms. All of our performance obligations under the terms of contracts with our customers have an original duration of one year or less.
Comparative Analysis Case (Continued) Our customers and bottling partners may be entitled to cash discounts, funds for promotional and marketing activities, volumebased incentive programs, support for infrastructure programs and other similar programs. The total revenue recorded, including any variable consideration, cannot exceed the amount for which it is probable that a significant reversal will not occur when uncertainties related to variability are resolved. As a result, we are recognizing revenue based on our faithful depiction of the consideration that we expect to receive. In making our estimates of variable consideration, we consider past results and make significant assumptions related to: (1) customer sales volumes; (2) customer ending inventories; (3) customer selling price per unit; (4) selling channels; and (5) discount rates, rebates and other pricing allowances, as applicable. In gathering data to estimate our variable consideration, we generally calculate our estimates using a portfolio approach at the country and product line level rather than at the individual contract level. The result of making these estimates will impact the line items trade accounts receivable and accounts payable and accrued expenses in our consolidated balance sheet. The actual amounts ultimately paid and/or received may be different from our estimates. The change in the amount of variable consideration recognized during the year ended December 31, 2020 related to performance obligations satisfied in prior periods was immaterial.
Comparative Analysis Case (Continued) PepsiCo’s Revenue Recognition note [Note 2 (p. 68) – Our Significant Accounting Policies] is as follows: Revenue Recognition (in part) We recognize revenue when our performance obligation is satisfied. Our primary performance obligation (the distribution and sales of beverage products and food and snack products) is satisfied upon the shipment or delivery of products to our customers, which is also when control is transferred. … The transfer of control of products to our customers is typically based on written sales terms that do not allow for a right of return. However, our policy for DSD, including certain chilled products, is to remove and replace damaged and out-of-date products from store shelves to ensure that consumers receive the product quality and freshness they expect. Similarly, our policy for certain warehousedistributed products is to replace damaged and out-of-date products. As a result, we record reserves, based on estimates, for anticipated damaged and out-of-date products. … Our products are sold for cash or on credit terms. Our credit terms, which are established in accordance with local and industry practices, typically require payment within 30 days of delivery in the United States, and generally within 30 to 90 days internationally, and may allow discounts for early payment. There were no material changes in credit terms as a result of the COVID-19 pandemic.
Comparative Analysis Case (Continued) We estimate and reserve for our expected credit loss exposure based on our experience with past due accounts and collectibility, write-off history, the aging of accounts receivable, our analysis of customer data, and forward-looking information (including the expected impact of the global economic uncertainty related to the COVID-19 pandemic), leveraging estimates of creditworthiness and projections of default and recovery rates for certain of our customers (including foodservice and vending businesses). We recorded an allowance for expected credit losses of $56 million in 2020 as a result of the COVID-19 pandemic. See Note 1 for further information. Expected credit loss expense is classified within selling, general and administrative expenses on our income statement. We are exposed to concentration of credit risk from our major customers, including Walmart. In 2020, sales to Walmart and its affiliates (including Sam's) represented approximately 14% of our consolidated net revenue, including concentrate sales to our independent bottlers, which were used in finished goods sold by them to Walmart. We have not experienced credit issues with these customers. The policies are similar.
Comparative Analysis Case (Continued) (c) The following charts summarize Coca-Cola's and Pepsi revenues by geographic region. Coca Cola: Revenue by geographic area North America $ 11,473 Bottling Investments 6,258 Europe, Middle East, and Africa 5,534 Asia Pacific 4,213 Latin America 3,499 Global Ventures 1,991 Eliminations / Corporate 46 Total $33,014
%
PepsiCo: Revenue by geographic area U.S Mexico Russia Canada United Kingdom China South Africa All other countries Total
% $40,800 3,924 3,009 2,989 1,882 1,732 1,282 14,754 $70,372
34.75% 18.96% 16.76% 12.76% 10.60% 6.03% 0.14% 100.00%
57.98% 5.58% 4.28% 4.25% 2.67% 2.46% 1.82% 20.98% 100.00%
As indicated Coca-Cola's largest revenue areas are North America (34.75%) and Europe, Middle East, and Africa (16.76%). Pepsico's revenues are concentrated in the U.S. (57.98%). LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
UYJ 17.3 Financial Statement Analysis Case WESTINGHOUSE ELECTRIC CORPORATION (a) For product sales, Westinghouse Electric Corporation uses the date of delivery, point of sale, basis for revenue recognition. For services rendered, Westinghouse uses the “when services are complete and billable method” of recognizing revenues. For nuclear steam supply system orders (approximately 5 years in duration) and other long-term construction projects, Westinghouse uses the percentage-of-completion method for recognizing revenue. And, WFSI revenues are recognized on the accrual basis, except when accounts become delinquent for two or more periods; then income is recognized only as payments are received; that is, on the cash basis. (b) For the most part, companies recognize revenue at the point of sale because that is when the performance obligation is satisfied. Under certain circumstances, companies recognize revenue over time. The most notable context in which revenue is recognized over time is longterm construction contract accounting. Long-term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. A company satisfies a performance obligation and recognizes revenue over time if at least one of the following three criteria is met: 1.
The customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs.
2.
The company’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced; or
3.
The company’s performance does not create an asset with an alternative use. For example, the asset cannot be used by another customer. In addition to this alternative use element, at least one of the following criteria must be met: (a) Another company would not need to substantially re-perform the work the company has completed to date if that other company were to fulfill the remaining obligation to the customer. (b) The company has a right to payment for its performance completed to date, and it expects to fulfill the contract as promised.
Financial Statement Analysis Case (Continued) Therefore, if criterion 1 or 2 is met, then a company recognizes revenue over time if it can reasonably estimate its progress toward satisfaction of the performance obligations. That is, it recognizes revenues and gross profits each period based upon the progress of the construction—referred to as the percentage-of-completion method. The rationale for using percentage-of-completion accounting is that under most of these contracts the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer’s ownership interest. As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression. The right to payment for performance completed to date does not need to be for a fixed amount. However, the company must be entitled to an amount that would compensate the company for performance completed to date (even if the customer can terminate the contract for reasons other than the company’s failure to perform as promised). Alternatively, if the criteria for recognition over time are not met (e.g., the company does not have a right to payment for work completed to date), the company recognizes revenues and gross profit at a point in time, that is, when the contract is completed. This approach is referred to as the cost-recovery method. (c) WFSI is probably a wholly-owned finance subsidiary of Westinghouse that provides financing for customers of Westinghouse. The character of the revenue being recognized by WFSI is interest revenue on notes receivable. So long as accounts are current, payments are being received, interest and principal are recognized in each payment. When two payments are missed, the account is declared delinquent and interest is no longer accrued. On delinquent accounts, it is probable that if and as cash is collected, the cost-recovery method is applied; that is, interest is recognized only after all principal is recovered. LO: 1, 2, 3, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
UYJ 17.4 Accounting, Analysis, and Principles Accounting Sales revenue ............................................................................. Expenses .................................................................................... Net income from pump bundle*................................................. Net income on consignment sales** ......................................... Net income ..................................................................................
$9,500,000 7,750,000 1,750,000 24,000 120,000 $1,894,000
*Since the sump-pump and installation bundle are delivered at the same time, there are two performance obligations. Any discount is applied to the pump/installation bundle. The total transaction price of $54,600 is allocated between the equipment and installation ($43,800) and the service contract [$10,800 ($10 X 36 X 30)]. Sales revenue ..................................................... Cost of goods sold [30 X ($540 + $150)] ........... Gross profit ....................................................
$43,800 20,700
Service revenue [($10,800 ÷ 36) X 10 months] Expenses [($7,560*** ÷ 36) X 10 months] .......... Income on service contract .......................... Net income on this arrangement ..................
$3,000 2,100
**Sales revenue (200 X $1,200) .......................... Cost of goods sold (200 X $540) ....................... Gross profit ....................................................
$240,000 108,000
Consignment expense ($240,000 X .05) ............ Net Income on this arrangement .................. ***$7 X 36 X 30
$23,100
900 $24,000
$132,000 12,000 $120,000
Accounting, Analysis, and Principles (Continued) Analysis Net income .................................................................................. Depreciation expense ................................................................ Increase in working capital ........................................................ Net cash flow from operating activities .................................... Less: Capital expenditures ....................................................... Dividends ......................................................................... Free cash flow ............................................................................
$1,894,000 175,000 (250,000) 1,819,000 500,000 120,000 $1,199,000
Principles Under the 5-step model, a company first identifies the contract with customer(s); identifies the separate performance obligations in the contract; determines the transaction price; allocates the transaction price to separate performance obligations, and recognizes revenue when each performance obligation is satisfied. As indicated, a company satisfies its performance obligation when the customer obtains control of the good or service. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if (1) the customer controls the asset as it is created or the company does not have an alternative use for the asset, and (2) the company has a right to payment. In the case of the sump-pump sales, the customer has control of the pumps when the pumps are delivered and installed. The service contract revenue is recognized over time as Diversified provides the services. With respect to the consignment sales, Menards is acting as an agent; revenue on those sales is recognized when the customers purchase (have control of) the pumps. Using control as a key element contributes to relevance because it indicates the cash flows that the seller is entitled to as a result of the revenue arrangement, which enhances the predictive value of the revenue information.
Accounting, Analysis, and Principles (Continued) Faithful representation may be sacrificed for situations in which companies must allocate the transaction price to more than one performance obligation in a contract. If an allocation is needed, the transaction price allocated to the various performance obligations is based on their relative fair value. In addition, faithful representation could be affected when companies must estimate returns, warranty obligations, and other elements that affect the transaction price. These estimates could be subject to error or bias. LO: 1, 2, 3, Bloom: AN, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Time and Purpose of Critical Thinking CT 17.1 (Time 20–30 minutes) Purpose—to provide the student an opportunity to describe the 5-step revenue recognition model and explain the importance of fair value measurement and the definitions of asset and liabilities to application of the 5-step model. CT 17.2 (Time 20–30 minutes) Purpose—to provide the student an opportunity to describe the revenue recognition principle and the importance of control. CT 17.3 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the conceptual merits of recognizing revenue at the point of sale. The student is required to explain and defend the reasons why the point of sale is usually used as the basis for the timing of revenue recognition, plus describe the situations where revenue would be recognized over time. CT 17.4 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the conceptual factors underlying the recognition of revenue. The student is required to explain and justify why revenue is often recognized as earned at the time of sale, and the situations when it would be appropriate to recognize revenue over time. CT 17.5 (Time 20–25 minutes) Purpose— to provide the student with an understanding of the conceptual factors underlying the recognition of revenue. The student is required to explain the factors that result in the constraint of or deferral of revenue recognition. CT 17.6 (Time 35–45 minutes) Purpose—to provide the student an opportunity to explain how a magazine publisher should recognize subscription revenue. The case is complicated by a 25% return rate and a premium offered to subscribers. The effect on the current ratio must be discussed. CT 17.7 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the criteria and applications utilized in the determination of revenue recognition for a bonus point program. The student is required to discuss the factors to be considered in determining when revenue should be recognized, plus apply these factors in discussing the accounting alternatives that should be considered for the recognition of revenues and related expenses with regard to the information presented in the case. CT 17.8 (Time 20–25 minutes) Purpose—to provide the student an ethical situation related to the recognition of revenue from membership fees. *CT 17.9 (Time 20–25 minutes) Purpose—to provide the student an opportunity to discuss the theoretical justification for use of the percentage-of-completion method. The student explains how progress billings are accounted for and how to determine the income recognized in the second year of a contract by the percentageof-completion method. The student indicates the effect on earnings per share in the second year of a four-year contract from using the percentage-of-completion method instead of the cost-recovery method.
Solutions to Critical Thinking CT 17.1 (a)
The 5-step model is as follows. 1.
Identify the contract with customers. A contract is an agreement that creates enforceable rights or obligations and (1) has commercial substance, (2) has been approved and both parties are committed to performing their obligations, (3) the company can identify each party’s rights regarding the goods or services to be transferred, (4) the payment terms, and (5) it is probable that consideration will be collected. A company applies the revenue guidance to contracts with customers and must determine if new performance obligations are created by a contract modification.
2.
Identify the separate performance obligations in the contract. A performance obligation is a promise in a contract to provide a product or service to a customer. A performance obligation exists if the customer can benefit from the good or service on its own or together with other readily available resources. A contract may be comprised of multiple performance obligations. The accounting for multiple performance obligations is based on evaluation of whether the product or service is distinct within the contract. If each of the goods or services is distinct, but is interdependent and interrelated, these goods and services are combined and reported as one performance obligation. In other words, the objective is to determine whether the nature of a company’s promise is to transfer individual goods and services to the customer or to transfer a combined item (or items) for which individual goods or services are inputs.
3.
Determine the transaction price. The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods and services. In determining the transaction price, companies must consider the following factors: (1) variable consideration, (2) time value of money, (3) noncash consideration, (4) consideration paid to a customer, and (5) upfront cash payments.
4.
Allocate the transaction price to separate performance obligations. If there is more than one performance obligation, allocate the transaction price based on what the good or service could be sold for on a standalone basis (standalone selling price). Estimates of standalone selling price can be based on (1) adjusted market assessment, (2) expected cost plus a margin approach, or (3) a residual approach.
5.
Recognize revenue when each performance obligation is satisfied. A company satisfies its performance obligation when the customer obtains control of the good or service. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following three criteria is met. (1) The customer receives and consumes the benefits as the seller performs.
CT 17.1 (Continued) (2) The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property). (3) The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer’s specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable. (b)
A contract is an agreement between two or more parties that creates enforceable rights or obligations. Contracts can be written, oral, or implied from customary business practice. By definition, revenue from a contract with a customer cannot be recognized until a contract exists. On entering into a contract with a customer, a company obtains rights to receive consideration from the customer and assumes obligations to transfer goods or services to the customer (performance obligations). In some cases, there are multiple contracts related to the transaction, and accounting for each contract may or may not occur, depending on the circumstances. These situations often develop when not only a product is provided, but some type of service is performed as well.
(c)
Companies often have to allocate the transaction price to more than one performance obligation in a contract. If an allocation is needed, the transaction price allocated to the various performance obligations is based on standalone selling prices. If this information is not available, companies should use their best estimate of what the good or service might sell for as a standalone unit. Depending on the circumstances, companies use the following approaches to determine standalone selling price: (1) Adjusted market assessment approach - Evaluate the market in which it sells goods or services and estimate the price that customers in that market are willing to pay for those goods or services. That approach also might include referring to prices from the company’s competitors for similar goods or services and adjusting those prices as necessary to reflect the company’s costs and margins; (2) Expected cost plus a margin approach - Forecast expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service; or (3) Residual approach - If the standalone selling price of a good or service is highly variable or uncertain, then a company may estimate the standalone selling price by reference to the total transaction price less the sum of the available standalone selling prices of other goods or services promised in the contract. A selling price is highly variable when a company sells the same good or service to different customers (at or near the same time) for a broad range of amounts. A selling price is uncertain when a company has not yet established a price for a good or service and the good or service has not previously been sold.
(d)
Companies use an asset-liability model to recognize revenue. For example, when a company delivers a product (satisfying its performance obligation), it has a right to consideration and therefore has a contract asset. If, on the other hand, the customer performs first, by prepaying, the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheets. Contract assets are of two types: (1) unconditional rights to receive consideration because the company has satisfied its performance obligation with a customer, and (2) conditional rights to receive consideration because the company has satisfied one performance obligation but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet should be reported separately as contract assets. A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received consideration from the customer. It is generally shown in an unearned revenue account.
LO: 2, 3, Bloom: K, C, Difficulty: Moderate, Time: 20-30, AACSB: Reflecting thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 17.2 (a)
A company recognizes revenue in the accounting period when a performance obligation is satisfied—the revenue recognition principle. A key element of the revenue recognition principle is that a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following three criteria is met. 1.
The customer receives and consumes the benefits as the seller performs.
2.
The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property).
3.
The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer’s specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.
The concept of change in control is the deciding factor in determining when a performance obligation is satisfied. The customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. Indicators that the customer has obtained control are as follows: 1. 2. 3. 4. 5. (b)
The company has a right to payment for the asset. The company transferred legal title to the asset. The company transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer has accepted the asset.
Companies use an asset-liability model to recognize revenue. For example, when a company delivers a product (satisfying its performance obligation), it has a right to consideration and therefore has a contract asset. If, on the other hand, the customer performs first by prepaying, the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheets. Contract assets are of two types: (1) unconditional rights to receive consideration because the company has satisfied its performance obligation with a customer, and (2) conditional rights to receive consideration because the company has satisfied one performance obligation but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet should be reported separately as contract assets. A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received consideration from the customer.
CT 17.2 (Continued) (c)
Collectibility refers to a customer’s credit risk—that is, the risk that a customer will be unable to pay the amount of consideration in accordance with the contract. Any time a company sells a product or performs a service on account, a collectibility issue occurs. Will the customer pay the promised consideration? Whether a company will get paid for satisfying a performance obligation is not a consideration in determining revenue recognition. The amount recognized is not adjusted for customer credit risk. Rather, companies report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an operating expense in the income statement. If significant doubt exists at contract inception about collectibility, it often indicates that the parties are not committed to their obligations. As a result, it may mean that the existence of a contract is not met.
LO: 1, 2, 3, Bloom: K, C, Difficulty: Moderate, Time: 20-30, AACSB: Reflective thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 17.3 (a)
The point of sale is the most widely used basis for the timing of revenue recognition because in most cases it provides the degree of objective evidence that control has transferred to the customer. In other words, sales transactions with outsiders represent the point in the revenue-generating process when most of the uncertainty about satisfying a performance obligation is resolved.
(b)
1.
Though it is recognized that revenue is earned throughout the entire production process, generally it is not feasible to measure revenue on the basis of operating activity. It is not feasible because of the absence of suitable criteria for consistently and objectively arriving at a periodic determination of the amount of revenue to recognize. Also, in most situations the sale represents the most important single step in satisfying a performance obligation. Prior to the sale, the amount of revenue anticipated from the processes of production is merely prospective revenue; its realization remains to be validated by actual sales. The accumulation of costs during production does not alone generate revenue. Rather, revenues are recognized by the completion of the entire process, including making sales. Thus, as a general rule, the sale cannot be regarded as being an unduly conservative basis for the timing of revenue recognition. Except in unusual circumstances, revenue recognition prior to sale would be anticipatory in nature and unverifiable in amount.
2.
To criticize the sales basis as not being sufficiently conservative because accounts receivable do not represent disposable funds, it is necessary to assume that the collection of receivables is the decisive step in satisfying a performance obligation and that periodic revenue measurement and, therefore, net income should depend on the amount of cash generated during the period. This assumption disregards the fact that the sale usually represents the decisive factor in satisfying a performance obligation and substitutes for it the administrative function of managing and collecting receivables. In other words, the investment of funds in receivables should be regarded as a policy designed to increase total revenues, properly recognized at the point of sale, and the cost of managing receivables (e.g., bad debts and collection costs) should be matched with the sales in the proper period.
CT 17.3 (Continued) The fact that some revenue adjustments (e.g., sales returns) and some expenses (e.g., bad debts and collection costs) may occur in a period subsequent to the sale does not detract from the overall usefulness of the sales basis for the timing of revenue recognition. Both can be estimated with sufficient accuracy so as not to detract from the reliability of reported net income. Thus, in the vast majority of cases for which the sales basis is used, estimating errors, though unavoidable, will be too immaterial in amount to warrant deferring revenue recognition to a later point in time. (c)
Over time. This basis of recognizing revenue is frequently used by firms whose major source of revenue is long-term construction projects. For these firms the point of sale is far less significant to satisfying a performance obligation than is production activity because the sale is assured under the contract (except of course where performance is not substantially in accordance with the contract terms). To defer revenue recognition until the completion of long-term construction projects could significantly impair the usefulness of the intervening annual financial statements because the volume of contracts completed during a period is likely to bear no relationship to production volume. During each year that a project is in process, a portion of the contract price is, therefore, appropriately recognized as that year’s revenue. The amount of the contract price to be recognized should be proportionate to the year’s production progress on the project. Income might be recognized on a production basis for some products whose salability at a known price can be reasonably determined as might be the case with some precious metals and agricultural products. It should be noted that the use of the production basis in lieu of the sales basis for the timing of revenue recognition is justifiable only when total profit or loss on the contracts can be estimated with reasonable accuracy and its ultimate realization is reasonably assured.
LO: 1, 2, 3, Bloom: K, C, Difficulty: Moderate, Time: 25-30, AACSB: Reflective thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 17.4 (a)
Recognizing revenue at point of sale is appropriate for many revenue arrangements because this is the time at which control of the asset transfers to the customer. That is, the concept of change in control is the deciding factor in determining when a performance obligation is satisfied. The customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. Change in control indicators are as follows: 1. 2. 3. 4. 5.
The company has a right to payment for the asset. The company transferred legal title to the asset. The company transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer has accepted the asset.
Thus, for many revenue arrangements (for delivery of goods and/or services), these indicators are present at point-of-sale.
CT 17.4 (Continued) (b)
Companies recognize revenue over a period of time if one of the following three criteria is met. 1.
The customer receives and consumes the benefits as the seller performs.
2.
The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property).
3.
The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer’s specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.
A company recognizes revenue from a performance obligation over time by measuring the progress toward completion. The method selected for measuring progress should depict the transfer of control from the company to the customer. Companies use various methods to determine the extent of progress toward completion. The most common are the cost-to-cost and units-of-delivery methods. The objective of all these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (e.g., costs incurred and labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed, etc.) track results. Neither is universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances. Both input and output measures have certain disadvantages. The input measure is based on an established relationship between a unit of input and productivity. If inefficiencies cause the productivity relationship to change, inaccurate measurements result. Another potential problem is front-end loading, in which significant upfront costs result in higher estimates of completion. To avoid this problem, companies should disregard some early-stage construction costs—for example, costs of uninstalled materials or costs of subcontracts not yet performed—if they do not relate to contract performance. Similarly, output measures can produce inaccurate results if the units used are not comparable in time, effort, or cost to complete. For example, using floors (stories) completed can be deceiving. Completing the first floor of an eight-story building may require more than one-eighth the total cost because of the substructure and foundation construction. The most popular input measure used to determine the progress toward completion is the cost-tocost basis. Under this basis, a company measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract. The percentage-of- completion method is discussed more fully in Appendix 17A, which examines the accounting for long-term contracts. LO: 1, 2, 3, Bloom: K, C, Difficulty: Moderate, Time: 25-30, AACSB: Reflective thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 17.5 (a)
Fahey will likely report $2,000,000 at the financial reporting date, the date of sale if using the gross method. Under the net method Fahey will report $1,700,000 ($2,000,000 − $300,000).
(b)
In situations where there may be returns or variable consideration, revenue on sales subject to reversal may not be recognized (constrained). Therefore, companies may only recognize if (1) they have experience with similar contracts and are able to estimate the returns and/or variable consideration and (2) based on experience, they do not expect a significant reversal of revenue previously recognized. To account for the sale of products with a right of return (and for some services that are provided subject to a refund), the seller should recognize all of the following. 1.
Revenue for the transferred products in the amount of consideration to which the seller is reasonably assured to be entitled (considering the products expected to be returned).
2.
An asset (and corresponding adjustment to cost of sales) for its right to recover products from the customer on settling the refund liability. However, in this situation, the Stairmasters will not be returned and an asset will not be recorded.
If recorded gross at point of sale, no liability or asset is recorded for unexercised returns until the end of the accounting period. (c)
Collectibility refers to a customer’s credit risk—that is, the risk that a customer will be unable to pay the amount of consideration in accordance with the contract. Any time a company sells a product or performs a service on account, a collectibility issue occurs. The amount recognized is not adjusted for customer credit risk. Rather, companies report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an operating expense in the income statement. If significant doubt exists at contract inception about collectibility, it often indicates that the parties are not committed to their obligations. As a result, it may mean that the existence of a contract is not met.
LO: 2, 3, Bloom: AP, Difficulty: Complex, Time: 35-45, AACSB: Reflecting thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 17.6 (a)
Cash receipts based on subscription sales should initially be credited to Unearned Sales Revenue. As each monthly issue is distributed, Unearned Sales Revenue is reduced (Dr.) and Sales Revenue is recognized (Cr.). A problem results because of the unqualified guarantee for a full refund. Certain companies experience such a high rate of returns to sales that they find it necessary to postpone revenue recognition (revenue recognized is constrained) until the return privilege has substantially expired. Cutting Edge is expecting a 25% return rate and it will not expire until the new subscriptions expire. Therefore, companies may only recognize revenue on sales with return privileges if (1) they have experience with similar contracts and are able to estimate the returns, and (2) based on experience, they do not expect a significant reversal of revenue previously recognized.
CT 17.6 (Continued) (b)
To account for the sale of products with a right of return (and for some services that are provided subject to a refund), the seller should recognize all of the following. 1.
Revenue for the transferred products in the amount of consideration to which the seller is reasonably assured to be entitled (considering the products expected to be returned).
2.
An asset (and corresponding adjustment to cost of sales) for its right to recover inventory from the customer and settling the refund liability.
If recorded gross at point of sale, no liability or asset is recorded for expected returns until the end of the accounting period. (c)
Since the atlas premium may be accepted whenever requested, it is necessary for Cutting Edge to record a liability (a performance obligation) for estimated premium claims outstanding. According to GAAP, the estimated premium claims outstanding is a liability which should be reported since it can be readily estimated [60% of the new subscribers X (cost of atlas − $2)] and its occurrence is probable. As the new subscription is obtained, Cutting Edge should record the estimated liability (Refer to Chapter 12) as follows: Premium Expense ..................................................................................... Premium Liability................................................................................
XXX XXX
Upon request for the atlas and payment of $2 by the new subscriber, Cutting Edge should record: Cash .......................................................................................................... Premium Liability ....................................................................................... Inventory of Premiums ....................................................................... (d)
XXX XXX XXX
The current ratio (Current Assets Current Liabilities) will change, but not in the direction Embry thinks. As subscriptions are obtained, current assets (cash or accounts receivable) will increase and current liabilities (unearned revenue) will increase by the same amount. In addition, the liabilities for estimated premium claims outstanding will increase with no change in current assets. Consequently, the current ratio will decrease rather than increase as proposed. Naturally as the revenue is recognized, these ratios will become more favorable. Similarly, the debt to equity ratio will not be decreased due to the increase in liabilities.
LO: 1, 2, 3, Bloom: C, AN, Difficulty: Complex, Time: 35-45, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 17.7 (a)
A company recognizes revenue in the accounting period when a performance obligation is satisfied—the revenue recognition principle. A key element of the revenue recognition principle is that a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services. The concept of change in control is the deciding factor in determining when a performance obligation is satisfied. The customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. Indicators of change in control include: 1. 2.
The company has a right to payment for the asset. The company transferred legal title to the asset.
CT 17.7 (Continued) 3. 4. 5.
The company transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer has accepted the asset.
Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following three criteria is met.
(b)
1.
The customer receives and consumes the benefits as the seller performs.
2.
The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property).
3.
The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer’s specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.
Griseta & Dubel Inc., in effect, collects cash for merchandise credits far in advance of when merchants furnish the goods. Thus, this is an example of upfront payments. In addition, since the data indicate that about 5 percent of the credits sold will never be redeemed, it also has revenue from this source unless these credits are redeemed. Griseta & Dubel’s revenues are recognized when the performance obligation is met when credits are redeemed. The performance obligation is to deliver premiums (tickets and other items) in the future. This revenue is recognized when the bonus points sales occur. Reasonable estimation is crucial to revenue recognition. Griseta and Dubel uses historical bonus points data to estimate the amount of consideration to allocate to the future bonus point revenue.
(c)
Griseta & Dubel’s major asset (in terms of data given in the question) would be its inventory of premiums. The major account with a credit balance would be performance obligation to deliver premiums to merchants in the future.
LO: 1, 2, 3, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Reflective thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CT 17.8 (a)
Honesty and integrity of financial reporting versus higher corporate profits are the ethical issues. Nies’s position represents GAAP. The financial statements should be presented fairly and that will not be the case if Avery’s approach is followed. External users of the statements such as investors and creditors, both current and future, will be misled.
(b)
Nies should insist on statement presentation in accordance with GAAP. If Avery will not accept Nies’s position, Nies will have to consider alternative courses of action, such as contacting higherups at Midwest, and assess the consequences of each.
LO: 1, 2, 3, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Reflective thinking, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
*CT 17.9 (a)
Widjaja Company should recognize revenue as it performs the work on the contract (the percentage-of-completion method) because it meets the criteria for revenue recognition over time.
(b)
Progress billings would be accounted for by increasing accounts receivable and increasing progress billings on contract, a contra-asset that is offset against the Construction in Process account. If the Construction in Process account exceeds the Billings on Construction in Process account, the two accounts would be shown net in the current assets section of the balance sheet. If the Billings on Construction in Process account exceeds the Construction in Process account, the two accounts would be shown net, in most cases, in the current liabilities section of the balance sheet.
(c)
The income recognized in the second year of the four-year contract would be determined using the cost-to-cost method of determining percentage of completion as follows: 1. The estimated total income from the contract would be determined by deducting the estimated total costs of the contract (the actual costs to date plus the estimated costs to complete) from the contract price. 2. The actual costs to date would be divided by the estimated total costs of the contract to arrive at the percentage completed. This would be multiplied by the estimated total income from the contract to arrive at the total income recognizable to date. 3. The income recognized in the second year of the contract would be determined by deducting the income recognized in the first year of the contract from the total income recognizable to date.
(d)
Earnings per share in the second year of the four-year contract would be higher using the percentage-of-completion method instead of the cost-recovery method because income would be recognized in the second year of the contract using the percentage-of-completion method, whereas no income would be recognized in the second year of the contract using the cost- recovery method.
LO: 6, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Codification Exercises CE17.1 (a)
Customer - A user or reseller. A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.
(b)
Performance Obligation - A promise in a contract with a customer to transfer to the customer either: a. A good or service (or a bundle of goods or services) that is distinct b. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
(c)
Standalone Selling Price - The price at which an entity would sell a promised good or service separately to a customer.
(d)
Transaction Price - The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.
LO: 1, 2, 3, Bloom: K, Difficulty: Simple, Time: 12-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CE17.2 According to FASB ASC 606-10-25-15: An entity shall account for a contract modification as a separate contract if both of the following conditions are present: a.
The scope of the contract increases because of the addition of promised goods or services that are distinct (in accordance with paragraphs 606-10-25-18 through 25-22).
b.
The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the standalone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.
LO: 4, Bloom: K, Difficulty: Moderate, Time: 10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CE17.3 According to FASB ASC 606-10-32-10: Refund Liabilities An entity shall recognize a refund liability if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer. A refund liability is measured at the amount of consideration received (or receivable) for which the entity does not expect to be entitled (that is, amounts not included in the transaction price). The refund liability (and corresponding change in the transaction price and, therefore, the contract liability) shall be updated at the end of each reporting period for changes in circumstances. To account for a refund liability relating to a sale with a right of return, an entity shall apply the guidance in paragraphs 606-10-55-22 through 55-29. LO: 3, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CE17.4 According to FASB ASC 606-10-32-36 to 38 Allocation of a Discount 36 - A customer receives a discount for purchasing a bundle of goods or services if the sum of the standalone selling prices of those promised goods or services in the contract exceeds the promised consideration in a contract. Except when an entity has observable evidence in accordance with paragraph 606-10-32-37 that the entire discount relates to only one or more, but not all, performance obligations in a contract, the entity shall allocate a discount proportionately to all performance obligations in the contract. The proportionate allocation of the discount in those circumstances is a consequence of the entity allocating the transaction price to each performance obligation on the basis of the relative standalone selling prices of the underlying distinct goods or services. 37 - An entity shall allocate a discount entirely to one or more, but not all, performance obligations in the contract if all of the following criteria are met: a. The entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a standalone basis. b. The entity also regularly sells on a standalone basis a bundle (or bundles) of some of those distinct goods or services at a discount to the standalone selling prices of the goods or services in each bundle. c. The discount attributable to each bundle of goods or services described in (b) is substantially the same as the discount in the contract, and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation (or performance obligations) to which the entire discount in the contract belongs. 38 - If a discount is allocated entirely to one or more performance obligations in the contract in accordance with paragraph 606-10-32-37, an entity shall allocate the discount before using the residual approach to estimate the standalone selling price of a good or service in accordance with paragraph 606-10-32-34(c). LO: 3, Bloom: K, Difficulty: Moderate, Time: 10-12, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
Codification Research Case (a)
Sale with a Right of Return is addressed at FASB ASC 606-10-55.
(b) According to FASB ASC 606-10-55-22 related to right of return: In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receive any combination of the following: a.
A full or partial refund of any consideration paid
b.
A credit that can be applied against amounts owed, or that will be owed, to the entity
c.
Another product in exchange.
Bill-and-Hold: According to FASB ASC 606-10-55-81: A bill-and-hold arrangement is a contract under which an entity bills a customer for a product, but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future. For example, a customer may request an entity to enter into such a contract because of the customer’s lack of available space for the product or because of delays in the customer’s production schedules. (c)
According to FASB ASC 606-10-55-23: To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity should recognize all of the following: a.
Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)
b.
A refund liability
Codification Research Case (Continued) c.
An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.
(d) According to FASB ASC 606-10-55-82 to 84: 82 - An entity should determine when it has satisfied its performance obligation to transfer a product by evaluating when a customer obtains control of that product (see paragraph 606-10-25-30). For some contracts, control is transferred either when the product is delivered to the customer’s site or when the product is shipped, depending on the terms of the contract (including delivery and shipping terms). However, for some contracts, a customer may obtain control of a product even though that product remains in an entity’s physical possession. In that case, the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the product even though it has decided not to exercise its right to take physical possession of that product. Consequently, the entity does not control the product. Instead, the entity provides custodial services to the customer over the customer’s asset. 83 - In addition to applying the guidance in paragraph 606-10-25-30, for a customer to have obtained control of a product in a bill-and-hold arrangement, all of the following criteria must be met: a.
The reason for the bill-and-hold arrangement must be substantive (for example, the customer has requested the arrangement).
b.
The product must be identified separately as belonging to the customer.
c.
The product currently must be ready for physical transfer to the customer.
d.
The entity cannot have the ability to use the product or to direct it to another customer.
Codification Research Case (Continued) 84 - If an entity recognizes revenue for the sale of a product on a billand-hold basis, the entity should consider whether it has remaining performance obligations (for example, for custodial services) in accordance with paragraphs 606-10-25-14 through 25-22 to which the entity should allocate a portion of the transaction price in accordance with paragraphs 606-10-32-28 through 32-41. LO: 1, 2, 3, Bloom: C, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Decision Making
CHAPTER 18 Accounting for Income Taxes Assignment Classification Table (By Topic) Topics
Brief Questions Exercises
Exercises
Problems
Critical Thinking
1. Reconcile pretax financial income with taxable income.
1, 14
1, 2, 3, 4, 5, 10, 16, 18, 19
1, 2, 3, 4, 8
2. Identify temporary and permanent differences.
3, 4, 12, 13
4, 5, 6, 7
2, 3, 4
3. Determine deferred income taxes and related items— single tax rate.
5, 6, 8, 9, 10, 13
1, 2, 3, 4, 5, 6, 7, 9
1, 3, 4, 5, 7, 8, 3, 4, 8, 9 10, 12, 13, 17
2
4. Classification of deferred taxes.
11
15,3
7, 8, 9, 14, 16, 3, 6, 7, 8 17, 18, 19, 20
2, 3, 5
5. Determine deferred income taxes and related items— multiple tax rates, expected future income.
10
2, 11, 14, 15, 16, 18, 19
1, 6, 7
6. Determine deferred taxes, multiple rates, expected future losses.
10
1, 2, 6, 7
7. Carryback and carryforward of NOL.
16, 17, 18
12, 13, 14, 21, 22, 23, 24, 5 *15, *16 25, *26, *27
8. Change in enacted future tax rate.
14
11
9. Tracking temporary differences through reversal. 10. Income statement presentation. 9, 10
11. Conceptual issues—tax allocation.
1, 2, 7
12. Valuation allowance—deferred 7, 18 tax asset. 13. Disclosure and other issues.
8
15, 19
*This material is addressed in the appendix.
14
2, 7
8, 15
2, 7
5, 6
1, 2, 3, 4, 5, 7, 1, 2, 3, 5, 10, 14, 17, 22, 7, 8, 9 23, 24, 25, 27 7
7
3, 4, 5
7, 12, 13, 23, 24, 25
1, 2, 7
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Critical Thinking
Problems
1.
Describe the fundamentals of accounting for income taxes.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 4, 5, 6, 7, 8, 9, 10
1, 2, 3, 4, 5, 6, 1, 2, 3, 4, 7, 8, 10, 11, 6, 7, 8, 9 12, 13, 14, 15, 16, 17, 18, 19, 20
1, 2, 3, 4, 5, 6, 7
2.
Identify additional issues in accounting for income taxes.
12, 13, 14, 15
3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 4, 5, 6, 1, 2, 3, 4, 7, 8, 10, 11, 7, 8, 9 12, 13, 14, 15, 16, 17, 18, 19, 20
3, 4, 5, 6
3.
Explain the accounting for loss carryforwards.
16, 17, 18
12, 13, 14
21, 22, 23, 24, 5 25, 26, 27
6
4.
Describe the presentation of deferred income taxes in financial statements.
15, 19
14
9, 14, 19, 20
5.
Apply the concepts and procedures of interperiod tax allocation. 15, 16
26, 27
*6. Explain the accounting for loss carrybacks.
*This material is addressed in the appendix.
1, 3, 6, 7, 8, 9
Assignment Characteristics Table Level of Difficulty
Time (minutes)
One temporary difference, future taxable amounts, one rate, no beginning deferred taxes.
Moderate
15–20
E18.2
Two differences, no beginning deferred taxes, tracked through 2 years.
Moderate
15–20
E18.3
One temporary difference, future taxable amounts, one rate, beginning deferred taxes.
Moderate
15–20
E18.4
Three differences, compute taxable income, entry for taxes.
Moderate
15–20
E18.5
Two temporary differences, one rate, beginning deferred taxes.
Moderate
15–20
E18.6
Identify temporary or permanent differences.
Moderate
10–15
E18.7
Terminology, relationships, computations, entries.
Moderate
10–15
E18.8
Two temporary differences, one rate, 3 years.
Moderate
10–15
E18.9
Three differences, classify deferred taxes.
Moderate
10–15
E18.10
Two temporary differences, one rate, beginning deferred taxes, compute pretax financial income.
Complex
20–25
E18.11
One difference, multiple rates, effect of beginning balance versus no beginning deferred taxes.
Moderate
20–25
E18.12
Deferred tax asset with and without valuation account.
Moderate
20–25
E18.13
Deferred tax asset with previous valuation account.
Complex
20–25
E18.14
Deferred tax liability, change in tax rate, prepare section of income statement.
Complex
15–20
E18.15
Two temporary differences, tracked through 3 years, multiple rates.
Moderate
30–35
E18.16
Three differences, multiple rates, future taxable income.
Moderate
20–25
E18.17
Two differences, one rate, beginning deferred balance, compute pretax financial income.
Complex
25–30
E18.18
Two differences, no beginning deferred taxes, multiple rates.
Complex
15–20
E18.19
Two temporary differences, multiple rates, future taxable income.
Moderate
20–25
E18.20
Two differences, one rate, first year.
Moderate
15–20
E18.21
Carryforward of NOL, no valuation account, no temporary differences.
Simple
15–20
E18.22
Two NOLs, no temporary differences, no valuation account, entries and income statement.
Moderate
20–25
E18.23
NOL carryforward, valuation account versus no valuation account.
Complex
30–35
E18.24
NOL carryforward, valuation account needed.
Complex
30–35
E18.25
NOL carryforward, valuation account needed.
Moderate
15–20
Item
Description
E18.1
Assignment Characteristics Table (Continued) Level of Difficulty
Time (minutes)
Item
Description
*E18.26
Carryback and carryforward of NOL, no valuation account, no temporary differences.
Moderate
15–20
*E18.27
NOL carryback and carryforward.
Moderate
15–20
P18.1
Three differences, no beginning deferred taxes, multiple rates.
Complex
40–45
P18.2
One temporary difference, tracked for 4 years, one permanent difference, change in rate.
Complex
50–60
P18.3
Second year of depreciation difference, two differences, single rate, discontinued operations.
Complex
40–45
P18.4 P18.5
Permanent and temporary differences, one rate.
Moderate Moderate
20–25 20–25
Moderate
20–25
NOL without valuation account. Two differences, two rates, future income expected.
P18.6 P18.7
One temporary difference, tracked 3 years, change in rates, income statement presentation.
Complex
45–50
P18.8
Two differences, 2 years, compute taxable income and pretax financial income.
Complex
40–50
P18.9
Five differences, compute taxable income and deferred taxes, draft income statement.
Complex
40–50
CT18.1
Objectives and principles for accounting for income taxes.
Simple
15–20
CT18.2
Basic accounting for temporary differences.
Moderate
20–25
CT18.3
Identify temporary differences and classification criteria.
Complex
20–25
CT18.4
Accounting and classification of deferred income taxes.
Moderate
20–25
CT18.5
Explain computation of deferred tax liability for multiple tax rates.
Complex
20–25
CT18.6
Explain future taxable and deductible amounts, how carryforward affects deferred taxes.
Complex
20–25
CT18.7
Deferred taxes, income effects.
Moderate
20–25
*This material is addressed in the appendix.
Answers to Questions 1.
Pretax financial income is reported on the income statement and is often referred to as income before income taxes. Taxable income is reported on the tax return and is the amount upon which a company’s income taxes payable are computed.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
2.
One objective of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year. A second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events already recognized in the financial statements or tax returns.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
3.
A temporary difference is a difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years when the reported amount of the asset is recovered or when the reported amount of the liability is settled. The temporary differences discussed in this chapter all result from differences between taxable income and pretax financial income which will reverse and result in taxable or deductible amounts in future periods. Examples of temporary differences are: (1) Gross profit or gain on installment sales reported for financial reporting purposes at the date of sale and reported in tax returns when later collected. (2) Depreciation for financial reporting purposes is less than that deducted in tax returns in early years of assets’ lives because of using an accelerated depreciation method for tax purposes. (3) Rent and royalties taxed when collected, but deferred for financial reporting purposes and recognized as when the performance obligation is satisfied in later periods. (4) Unrealized gains or losses recognized in income for financial reporting purposes but deferred for tax purposes.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
4.
An originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability. A reversing difference occurs when a temporary difference that originated in prior periods is eliminated and the related tax effect is removed from the tax account.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
5.
Book basis of assets ................................................................................... Tax basis of assets ..................................................................................... Future taxable amounts .............................................................................. Tax rate ...................................................................................................... Deferred tax liability (end of 2026) ..............................................................
$900,000 700,000 200,000 17% $ 34,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
6.
Book basis of asset
$90,000
Income taxes payable (2026)
$230,000
Tax basis of asset
–0–
Deferred tax liability (end of 2026)
$15,300
Future taxable amounts
90,000
Deferred tax liability (beginning of 2026)
68,000
Tax rate
X 17%
Deferred tax benefit (2026)
52,700
Deferred tax liability (end of 2026)
$15,300
Income tax expense for 2026
$177,300
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 18 (Continued)
7.
A future taxable amount will increase taxable income relative to pretax financial income in future periods due to temporary differences existing at the balance sheet date. A future deductible amount will decrease taxable income relative to pretax financial income in future periods due to existing temporary differences. A deferred tax asset is recognized for all deductible temporary differences. However, a deferred tax asset should be reduced by a valuation account if, based on all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. More likely than not means a level of likelihood that is slightly more than 50%.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
8.
Taxable income
$100,000
Future taxable amounts
$70,000
Tax rate
X
Tax rate
X 20%
Income taxes payable
$ 20,000
Deferred tax liability (end of 2026)
$14,000
Deferred tax liability (end of 2026)
$ 14,000
Current tax expense
$20,000
Deferred tax liability (beginning of 2026)
(
–0–
Deferred tax expense
14,000
Deferred tax expense for 2026
$ 14,000
Income tax expense for 2026
$34,000
20%
)
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
9.
In this case, the decrease in the deferred tax asset of $20,000 is added to income taxes payable of $460,000 to compute income tax expense of $480,000 for the year.
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
10.
In this case, the increase in the deferred tax liability increased income tax expense by $40,000 and the increase in the deferred tax asset decreased income tax expense by $10,000 Income tax expense for 2025 is therefore $350,000 ($320,000 + $40,000 − $10,000).
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
11.
Deferred tax accounts are reported on the balance sheet as assets and liabilities. Companies should classify these accounts as a net noncurrent amount on the balance sheet. That is, deferred tax assets and deferred tax liabilities are separately recognized and measured and are then offset in the balance sheet. The net deferred tax asset or net deferred tax liability is therefore reported in the noncurrent section of the balance sheet.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
12.
A permanent difference is a difference between taxable income and pretax financial income that, under existing applicable tax laws and regulations, will not be offset by corresponding differences or “turn around” in other periods. Therefore, a permanent difference is caused by an item that: (1) is included in pretax financial income but never in taxable income, or (2) is included in taxable income but never in pretax financial income.
Questions Chapter 18 (Continued) Examples of permanent differences are: (1) interest received on municipal obligations (such interest is included in pretax financial income but is not included in taxable income), (2) premiums paid on officers’ life insurance policies in which the company is the beneficiary (such premiums are not allowable expenses for determining taxable income but are expenses for determining pretax financial income), and (3) fines and expenses resulting from a violation of law. Item (3), like item (2), is an expense which is not deductible for tax purposes. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
13.
Pretax financial income........................................................................................ Interest income on municipal bonds.................................................................... Hazardous waste fine ......................................................................................... Depreciation ($60,000 – $45,000)....................................................................... Taxable income .................................................................................................. Tax rate .............................................................................................................. Income taxes payable .........................................................................................
$550,000 (70,000) 25,000 15,000 520,000 X 30% $156,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
14.
$200,000 (2028 taxable amount) 10% (.30 – .20) $ 20,000 Decrease in deferred tax liability at the end of 2025 Deferred Tax Liability ............................................................................... Income Tax Expense .......................................................................
20,000 20,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
15.
Some of the reasons for requiring income tax component disclosures are: (a) Assessment of the quality of earnings. Many investors seeking to assess the quality of a company’s earnings are interested in the reconciliation of pretax financial income to taxable income. Earnings that are enhanced by a favorable tax effect should be examined carefully, particularly if the tax effect is nonrecurring. (b) Better prediction of future cash flows. Examination of the deferred portion of income tax expense provides information as to whether taxes payable are likely to be higher or lower in the future.
LO: 2, 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
16.
The loss carryforward provision permits a company to carry forward a net operating loss indefinitely into the future, offsetting future taxable income. The loss is uncertain because taxable income may not arise in the future.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
17.
The company may choose to carry the net operating loss forward. For financial reporting purposes, the benefits of an operating loss carryforward are recognized as a deferred tax asset in the loss year. If it is more likely than not that the asset will be realized, the tax benefit of the loss is also recognized by a credit to Income Tax Expense on the income statement. Conversely, if it is more likely than not that the loss carryforward will not be realized in future years, then an allowance account is established in the loss year and no tax benefit is recognized on the income statement of the loss year.
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 18 (Continued)
18.
Many believe that future deductible amounts arising from net operating loss carryforwards are different from future deductible amounts arising from normal operations. One rationale provided is that a deferred tax asset arising from normal operations results in a tax prepayment—a prepaid tax asset. In the case of loss carryforwards, no tax prepayment has been made. Others argue that realization of a loss carryforward is less likely—and thus should require a more severe test—than for a net deductible amount arising from normal operations. Some have suggested that the test be changed from “more likely than not” to “probable” realization. Others have indicated that because of the nature of net operating losses, deferred tax assets should never be established for these items.
LO: 3, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
19.
Uncertain tax positions are tax positions for which the tax authorities may disallow a deduction in whole or in part. Uncertain tax positions often arise when a company takes an aggressive approach in its tax planning, such as instances in which the tax law is unclear or the company may believe that the risk of audit is low. Such positions give rise to tax benefits by either reducing income tax expense or related payables or by increasing an income tax refund receivable or deferred tax asset. In assessing whether an uncertain tax position should be recognized, companies must determine whether a tax position will be sustained upon audit. If the probability is more than 50 percent, the company may reduce its liability or increase its assets. If the probability is less that 50 percent, companies may not record the tax benefit. In determining “more likely than not,” companies must assume that they will be audited by the tax authorities. If the recognition threshold is passed, companies must then estimate the amount to record as an adjustment to its tax assets and liabilities.
LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Solutions to Brief Exercises Brief Exercise 18.1 2025 taxable income ............................................................... Tax rate .................................................................................... 12/31/25 income taxes payable...............................................
$120,000 X 20% $ 24,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.2 Excess depreciation on tax return ......................................... Tax rate .................................................................................... Deferred tax liability ................................................................
$ 40,000 X 30% $ 12,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.3 Income Tax Expense ................................................. Deferred Tax Liability ......................................... Income Taxes Payable .......................................
$67,500*** 12,000** 55,500*
*($225,000 - $40,000) x .30 = $55,500 **$40,000 x .30 = $12,000 ***$55,500 + $12,000 = $67,500 The $12,000 deferred tax liability should be classified as a noncurrent liability. LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.4 Current tax expense for 2026 ................................................. Deferred tax liability, 12/31/26 ................................... $42,000 Deferred tax liability, 12/31/25 .................................... 25,000 Deferred tax expense for 2026 ............................................... Total income tax expense for 2026 ........................................ LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 48,000 17,000 $65,000
Brief Exercise 18.5 Book value of warranty liability .................................................... Tax basis of warranty liability ....................................................... Cumulative temporary difference at 12/31/25 .............................. Tax rate .......................................................................................... 12/31/25 deferred tax asset ...........................................................
$105,000 –0– 105,000 X 20% $ 21,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.6 Current tax expense for 2026 ....................................................... Deferred tax asset, 12/31/26............................................. $59,000 Deferred tax asset, 12/31/25.............................................. 30,000 Deferred tax benefit for 2026 ........................................................ Total income tax expense for 2026 ..............................................
$ 61,000 (29,000) $32,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.7 Income Tax Expense ....................................................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ..............................
60,000 60,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.8 Income before income taxes .......................................... Income tax expense Current ...................................................................... Deferred .................................................................... Net income .......................................................................
$195,000 $24,000 15,000
39,000 $156,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.9 Income Tax Expense ....................................................... Income Taxes Payable ($148,000* x 25%) .............. Deferred Tax Liability ($10,000 x 25%) ...................
39,500
*$154,000 + $4,000 – $10,000 = $148,000 LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
37,000 2,500
Brief Exercise 18.10 Year 2026 2027 2028
Future taxable amount $ 42,000 244,000 294,000
X
Tax Rate 17% 17% 20%
=
Deferred tax liability $ 7,140 41,480 58,800 $107,420
LO: 1, 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.11 Income Tax Expense ...................................................... Deferred Tax Liability [$2,000,000 x (.20 - .17)] .....
60,000 60,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.12 Deferred Tax Asset ($500,000 x .20).............................. Income Tax Expense (Loss Carryforward) ...........
100,000 100,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.13 Deferred Tax Asset ($500,000 x .20).............................. Income Tax Expense (Loss Carryforward) ...........
100,000
Income Tax Expense ..................................................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value.............................
100,000
100,000
100,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 18.14 Deferred tax liability ($38,000 + $96,000) ...................... Deferred tax asset ($62,000 + $27,000) ......................... Net deferred tax liability .................................................
$134,000 89,000 $ 45,000
The net deferred tax liability of $45,000 should be reported as a noncurrent deferred tax liability. LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 18.15 Income Tax Refund Receivable .................................... Income Tax Expense (Loss Carryback) $97,500* + [($480,000 – $325,000) ** x 30%] ..... *2024 Tax Year **2025 Tax Year
144,000 144,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
* Brief Exercise 18.16 Income Tax Refund Receivable ($350,000 x 20%) ....... Income Tax Expense (Loss Carryback)................
70,000
Deferred Tax Asset [($500,000 – $350,000) x 20%]...... Income Tax Expense (Loss Carryforward) ...........
30,000
70,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
30,000
Solutions to Exercises Exercise 18.1 (15–20 minutes) (a) Pretax financial income for 2025 Temporary difference resulting in future taxable amounts in 2026 in 2027 in 2028 Taxable income for 2025
$300,000 (55,000) (60,000) (65,000) $120,000
Taxable income for 2025 Enacted tax rate Income taxes payable for 2025 (b) Future taxable (deductible) amounts Tax rate Deferred tax liability (asset)
$120,000 30% $ 36,000 Future Years 2026 2027 $55,000 $60,000 30% 30% $16,500 $18,000
2028 $65,000 30% $19,500
Total $180,000 $ 54,000
Current tax expense for 2025 (Income taxes payable) $ 36,000 Deferred tax liability at the end of 2025 $54,000 Deferred tax liability at the beginning of 2025 –0– Deferred tax expense for 2025 (increase in deferred tax liability) 54,000 Income tax expense for 2025 $90,000 Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability ....................................... (c) Income before income taxes Income tax expense Current Deferred Net income
90,000 36,000 54,000 $300,000 $36,000 54,000
90,000 $210,000
Note: The current/deferred tax expense detail can be presented in the notes to the financial statements. LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.2 (15–20 minutes) (a) Pretax financial income for 2024 Excess of tax depreciation over book depreciation Rent received in advance Taxable income for 2024 (b) Income Tax Expense ($56,000 + $8,000 - $4,000). Deferred Tax Asset ................................................ Income Taxes Payable ($280,000 x .20) ........ Deferred Tax Liability ..................................... Temporary Difference **Depreciation *Unearned rent
Future Taxable (Deductible) Amounts ($40,000 ( (20,000)
Tax Rate 20% 20%
(c) Income Tax Expense ............................................. Deferred Tax Liability [($40,000/4) x .20] .............. Income Taxes Payable ($325,000 x .20) ........ Deferred Tax Asset ($20,000 x .20)................ Temporary Difference **Depreciation *Unearned rent
Future Taxable (Deductible) Amounts ($30,000
Tax Rate 20% 20%
$300,000 (40,000) 20,000 $280,000 60,000 4,000* 56,000 8,000** Deferred Tax (Asset) $(4,000) $(4,000)
Liability $8,000 $8,000
67,000* 2,000 65,000 4,000 Deferred Tax (Asset) $ $
0 0
Liability $6,000 $6,000
*($65,000 – $2,000 + $4,000) Current tax expense for 2025 Deferred tax liability at the beginning of 2025 Deferred tax liability at the end of 2025 Deferred tax benefit for 2025 (decrease required in deferred tax liability) Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax expense for 2025 (decrease required in deferred tax asset) Income tax expense for 2025
$ 65,000 $8,000 6,000 (2,000) 0 4,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.3 (15–20 minutes)
4,000 $67,000
(a) Taxable income for 2025 Enacted tax rate Income taxes payable for 2025 (b) Future taxable (deductible) amounts Tax rate Deferred tax liability (asset)
$405,000 20% $ 81,000 Future Years 2026 2027 Total $175,000 $175,000 $350,000 20% 20% $ 35,000 $ 35,000 $ 70,000
Current tax expense for 2025 Deferred tax liability at the end of 2025 Deferred tax liability at the beginning of 2025 Deferred tax expense for 2025 (increase required in deferred tax liability) Income tax expense for 2025 Income Tax Expense ........................................ Income Taxes Payable ........................... Deferred Tax Liability ............................. (c) Income before income taxes Income tax expense Current Deferred Net income
$ 81,000 $ 70,000 46,000 24,000 $105,000 105,000 81,000 24,000 $525,000 $81,000 24,000
105,000 $420,000
Note to instructor: Because of the flat tax rate for all years, the amount of cumulative temporary difference existing at the beginning of the year can be calculated by dividing $46,000 by 20%, which equals $230,000. The difference between the $230,000 cumulative temporary difference at the beginning of 2025 and the $350,000 cumulative temporary difference at the end of 2025 represents the net amount of temporary difference originating during 2025 (which is $120,000). With this information, we can reconcile pretax financial income with taxable income as follows: Pretax financial income Temporary difference originating giving rise to net future taxable amounts Taxable income
$525,000 (120,000) $405,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 18.4 (15–20 minutes)
(a) Pretax financial income for 2025 Excess depreciation per tax return Excess rent collected over rent earned Nondeductible fines Taxable income
$70,000 (16,000) 22,000 11,000 $87,000
Taxable income Enacted tax rate Income taxes payable
$87,000 30% $26,100
(b) Income Tax Expense ............................................... Deferred Tax Asset .................................................. Income Taxes Payable ..................................... Deferred Tax Liability ....................................... Temporary Difference Depreciation Unearned rent Totals
Future Taxable (Deductible) Amounts ($16,000 ( (22,000) $ (6,000)
Tax Rate 30% 30%
24,300 6,600 26,100 4,800 Deferred Tax (Asset) Liability $4,800 $(6,600) $(6,600)* $4,800*
*Because of a flat tax rate, these totals can be reconciled: $(6,000) x .30 = $(6,600) + $4,800. Deferred tax liability at the end of 2025 Deferred tax liability at the beginning of 2025 Deferred tax expense for 2025 (increase required in deferred tax liability)
$4,800 0
Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax benefit for 2025 (increase required in deferred tax asset)
$(6,600 0
$4,800
$(6,600)
Current tax expense for 2025 (Income taxes payable) $ 26,100 Deferred tax expense for 2025 $ 4,800 Deferred tax benefit for 2025 (6,600) Net deferred tax benefit for 2025 (1,800) Income tax expense for 2025 $24,300
Exercise 18.4 (Continued) (c) Income before income taxes Income tax expense Current Deferred Net income
$70,000 $26,100 (1,800)
24,300 $45,700
Note: The details on the current/deferred tax expense may be presented in a note to the financial statements. (d)
$24,300 = 34.7% effective tax rate for 2025. $70,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.5 (15–20 minutes) (a) Taxable income Enacted tax rate Income taxes payable
$95,000 20% $19,000
(b) Income Tax Expense ............................................... Deferred Tax Asset .................................................. Income Taxes Payable ..................................... Deferred Tax Liability ....................................... Temporary Difference First one Second one Totals
Future Taxable (Deductible) Amounts ($240,000 ( (35,000) $205,000
Tax Rate 20% 20%
40,000 7,000 19,000 28,000 Deferred Tax (Asset) Liability $48,000 $(7,000) $(7,000)* $48,000*
*Because of a flat tax rate, these totals can be reconciled: $205,000 x .20 = $(7,000) + $48,000. Deferred tax liability at the end of 2025 Deferred tax liability at the beginning of 2025 Deferred tax expense for 2025 (increase required in deferred tax liability) Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax benefit for 2025 (increase required in deferred tax asset) Exercise 18.5 (Continued)
$48,000 20,000 $28,000 $(7,000 –0– $(7,000)
Current tax expense for 2025 (Income taxes payable) $ 19,000 Deferred tax expense for 2025 $28,000 Deferred tax benefit for 2025 (7,000) Net deferred tax benefit for 2025 21,000 Income tax expense for 2025 $40,000 (c) Income before income taxes Income tax expense Current Deferred Net income
$200,000 $19,000 21,000
40,000 $160,000
Note: The details on the current/deferred tax expense can be disclosed in the notes to the financial statements. Note to instructor: Because of the same tax rate for all years, the amount of cumulative temporary difference existing at the beginning of the year can be calculated by dividing the $20,000 balance in Deferred Tax Liability by 20%, which equals $100,000. This information may now be combined with the other facts given in the exercise to reconcile pretax financial income with taxable income as follows: Pretax financial income Net originating temporary difference giving rise to future taxable amounts ($240,000 – $100,000) Originating temporary differences giving rise to future deductible amounts Taxable income LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$200,000 (140,000) 35,000 $ 95,000
Exercise 18.6 (10–15 minutes) (a) (b) (c) (d)
(2) (1) (3) (1)
(e) (f) (g) (h)
(2) (2) (3) (3)
(i) (j) (k)
(3)* (1) (1)
*When the cost method is used for financial reporting purposes, the dividends are recognized in the income statement in the period they are received, which is the same period they be must be reported on the tax return. However, depending on the level of ownership by the investor, 70% or 80% of the dividends received from other U.S. corporations may be excluded from taxation because of a “dividends received deduction.” These tax-exempt dividends create a permanent difference. LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.7 (10–15 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j)
greater than $190,000 = ($38,000 divided by 20%) are not less than benefit; $15,000 = ($65,000 - $50,000) $1,750 = [($100,000 x .20) – $18,250] debit $59,000 = ($82,000 – $23,000) more likely than not; will not be benefit
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.8 (10–15 minutes) (a)
2025
Income Tax Expense .............................................. Deferred Tax Asset ($20,000 x .20) ........................ Deferred Tax Liability ($30,000 x .20) ............ Income Taxes Payable ($830,000 x .20) ........
168,000 4,000 6,000 166,000
2026 Income Tax Expense .............................................. Deferred Tax Asset ($10,000 x .20) ........................ Deferred Tax Liability ($40,000 x .20) ............ Income Taxes Payable ($880,000 x .20) ........
182,000 2,000 8,000 176,000
2027 Income Tax Expense .............................................. Deferred Tax Asset ($8,000 x .20) .......................... Deferred Tax Liability ($10,000 x .20) ............ Income Taxes Payable ($943,000 x .20) ........
189,000 1,600 2,000 188,600
(b) Deferred tax asset ($4,000 + $2,000 + $1,600) Deferred tax liability ($6,000 + $8,000 + $2,000) Net non-current liability (deferred tax liability)
$ 7,600 16,000 $ 8,400
(c) Pretax financial income Income tax expense Current Deferred ($2,000 – $1,600) Net Income
$945,000 $188,600 400
189,000 $756,000
Note: The details on the current/deferred tax expense can be disclosed in the notes to the financial statements. LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.9 (10–15 minutes)
Temporary Difference Excess depreciation Lawsuit obligation Installment sale Totals
Resulting Deferred Tax (Asset) Liability $200,000 $(50,000) 225,000 $(50,000) $425,000
Deferred tax asset Deferred tax liability Net non-current liability (deferred tax liability)
$ 50,000 425,000 $375,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.10 (20–25 minutes) (a) To complete a reconciliation of pretax financial income and taxable income, solving for the amount of pretax financial income, we must first determine the amount of temporary differences arising or reversing during the year. To accomplish that, we must determine the amount of cumulative temporary differences underlying the beginning balances of the deferred tax liability of $30,000 and the deferred tax asset of $10,000. $30,000 ÷ .20 = $150,000 beginning cumulative temporary difference. $10,000 ÷ .20 = $ 50,000 beginning cumulative temporary difference. Cumulative temporary difference at 12/31/25 which will result in future taxable amounts Cumulative temporary difference at 1/1/25 which will result in future taxable amounts Originating difference in 2025 which will result in future taxable amounts
$230,000 150,000 $ 80,000
Exercise 18.10 (Continued) Cumulative temporary difference at 12/31/25 which will result in future deductible amounts Cumulative temporary difference at 1/1/25 which will result in future deductible amounts Originating difference in 2025 which will result in future deductible amounts
$95,000 50,000 $45,000
Pretax financial income Originating difference which will result in future taxable amounts Originating difference which will result in future deductible amounts Taxable income for 2025
$
X
(80,000) 45,000 $105,000
Solving for pretax financial income: X – $80,000 + $45,000 = $105,000 X = $140,000 = Pretax financial income (b) Income Tax Expense ................................................ Deferred Tax Asset ................................................... Income Taxes Payable ...................................... ($105,000 x 20%) Deferred Tax Liability ........................................ Temporary Difference First one Second one Totals
Future Taxable (Deductible) Amounts ($230,000 ( (95,000) $135,000
Tax Rate 20% 20%
28,000 9,000 21,000 16,000
Deferred Tax (Asset) Liability $46,000 $(19,000) $(19,000) $46,000* *
**Because of a flat tax rate, these totals can now be reconciled: [$135,000 x .20] = [$(19,000) + $46,000]. Deferred tax liability at the end of 2025 Deferred tax liability at the beginning of 2025 Deferred tax expense for 2025 (net increase required in deferred tax liability)
$46,000 30,000 $16,000
Exercise 18.10 (Continued) Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax benefit for 2025 (net increase required in deferred tax asset)
$(19,000 10,000
Current tax expense for 2025 (Income taxes payable) Deferred tax expense for 2025 $16,000 Deferred tax benefit for 2025 (9,000) Net deferred tax expense (benefit) for 2025 Income tax expense for 2025
$ 21,000
$ (9,000)
(c) Income before income taxes Income tax expense Current Deferred Net income
7,000 $28,000 $140,000
$21,000 7,000
28,000 $ 112,000
(d) Because of the same tax rate for all years involved and no permanent differences, the effective rate should equal the statutory rate. The following calculation proves that it does: $28,000 ÷ $140,000 = 20% effective tax rate for 2025. LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 18.11 (20–25 minutes) (a) Income Tax Expense .............................................. Income Taxes Payable .................................... Deferred Tax Liability ......................................
178,500 128,000 50,500
Taxable income for 2024 Enacted tax rate Income taxes payable for 2024
Future taxable (deductible) amounts Enacted tax rate Deferred tax liability (asset)
$320,000 40% $128,000
2025
Future Years 2026 2027
2028
Total
$60,000 30% $18,000
$50,000 30% $15,000
$30,000 25% $ 7,500
$180,000
$40,000 25% $10,000
$ 50,500
Exercise 18.11 (Continued) Current tax expense for 2024 Deferred tax liability at the end of 2024 Deferred tax liability at the beginning of 2024 Deferred tax expense for 2024 (net increase required in deferred tax liability) Income tax expense for 2024 (b) Income Tax Expense ............................................. Income Taxes Payable ................................... Deferred Tax Liability .....................................
$ 128,000 $ 50,500 0 50,500 $178,500 156,500 128,000 28,500
The income taxes payable for 2024 of $128,000 and the $50,500 balance for Deferred Tax Liability at December 31, 2024, would be computed the same as they were for part (a) of this exercise. The resulting change in the deferred tax liability and total income tax expense would be computed as follows: Current tax expense for 2024 (Income taxes payable) 128,000 Deferred tax liability at the end of 2024 $ 50,500 Deferred tax liability at the beginning of 2024 22,000 Deferred tax expense for 2024 (net increase required in deferred tax liability) 28,500 Income tax expense for 2024 $156,500 LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 18.12 (20–25 minutes) (a) Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ................................... Taxable income Enacted tax rate Income taxes payable Cumulative Future Taxable Date Tax Rate (Deductible) Amounts 12/31/25 $(450,000) 20%
149,000 15,000 164,000 $820,000 20% $164,000 Deferred Tax (Asset) Liability $(90,000)
Exercise 18.12 (Continued) Current tax expense for 2025 (Income taxes payable) $ 164,000 Deferred tax asset at the end of 2025 $ 90,000 Deferred tax asset at the beginning of 2025 75,000 Deferred tax benefit for 2025 (increase in deferred tax asset account) (15,000) Income tax expense for 2025 $149,000 (b) The journal entry at the end of 2025 to establish a valuation account: Income Tax Expense .............................................. Allowance to Reduce Deferred Tax Asset to Expected Realizable Value .....................
15,000 15,000
Note to instructor: Although not requested by the instructions, the pretax financial income can be computed by completing the following reconciliation: Pretax financial income for 2025 Originating difference which will result in future deductible amounts Taxable income for 2025
$
X
75,000a $820,000
Solving for pretax financial income: X + $75,000 = $820,000 X = $745,000 = Pretax financial income a
$450,000 – $375,000 = $75,000
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.13 (20–25 minutes) (a) Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable .................................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value............................. Income Tax Expense (Allowance) .................. Taxable income Enacted tax rate Income taxes payable Exercise 18.13 (Continued)
149,000 15,000 164,000 22,500 22,500 $820,000 20% $164,000
Cumulative Future Taxable Date Tax Rate (Deductible) Amounts 12/31/25 $(450,000) 20%
Deferred Tax (Asset) Liability $(90,000)
Current tax expense for 2025 (Income taxes payable) $164,000 Deferred tax asset at the end of 2025 $ 90,000 Deferred tax asset at the beginning of 2025 75,000 Deferred tax benefit for 2025 (increase in deferred tax asset account) (15,000) Income tax expense for 2025 $149,000 $ –0– 22,500 $22,500
Valuation account needed at the end of 2025 Valuation account balance at the beginning of 2025 Reduction in valuation account during 2025 (b) Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ...................................
149,000 15,000 164,000
Income Tax Expense (Allowance)......................... 67,500 Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ($90,000 – $22,500) Taxable income Enacted tax rate Income taxes payable Cumulative Future Taxable Date Tax Rate (Deductible) Amounts 12/31/25 $(450,000) 20% Current tax expense for 2025 (Income taxes payable) Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax benefit for 2025 (increase in deferred tax asset account) Income tax expense for 2025
67,500 $820,000 20% $164,000
Deferred Tax (Asset) Liability $(90,000) 164,000 $ 90,000 75,000 (15,000) $149,000
Exercise 18.13 (Continued) Valuation account needed at the end of 2025 Valuation account balance at the beginning of 2025 Increase in valuation account during 2025
$90,000 22,500 $67,500
Note to instructor: Although not requested by the instructions, the pretax financial income can be computed by completing the following reconciliation: Pretax financial income for 2025 Originating difference which will result in future deductible amounts Taxable income for 2025
$
X
75,000a $820,000
Solving for pretax financial income: X + $75,000 = $820,000 X = $745,000 = Pretax financial income a
$450,000 – $375,000 = $75,000.
LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.14 (15–20 minutes) Future Years 2025 2026
(a) Future taxable (deductible) amounts Tax rate Deferred tax liability (asset)
$1,500,000 30%* $ 450,000
$1,500,000 20% $ 300,000
Total $3,000,000 $ 750,000
*The prior tax rate of 30% is computed by dividing the $900,000 balance of the deferred tax liability account at January 1, 2024, by the $3,000,000 cumulative temporary difference at that same date. Resulting deferred tax liability classified as non-current of $750,000 (*$450,000 + $300,000)
Exercise 18.14 (Continued) (b) Deferred Tax Liability ............................................... Income Tax Expense .........................................
150,000 150,000
There are no changes during 2024 in the cumulative temporary difference. The entire change in the deferred tax liability account is due to the change in the enacted tax rate. That change is computed as follows: Deferred tax liability at the end of 2024 (computed in (a)) Deferred tax liability at the beginning of 2024 Deferred tax benefit for 2024 due to change in enacted tax rate (decrease in deferred tax liability required) (c) Income before income taxes Income tax expense Current Adjustment due to change in tax rate Net income
$
750,000 900,000
$ (150,000) $ 5,000,000* $1,500,000** (150,000)
1,350,000 $3,650,000
*Pretax financial income is equal to the taxable income for 2024 because there were no changes in the cumulative temporary difference and no permanent differences. **Taxable income for 2024 Tax rate for 2024 (computed in (a)) Current tax expense
$5,000,000 30% $1,500,000
Current tax expense for 2024 would also need to be recorded. The entry would be a debit to Income Tax Expense and a credit to Income Taxes Payable for $1,500,000. LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.15 (30–35 minutes) Journal entry at December 31, 2024: Income Tax Expense ................................................. Deferred Tax Asset .................................................... Income Taxes Payable ....................................... Deferred Tax Liability ......................................... Taxable income for 2024 Enacted tax rate Income taxes payable for 2024
34,100 2,500 32,600 4,000 $163,000 20% $ 32,600
The deferred tax account balances at December 31, 2024, are determined as follows: Temporary Difference Installment sales Warranty costs Totals
Future Taxable (Deductible) Amounts ($16,000 ( (10,000) $ 6,000
Rate 25% 25%
Deferred Tax (Asset) Liability $4,000 $(2,500) $(2,500)* $4,000*
*Because all deferred taxes were computed at the same rate, these totals can be reconciled as follows: $6,000 x .25 = $(2,500) + $4,000. Deferred tax liability at the end of 2024 Deferred tax liability at the beginning of 2024 Deferred tax expense for 2024 (net increase required in deferred tax liability)
$4,000 –0–
Deferred tax asset at the end of 2024 Deferred tax asset at the beginning of 2024 Deferred tax expense (benefit) for 2024 (net increase required in deferred tax asset)
$(2,500 –0–
Current tax expense for 2024 (Income taxes payable) Deferred tax expense for 2024 ...................... $ 4,000 Deferred tax benefit for 2024 ........................ (2,500) Net deferred tax expense for 2024 Income tax expense for 2024
$4,000
$(2,500) $ 32,600
1,500 $34,100
Exercise 18.15 (Continued) Journal entry at December 31, 2025: Income Tax Expense ................................................ Deferred Tax Liability ............................................... Income Taxes Payable ...................................... Deferred Tax Asset............................................
52,500 2,000 53,250 1,250
Taxable income for 2025 Enacted tax rate Income taxes payable for 2025
$213,000 25% $ 53,250
The deferred tax account balances at December 31, 2025, are determined as follows: Temporary Difference Installment sales Warranty costs Totals
Future Taxable (Deductible) Amounts ($8,000 ( (5,000) $3,000
Rate 25% 25%
Deferred Tax (Asset) Liability $2,000 $(1,250) $(1,250) $2,000*
*Because all deferred taxes were computed at the same rate, these totals can be reconciled as follows: $3,000 x .25 = $(1,250) + $2,000. Deferred tax liability at the end of 2025 Deferred tax liability at the beginning of 2025 Deferred tax benefit for 2025 (decrease required in deferred tax liability)
$ 2,000( 4,000
Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax expense for 2025 (decrease required in deferred tax asset)
$1,250 2,500
Current tax expense for 2025 Deferred tax benefit for 2025 Deferred tax expense for 2025 Net deferred tax benefit for 2025 Income tax expense for 2025
$(2,000)
$1,250 $ 53,250 $ (2,000) 1,250 (750) $52,500
Exercise 18.15 (Continued) Journal entry at December 31, 2026: Income Tax Expense ................................................ Deferred Tax Liability ............................................... Income Taxes Payable ...................................... Deferred Tax Asset ...........................................
22,500 2,000 23,250 1,250
Taxable income for 2026 Enacted tax rate Income taxes payable for 2026
$93,000 25% $23,250
Deferred tax liability at the end of 2026 Deferred tax liability at the beginning of 2026 Deferred tax benefit for 2026 (decrease required in deferred tax liability)
$( 0 2,000 $(2,000)
Deferred tax asset at the end of 2026 Deferred tax asset at the beginning of 2026 Deferred tax expense for 2026 (decrease required in deferred tax asset)
$
0 1,250
Current tax expense for 2026 Deferred tax benefit for 2026 Deferred tax expense for 2026 Net deferred tax benefit for 2026 Income tax expense for 2026
$23,250
$1,250 $ (2,000) 1,250 (750) $22,500
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.16 (20–25 minutes) (a)
December 31, 2025 Deferred Tax Temporary Difference Installment sales Depreciation Unearned rent Totals
Future Taxable (Deductible) Amounts ($ 96,000) 30,000 ( (100,000) ($ 26,000)
Tax Rate 20% 20% 20%
(Asset)
Liability $19,200 6,000
$(20,000) $(20,000)* $25,200*
*Because of a flat tax rate, these totals can be reconciled: [$26,000 x .20] = [$(20,000) + $25,200].
Exercise 18.16 (Continued) (b) Pretax financial income for 2025 Excess gross profit per books Excess depreciation per tax return Excess rental income per tax return Taxable income (c) Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ................................... Deferred Tax Liability .....................................
$250,000 (96,000) (30,000) 100,000 $224,000 106,000 20,000 100,800 25,200
Taxable income Tax rate Income taxes payable
$224,000 45% $100,800
Deferred tax liability at the end of 2025 Deferred tax liability at the beginning of 2025 Deferred tax expense for 2025 (net increase required in deferred tax liability)
$25,200 –0–
Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax benefit for 2025 (net increase required in deferred tax asset)
$ 20,000 –0–
$25,200
$(20,000)
Current tax expense for 2025 (Income taxes payable) $ 100,800 Deferred tax expense for 2025 $ 25,200 Deferred tax benefit for 2025 (20,000) Net deferred tax expense for 2025 5,200 Income tax expense for 2025 $106,000 LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.17 (25–30 minutes) (a)
Resulting Deferred Tax In millions
Temporary Difference Rate
(Asset) $100 million estimated costs per books $50 million excess depreciation per tax Totals
20% 20%
$(20) $10 $10
$(20)
(b) Non-Current assets Deferred tax asset ($20,000,000 − $10,000,000) (c) Income before income taxes Income tax expense Current Deferred Net income
Liability
$10,000,000 $85,000,0002
$32,000,0001 (15,000,000)3
1
Taxable income for 2025 Enacted tax rate Income taxes payable for 2025
17,000,0004 $68,000,000 $160,000,000 20% $ 32,000,000
2
$5,000,000 ÷ .20 = $25,000,000 cumulative taxable temporary difference at the beginning of 2025.
Cumulative taxable temporary difference at the end of 2025 Cumulative taxable temporary difference at the beginning of 2025 Taxable temporary difference originating during 2025 Cumulative deductible temporary difference at the end of 2025 Cumulative deductible temporary difference at the beginning of 2025 Deductible temporary difference originating during 2025
$50,000,000 25,000,000 $25,000,000 $100,000,000 –0– $100,000,000
Exercise 18.17 (Continued) Pretax financial income for 2025 Taxable temporary difference originating Deductible temporary difference originating Taxable income for 2025
$
X (25,000,000) 100,000,000 $160,000,000
Solving for x: X – $25,000,000 + $100,000,000 = $160,000,000 X = $85,000,000 = Pretax financial income 3
Deferred tax liability at the end of 2025 Deferred tax liability at the beginning of 2025 Deferred tax expense for 2025 (increase in deferred tax liability)
$10,000,000 5,000,000
Deferred tax asset at the end of 2025 Deferred tax asset at the beginning of 2025 Deferred tax benefit for 2025 (increase in deferred tax asset) Deferred tax expense for 2025 Net deferred tax benefit for 2025
$(20,000,000 –0–
4
$ 5,000,000
(20,000,000) 5,000,000 $(15,000,000)
Net deferred tax benefit for 2025 Current tax expense for 2025 (Income taxes payable) Income tax expense for 2025
$(15,000,000) 32,000,000 $ 17,000,000
LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.18 (15–20 minutes) (a) Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ................................... Deferred Tax Liability ..................................... 2025 Future taxable (deductible) amounts Depreciation Warranty costs Enacted tax rate Deferred tax liability Deferred tax (asset)
($ 20,000) (200,000) 34% ($ 6,800) ($ (68,000)
Future Years 2026
128,800 68,000 176,800 20,000 2027
$30,000
$10,000
34% $10,200
30% $ 3,000
Total $( 60,000) $(200,000) $ 20,000 $ (68,000)
Exercise 18.18 (Continued) Taxable income for 2024 Tax rate Income taxes payable for 2024
$520,000 34% $176,800
Deferred tax liability at the end of 2024 Deferred tax liability at the beginning of 2024 Deferred tax expense for 2024 (increase required in deferred tax liability account)
$ 20,000 –0–
Deferred tax asset at the end of 2024 Deferred tax asset at the beginning of 2024 Deferred tax benefit for 2024 (increase in deferred tax asset)
$(68,000 –0–
Current tax expense for 2024 Deferred tax benefit for 2024 Deferred tax expense for 2024 Net deferred tax benefit for 2024 Income tax expense for 2024
$ 20,000
$(68,000) $ 176,800 $ (68,000) 20,000 (48,000) $128,800
(b) Non-current assets Deferred tax asset ($68,000 − $20,000) LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$48,000
Exercise 18.19 (20–25 minutes) (a) Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ................................... Deferred Tax Liability .....................................
214,800 6,800 170,000 51,600
Taxable income Enacted tax rate Income taxes payable
$500,000 34% $170,000
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Installment sale
*$ 40,000*
34%1
$13,600
Installment sale Loss accrual Totals
** 190,000** *( (34,000)** **$196,000
20%2 20%
38,000
Deferred Tax (Asset)
$(6,800) $(6,800)
Liability
$51,600
*$50,000 + $60,000 + $80,000 = $190,000. **$15,000 + $19,000 = $34,000. 1 Tax rate for 2025. 2 Tax rate for 2026–2029.
Deferred tax liability at the end of 2024 Deferred tax liability at the beginning of 2024 Deferred tax expense for 2024 (increase required in deferred tax liability)
$51,600 –0–
Deferred tax asset at the end of 2024 Deferred tax asset at the beginning of 2024 Deferred tax benefit for 2024 (increase required in deferred tax asset)
$ 6,800 –0–
$51,600
$(6,800)
Current tax expense for 2024 (Income taxes payable) $ 170,000 Deferred tax expense for 2024 $ 51,600 Deferred tax benefit for 2024 (6,800) Net deferred tax expense for 2024 44,800 Income tax expense for 2024 $214,800 (b) Non-Current liabilities Deferred tax liability ($51,600 − $6,800) LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$44,800
Exercise 18.20 (15–20 minutes) (a) Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable .................................... Deferred Tax Liability ......................................
125,800 10,200 119,000 17,000
Taxable income Enacted tax rate Income taxes payable Temporary Difference Accounts receivable Litigation liability Totals
Future Taxable (Deductible) Amounts $50,000 ( (30,000) ($20,000
$350,000 34% $119,000 Tax Rate 34% 34%
Deferred Tax (Asset) Liability *$17,000 $(10,200) $(10,200)
$17,000
*Because of a flat tax rate for all periods, these totals can be reconciled as follows: $20,000 x .34 = $(10,200) + $17,000. Deferred tax liability at the end of 2024 Deferred tax liability at the beginning of 2024 Deferred tax expense for 2024 (increase required in deferred tax liability)
$17,000 –0–
Deferred tax asset at the end of 2024 Deferred tax asset at the beginning of 2024 Deferred tax benefit for 2024 (increase required in deferred tax asset)
$(10,200 –0–
Current tax expense for 2024 (Income taxes payable) Deferred tax expense for 2024 Deferred tax benefit for 2024 Net deferred tax expense for 2024 Income tax expense for 2024
$17,000
$(10,200) $ 119,000 $ 17,000 (10,200) 6,800 $125,800
Exercise 18.20 (Continued) (b)
Temporary Difference Accounts receivable Litigation liability Totals
Resulting Deferred Tax (Asset) Liability $17,000 $(10,200) $(10,200)
____ $17,000
A non-current liability for $6,800 ($17,000 − $10,200) is reported on the balance sheet. LO: 1, 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.21 (15–20 minutes) 2022 Income Tax Expense ........................................................ Income Taxes Payable ($80,000 x .20) .....................
16,000
2023 Deferred Tax Asset ($40,000 x .20) .................................. Income Tax Expense (Loss Carryforward) ..............
8,000
2024 Deferred Tax Asset ($35,000 x .20) .................................. Income Tax Expense (Loss Carryforward)..............
7,000
2025 Income Tax Expense ........................................................ Deferred Tax Asset ($75,000 x .20) .......................... Income Tax Payable [($120,000 - $75,000] x .20) ....
16,000
8,000
7,000 24,000 15,000 9,000
Exercise 18.21 (Continued) 2026 Income Tax Expense ......................................................... Income Tax Payable ($100,000 x .20) .......................
20,000 20,000
Note: Income Tax Expense (Loss Carryforward) amounts are negative components of income tax expense. LO: 3, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.22 (20–25 minutes) 2021 (a) Deferred Tax Asset .................................................... Income Tax Expense (Loss Carryforward) ....... ($70,000 x .20)
14,000 14,000
2021 (b) Operating loss before income taxes Income tax benefit Deferred (loss carryforward) Net loss 2022 (c) Income Tax Expense ................................................. Deferred Tax Asset ($70,000 x .20) ................... Income tax Payable [($90,000 - $70,000) x .20].
$(70,000) 14,000 $(56,000) 18,000 14,000 4,000
2022 (d) Income before income taxes Income tax expense Current Deferred Net income 2025 (e) Deferred Tax Asset ($60,000 x .25) ........................... Income Tax Expense (Loss Carryforward) .......
$90,000 $ 4,000 14,000
18,000 $72,000
15,000 15,000
Exercise 18.22 (Continued) (f)
Operating loss before income taxes Income tax benefit Deferred Net loss
$(60,000) 15,000* $(45,000)
* Carryforward ($60,000 x .25) LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.23 (30–35 minutes) (a)
2023 Income Tax Expense ................................................ Income Taxes Payable ($120,000 x .17) ...........
20,400 20,400
2024 Income Tax Expense .............................................. Income Taxes Payable ($90,000 x .17) ...........
15,300 15,300
2025 Deferred Tax Asset ................................................ Income Tax Expense (Loss Carryforward) ... *(.19 x $200,000) 2026
38,000*
Income Tax Expense ............................................. Income Taxes Payable ................................... Deferred Tax Asset ($200,000 x .19) ..............
57,000
38,000*
19,000* 38,000
*[($300,000 – $200,000) x 19%] (b) Operating loss before income taxes Income tax benefit Deferred Net loss * Loss carryforward ($200,000 x .19)
$(200,000) 38,000* $(162,000)
Exercise 18.23 (Continued) (c)
2025 Deferred Tax Asset ................................................. Income Tax Expense (Loss Carryforward) ....
38,000 38,000*
*$200,000 x .19 Income Tax Expense (Allowance) ......................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ..................... (.25 x $38,000)
9,500 9,500
2026 Income Tax Expense ................................................. Deferred Tax Asset ............................................ Income Taxes Payable ....................................... [($300,000 – $200,000) x .19] Allowance to Reduce Deferred Tax Asset to Expected Realizable Value................................ Income Tax Expense (Loss Carryforward) .......
57,000 38,000 19,000
9,500 9,500
(d) Operating loss before income taxes Income tax benefit Deferred (carryforward) ($38,000 – $9,500) Net loss
$(200,000) 28,500 $(171,500)
Note: Although not required, using the assumption in part (a), the income tax section of the 2026 income statement would appear as follows: Income before income taxes Income tax expense Current Deferred Net income
$300,000 $19,000 38,000
57,000 $243,000
Exercise 18.23 (Continued) Note: Although not required, using the assumption in part (c), the income tax section of the 2026 income statement would appear as follows: Income before income taxes Income tax expense Current Deferred Net income
$300,000 $19,000 28,500 *
47,500 $252,500
* Carryforward ($38,000) – Allowance ($9,500) LO: 3, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 18.24 (30–35 minutes) (a)
2023 Income Tax Expense ............................................. Income Taxes Payable ($120,000 x .20) ..........
24,000 24,000
2024 Income Tax Expense ............................................. Income Taxes Payable ($90,000 x .20) ............
18,000 18,000
2025 Deferred Tax Asset ................................................ Income Tax Expense (Loss Carryforward).....
20,000 20,000*
*.25 x ($80,000) = $20,000 Income Tax Expense (Allowance) ......................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ...................... (.50 x $20,000)
10,000 10,000
Exercise 18.24 (Continued) 2026 Income Tax Expense .............................................. Deferred Tax Asset ........................................... Income Tax Payable ......................................... *(.25 x $80,000) **[.25 x ($120,000 - $80,000)] Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ............................. Income Tax Expense (Carryforward) ...............
30,000 20,000* 10,000**
10,000
(b) Operating loss before income taxes Income tax benefit Deferred Net loss
10,000 $(80,000) 10,000* $(70,000)
* Benefit due to loss carryforward ($20,000 – $10,000) (c) Income before income taxes for 2026 Income tax expense $10,000* Current Deferred 10,000** Net income *[($120,000 - $80,000) x .25 ** Carryforward ($20,000) – Allowance ($10,000) LO: 3, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$120,000 20,000 $100,000
Exercise 18.25 (15–20 minutes) (a)
2025 Income Tax Expense ($120,000 x .20) ................. Income Taxes Payable ..................................
24,000 24,000
2026 Deferred Tax Asset ............................................... Income Tax Expense (Carryforward) ........... *($150,000 x .20)
30,000
Income Tax Expense (Carryforward) ................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ................... (.20 x $30,000)
6,000
30,000*
6,000
2027 Income Tax Expense ($30,000 + $8,000) ............. Deferred Tax Asset........................................ Income Taxes Payable .................................. [($190,000 – $150,000) x .20] Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ........................... Income Tax Expense (Carryforward) (.20 x $30,000) ...............................................
38,000 30,000 8,000
6,000
(b) Loss before income taxes Income tax benefit Deferred Net loss * Carryforward ($30,000) – Allowance ($6,000) LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: No
6,000 $(150,000) 24,000* $(126,000)
*Exercise 18.26 (15–20 minutes) 2022 Income Tax Expense ........................................................ Income Taxes Payable ($80,000 x .20).....................
16,000
2023 Income Tax Refund Receivable ($160,000 x .45) ............ Income Tax Expense (Loss Carryback) ..................
72,000
2024 Income Tax Refund Receivable ($80,000 x .20) .............. Income Tax Expense (Loss Carryback) .................
16,000
Deferred Tax Asset........................................................... Income Tax Expense (Loss Carryforward) ............. [.20 x ($180,000 – $80,000)] 2025 Income Tax Expense ......................................................... Deferred Tax Asset ($100,000 x .20) ......................... Income Tax Payable [($140,000 - $100,000) x .20 ... 2026 Income Tax Expense ......................................................... Income Tax Payable ($100,000 x .20) .......................
16,000
72,000
16,000 20,000 20,000
28,000 20,000 8,000 20,000 20,000
Note: Income tax expense related to Loss Carryback and Carryforward amounts are negative components of income tax expense. LO: 3, 6 Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 18.27 (15–20 minutes) (a)
2025 Income Tax Expense ($120,000 x .20) ................. Income Taxes Payable ..................................
24,000 24,000
2026 Income Tax Refund Receivable ........................... Deferred Tax Asset ............................................... Income Tax Expense (Loss Carryback) ....... Income Tax Expense (Loss Carryforward) ..
143,000 20,000* 143,000** 20,000
*[($570,000 – $350,000 – $120,000) x .20] ***($350,000 x .34) + ($120,000 x .20) 2027 Income Tax Expense ............................................ Income Taxes Payable .................................. [($180,000 – $100,000) x .20] Deferred Tax Asset........................................ (b) Loss before income taxes for 2026 Income tax benefit Income Tax Expense (Loss Carryback) Income Tax Expense (Loss Carryforward) Net loss for 2026
36,000 16,000 20,000 $(570,000) $143,000 20,000
LO: 3, 6 Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
163,000 $(407,000)
Time and Purpose of Problems Problem 18.1 (Time 40–45 minutes) Purpose—to provide students with an understanding of how to compute both taxable and pretax financial income with one permanent and two temporary differences. The student is required to compute deferred income taxes for two years using multiple tax rates with no beginning deferred income taxes. Problem 18.2 (Time 50–60 minutes) Purpose—to provide the student with a situation where: (1) a temporary difference originates over a three-year period and begins to reverse in the fourth period, (2) a change in an enacted tax rate occurs in a year in which there is a change in the amount of cumulative temporary difference, (3) the amount of originating or reversing temporary difference must be calculated each year in order to determine the cumulative temporary difference at the end of each year, and (4) there is a permanent difference along with a temporary difference each year. Journal entries are required for each of four years, including the entry for the adjustment of deferred taxes due to the change in the enacted tax rate. Problem 18.3 (Time 40–45 minutes) Purpose—to provide the student with an understanding of how future temporary differences for existing depreciable assets are considered in determining the future years in which existing temporary differences result in taxable or deductible amounts. The student is given information about pretax financial income, one temporary difference, and one permanent difference. The student must compute all amounts related to income taxes for the current year and prepare the journal entry to record them. In order to determine the beginning balance in a deferred tax account, the student must calculate deferred taxes for the prior year’s balance sheet. An income statement presentation is also required and a discontinued operation is recognized in the current period. Problem 18.4 (Time 20–25 minutes) Purpose—to provide the student with an understanding of permanent and temporary differences when there are multiple differences and a single rate. Problem 18.5 (Time 20–25 minutes) Purpose—to provide the student with a situation involving a net operating loss which requires analysis of the benefits of the loss carryforward realized in the year following the loss year. Income statement presentations are required for the loss year where the benefits of the carryforward are recognized and the year following the loss year where the benefits of the carryforward are realized. Problem 18.6 (Time 20–25 minutes) Purpose—to provide the student with an understanding of how the computation and classification of deferred income taxes are affected by the individual future year(s) in which future taxable and deductible amounts are scheduled to occur because of existing temporary differences. Two situations are given and the student is required to compute and classify the deferred income taxes for each. A net deferred tax asset results in both cases. Problem 18.7 (Time 45–50 minutes) Purpose—to provide the student with a situation where: (1) a temporary difference originates in one period and reverses over the following two periods, (2) a change in an enacted tax rate occurs in a year in which there is a change in the amount of cumulative temporary difference, and (3) the amount of originating or reversing temporary difference must be calculated each year in order to determine the cumulative temporary difference at the end of each year. Journal entries are required for each of three years, including the entry for the adjustment of deferred taxes due to the change in the enacted tax rate.
Time and Purpose of Problems (Continued) Problem 18.8 (Time 40–50 minutes) Purpose—to test a student’s understanding of the relationships that exist in the subject area of accounting for income taxes. The student is required to compute and classify deferred income taxes for two successive years. The journal entry to record income taxes is also required for each year. A draft of the income tax expense section of the income statement is also required for each year. An interesting twist to this problem is that the student must compute taxable income for two individual periods based on facts about the tax rate and amount of taxes paid for each period and then combine that information with data on temporary differences to compute pretax financial income. Problem 18.9 (Time 40–50 minutes) Purpose—to test a student’s ability to compute and classify deferred taxes for three temporary differences and to draft the income tax expense section of the income statement for the year.
Solutions to Problems Problem 18.1
(a)
X (.20) = $160,000 taxes due for 2025 X = $160,000 ÷ .20 X = $800,000 taxable income for 2025 $800,000a 120,000b 10,000 (40,000)c $890,000g
(b) Taxable income [from part (a)]................................ Excess depreciation ................................................ Municipal interest .................................................... Unearned rent .......................................................... Pretax financial income for 2025..................... (c)
2025 Income Tax Expense ($160,000 + $20,400 – $6,800).............................. Deferred Tax Asset ($40,000 x .17) ......................... Income Taxes Payable .................................... Deferred Tax Liability ($120,000 x .17) ............
173,600 6,800 160,000 20,400
2026 Income Tax Expense ($81,600 + $3,400 – $5,100).................................. Deferred Tax Liability [$20,400 – ($90,000 x .17)] .. Income Taxes Payable ($480,000 x .17) .......... Deferred Tax Asset [$6,800 – ($20,000 x .17)] ............................. (d) Income before income taxes ................................... Income tax expense Current .............................................................. Deferred ($20,400 – $6,800) ............................. Net income ...............................................................
79,900 5,100 81,600 3,400 $890,000 $160,000 13,600
LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
173,600 $716,400
Problem 18.2
(a) Before deferred taxes can be computed, the amount of temporary difference originating (reversing) each period and the resulting cumulative temporary difference at each year-end must be computed: Pretax financial income Nondeductible expense Subtotal Taxable income Temporary difference originating (reversing)
2025 2026 2027 2028
2025 $290,000 30,000 320,000 180,000
2026 $320,000 30,000 350,000 225,000
2027 $350,000 30,000 380,000 260,000
$140,000
$125,000
$120,000
2028 ($(420,000 30,000 (450,000 560,000 ( $(110,000)
Cumulative Temporary Difference At End of Year $140,000 $265,000 ($140,000 + $125,000) $385,000 ($265,000 + $120,000) $275,000 ($385,000 – $110,000)
Because the temporary difference causes pretax financial income to exceed taxable income in the period it originates, the temporary difference will cause future taxable amounts. Taxable income for 2025 .................................................... Enacted tax rate for 2025.................................................... Current tax expense for 2025 (Income taxes payable) .....
$180,000 X .35 $ 63,000
2025 Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability .......................................
112,000 63,000 49,000
Problem 18.2 (Continued) The deferred taxes at the end of 2025 would be computed as follows: Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$140,000
35%
$49,000
Deferred tax liability at the end of 2025............................... Deferred tax liability at the beginning of 2025 .................... Deferred tax expense for 2025 (increase in deferred tax liability) .........................................................
$ 49,000 –0–
Current tax expense for 2025 (Income taxes payable) ....... Deferred tax expense for 2025 ............................................. Income tax expense for 2025 ...............................................
$ 63,000 49,000 $112,000
$ 49,000
2026 Deferred Tax Liability .............................................. Income Tax Expense ........................................ (To record the adjustment for the decrease in the enacted tax rate)
21,000*
Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability ....................................... (To record income taxes for 2026)
70,000
21,000
45,000 25,000
*The adjustment due to the change in the tax rate is computed as follows: Cumulative temporary difference at the end of 2025 ............................................................................... Newly enacted tax rate for future years .............................. Adjusted balance of deferred tax liability at the end of 2025 ............................................................. Current balance of deferred tax liability.............................. Adjustment due to decrease in enacted tax rate ................
$140,000 X .20 28,000 49,000 $(21,000)
Problem 18.2 (Continued) Taxable income for 2026 ....................................................... Enacted tax rate ..................................................................... Current tax expense for 2026 (Income taxes payable) ........
$225,000 X .20 $ 45,000
The deferred taxes at December 31, 2026, are computed as follows: Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$265,000
20%
$53,000
Deferred tax liability at the end of 2026 ................................ Deferred tax liability at the beginning of 2026 after adjustment ................................................................. Deferred tax expense for 2026 exclusive of adjustment due to change in tax rate (increase in deferred tax liability) ...................................................... Current tax expense for 2026 (Income taxes payable) ........ Deferred tax expense for 2026 ............................................. Income tax expense (total) for 2026, exclusive of adjustment due to change in tax rate ...........................
$53,000 28,000 $ 25,000 $ 45,000 25,000 $ 70,000
2027 Income Tax Expense ............................................. Income Taxes Payable ................................... Deferred Tax Liability ..................................... Taxable income for 2027 ....................................... Enacted tax rate ..................................................... Current tax expense for 2027 (Income taxes payable).......................................
76,000 52,000 24,000 $260,000 X .20 $ 52,000
The deferred taxes at December 31, 2027, are computed as follows: Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$385,000f
20%
$77,000
Problem 18.2 (Continued) Deferred tax liability at the end of 2027................................ Deferred tax liability at the beginning of 2027 ..................... Deferred tax expense for 2027 (increase in deferred tax liability) ..........................................................
$77,000 53,000
Current tax expense for 2027 (Income taxes payable) ........ Deferred tax expense for 2027 .............................................. Income tax expense for 2027 ................................................
$ 52,000 24,000 $76,000
$24,000
2028 Income Tax Expense ............................................ Deferred Tax Liability ........................................... Income Taxes Payable ..................................
90,000 22,000 112,000
Taxable income for 2028 ....................................................... Enacted tax rate ..................................................................... Current tax expense for 2028 (Income taxes payable) ........
$560,000 X .20 $112,000
The deferred taxes at December 31, 2028, are computed as follows:
(b)
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$275,000
20%
$55,000
Deferred tax liability at the end of 2028................................ Deferred tax liability at the beginning of 2028 ..................... Deferred tax benefit for 2028 (decrease in deferred tax liability) ...........................................................
$55,000 77,000 $(22,000)
Current tax expense for 2028 (Income taxes payable) ........ Deferred tax benefit for 2028 ................................................ Income tax expense for 2028 ................................................
$ 112,000 (22,000) $90,000
2026 Income before income taxes ............................... Income tax expense Current ............................................................ Deferred........................................................... Adjustment due to change in tax rate ........... Net income ............................................................
$320,000 $45,000 25,000 (21,000)
LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 50-60, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
49,000 $271,000
Problem 18.3
2025 2026 2027 2028 2029 2030 2031 2032 Totals
Book Depreciation $ 150,000** 150,000 150,000 150,000 150,000 150,000 150,000 150,000 $1,200,000
Tax Depreciation $ 120,000* 240,000 240,000 240,000 240,000 120,000* 0 0 $1,200,000
Difference ($ 30,000 (90,000) (90,000) (90,000) (90,000) 30,000 150,000 150,000 ($ 0
*($1,200,000 ÷ 5) x .5 **($1,200,000 ÷ 8) = $150,000 (a) Pretax financial income for 2026 ......................... Nontaxable interest............................................... Excess depreciation ($240,000 – $150,000) ........ Taxable income for 2026 ...................................... Tax rate .................................................................. Income taxes payable for 2026 ............................ (b) Income Tax Expense ............................................ Income Taxes Payable .................................. Deferred Tax Liability .................................... Deferred Tax Asset........................................
$1,400,000 (60,000) (90,000) $1,250,000 x .20 $ 250,000 268,000 250,000 12,000 6,000
Problem 18.3 (Continued) Scheduling—End of 2026
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
2027
Future Years 2028
2029
$(90,000)
$(90,000)
$(90,000)
20% $(18,000)
20% $(18,000)
20% $(18,000)
2030
Future Years 2031
2032
Total
$30,000 X 20% $ 6,000
$150,000 X 20% $ 30,000
$150,000 X 20% $ 30,000
$60,000 $12,000
Scheduling—End of 2025
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
2026
Future Years 2027
2028
2029
$(90,000) 20% $(18,000)
$(90,000) 20% $(18,000)
$(90,000) 20% $(18,000)
$(90,000) 20% $(18,000)
2030
Future Years 2031
2032
Total
$30,000 20% $ 6,000
$150,000 20% $ 30,000
$150,000 20% $ 30,000
$(30,000) $ (6,000)
Problem 18.3 (Continued) The net deferred tax asset at December 31, 2025, is $6,000. Deferred tax liability at the end of 2026 ................................. Deferred tax liability at the beginning of 2026 ...................... Deferred tax expense for 2026 (increase in deferred tax liability) ...........................................................
$ 12,000 –0– $ 12,000 $ –0–
Deferred tax asset at the end of 2026 .................................... Deferred tax asset at the beginning of 2026 ......................... Deferred tax expense for 2026 (decrease in deferred tax asset) ..............................................................
6,000 $
Deferred tax expense for 2026 (from deferred tax liability) ................................................. Deferred tax expense for 2026 (from deferred tax asset) .................................................... Net deferred tax expense for 2026 .........................................
$ 12,000 6,000 $ 18,000
Current tax expense for 2026 (Income taxes payable) ......... Deferred tax expense for 2026 ............................................... Income tax expense for 2026 ................................................. (c) Income from continuing operations before income taxes ....................................... Income tax expense Current ($250,000 – $40,000b) ..................... Deferred ....................................................... Income from continuing operations .................. Gain on discontinued operations ............... Less applicable income tax ........................ Net income ..........................................................
6,000
$250,000 18,000 $268,000 $1,200,000a
$210,000 18,000 200,000 40,000b
228,000 972,000 160,000 $ 1,132,000
a
$1,400,000 pretax financial income – $200,000 gain on discontinued operations = $1,200,000. b ($200,000 x 20%)
(d) Long-term liabilities Deferred tax liability............................................
$12,000
LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Problem 18.4
(a)
Schedule of Pretax Financial Income and Taxable Income for 2025 Pretax financial income ....................................................... Permanent differences Life insurance expense.................................................. Bond interest revenue ................................................... Pollution fines ................................................................ Temporary differences Depreciation expense .................................................... Installment sales ($100,000 – $75,000) ......................... Warranty expense ($50,000 – $10,000) ......................... Taxable income ............................................................. * Depreciation for books ($300,000/5) Depreciation tax return ($300,000 x 30%) Difference
$750,000 9,000 (4,000) 4,200 $759,200 (30,000)* (25,000) 40,000 $744,200
= $60,000 = 90,000 $30,000
The income taxes payable for 2025 is as follows: Taxable income ....................................... $744,200 Tax rate .................................................... 30% Income taxes payable ............................. $223,260 The computation of the deferred income taxes for 2025 is as follows: Temporary differences Depreciation expense Installment sales ($100,000 – $75,000) Warranty expense ($50,000 – $10,000) DTA = Deferred Tax Asset DTL = Deferred Tax Liability
$(30,000) x .30 = $(9,000) DTL (25,000) x .30 = (7,500) DTL 40,000 x .30 = 12,000 DTA
Problem 18.4 (Continued) (b)
The journal entry to record income taxes payable, income tax expense and deferred income taxes is as follows: Income Tax Expense ............................................. Deferred Tax Asset ................................................ Deferred Tax Liability ($9,000 + $7,500) ......... Income Taxes Payable .................................... Current tax expense for 2025 (income taxes payable) ................................... Deferred tax expense for 2025.............................. (from deferred tax liability) ($9,000 + $7,500) .... Deferred tax benefit for 2025 (from deferred tax asset) ................................. Net deferred tax expense for 2025 ....................... Income tax expense for 2025 ................................
227,760* 12,000 16,500 223,260 $ 223,260 $ 16,500 (12,000)
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
4,500 $227,760
Problem 18.5 (a)
2025 Deferred Tax Asset .................................................... Income Tax Expense (Loss Carryforward) ($180,000 x 20%).............................................
36,000 36,000
2026 Income Tax Expense ................................................. Deferred Tax Asset ............................................ Income Taxes Payable [($230,000 – $180,000) x .20] ..........................
46,000 36,000 10,000
2027 Income Tax Expense ................................................. Income Taxes Payable ($100,000 x .20) ............
20,000 20,000
(b) A deferred tax asset of $36,000 should be classified as a non-current asset on the balance sheet. Also, retained earnings is increased by $36,000 as a result of the entry to record the benefit of the loss carryforward.
Problem 18.5 (Continued) (c)
2025 Income Statement Operating loss before income taxes ............... Income tax benefit Income tax expense (carryforward) ......... Net loss..............................................................
(d)
$(180,000) 36,000 $(144,000)
2026 Income Statement Income before income taxes ............................ Income tax expense Current ....................................................... Deferred ..................................................... Net income ........................................................
$230,000 $ 10,000a 36,000
46,000 $184,000
a
Loss carryforward (2025) ............................... Taxable income 2026 before loss carryforward Taxable income 2026 ...................................... Enacted tax rate for 2026 ................................ Income taxes payable for 2026 .................
(180,000) 230,000 50,000 20% $ 10,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 18.6 1. Temporary Difference
Future Taxable (Deductible) Amounts
2026 2027 2028 2029 2029 2030 Totals a
Tax rate for 2026. b Tax rate for 2027. c Tax rate for 2028.
$
300 300 300 300 (1,600) 300 $ (100)
Tax Rate
30%a 30%b 30%c 35%d 35%d 35%e
Deferred Tax (Asset) Liability
$ 90 90 90 105 $(560) $(560)
105 $480
d e
Tax rate for 2029. Tax rate for 2030. MOONEY CO. Balance Sheet December 31, 2025
Other assets (noncurrent) Deferred tax asset ($560f – $480g) .....................................
$80
2. Temporary Difference
Future Taxable (Deductible) Amounts
2026 2027 2028 2028 2029 Totals a
Tax rate for 2026. b Tax rate for 2027.
$
300 300 300 (2,300) 300 $ (1,100) c
Tax rate for 2028. Tax rate for 2029.
d
Tax Rate 30%a 30%b 30%c 30%c 35%d
Deferred Tax (Asset)
Liability
$ 90 90 90 $(690) $(690)
105 $375
Problem 18.6 (Continued) ROESCH CO. Balance Sheet December 31, 2025 Other assets (noncurrent) Deferred tax asset ($690 – $375) ...................................... LO: 1, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
v
$315
Problem 18.7 (a) Before deferred taxes can be computed, the amount of cumulative temporary difference existing at the end of each year must be computed:
Pretax financial income Taxable income Temporary difference originating (reversing) Cumulative temporary difference at the beginning of the year Cumulative temporary difference at the end of the year
2025 $130,000 90,000 40,000 0 $ 40,000
2026 ($70,000 ( 90,000 ( (20,000) ( 40,000 ( $20,000
2027 ($70,000 ( 90,000 (20,000) 20,000 ( $ –0–
2025 Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability .......................................
52,000 36,000 16,000
Taxable income for 2025 ......................................... Enacted tax rate for 2025 ........................................ Current tax expense for 2025 (Income taxes payable) .......................................
a
$90,000 X 40% $36,000
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
December 31, 2025 Deferred Tax (Asset) Liability
Installment Accounts Receivable
( $ 40,000
40%a
$16,000
Tax rate enacted for 2025.
Deferred tax liability at the end of 2025................................. Deferred tax liability at the beginning of 2025 ...................... Deferred tax expense for 2025 (increase in deferred tax liability) ...........................................................
$16,000 –0– $16,000
Problem 18.7 (Continued) Current tax expense for 2025 (Income taxes payable) ......... Deferred tax expense for 2025 ............................................... Income tax expense for 2025 .................................................
$ 36,000 16,000 $52,000
2026 Deferred Tax Liability .............................................. Income Tax Expense ........................................ (To record the adjustment for the decrease in the enacted tax rate)
8,000
Income Tax Expense ............................................... Deferred Tax Liability .............................................. Income Taxes Payable .....................................
14,000 4,000
8,000*
18,000
*Cumulative temporary difference at the end of 2025 .......... Newly enacted tax rate for future year .................................. Adjusted balance of deferred tax liability at the end of 2025 ................................................................................. Current balance of deferred tax liability ................................ Adjustment due to decrease in enacted tax rate ..................
$40,000 20% 8,000 16,000 $ (8,000)
Taxable income for 2026 ........................................................ Enacted tax rate for 2026........................................................ Current tax expense for 2026 (Income taxes payable) .........
$90,000 20% $18,000
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
December 31, 2026 Deferred Tax (Asset) Liability
Installment Accounts Receivable
$20,000j
20%b
$ 4,000
b
Tax rate enacted for 2026.
Deferred tax liability at the end of 2026 ................................. Deferred tax liability at the beginning of 2026 after adjustment ($16,000 – $8,000) ................................... Adjusted balance of deferred tax liability at the end of 2026
$ 4,000 8,000 $(4,000)
Problem 18.7 (Continued) Current tax expense for 2026 (Income taxes payable) ......... Deferred tax benefit for 2026 ................................................. Income tax expense for 2026 .................................................
$ 18,000 (4,000) $14,000
2027 Income Tax Expense ............................................... Deferred Tax Liability .............................................. Income Taxes Payable .....................................
14,000 4,000
Taxable income for 2027 ........................................................ Enacted tax rate for 2027 ....................................................... Current tax expense for 2027 (Income taxes payable) .........
(b)
Temporary Difference
Future Taxable (Deductible) Amounts
Installment Accounts Receivable
( $–0–
18,000 $90,000 20% $18,000
December 31, 2027 Deferred Tax Tax Rate (Asset) Liability 20%
$–0– $ –0– 4,000
Deferred tax liability at the end of 2027................................. Deferred tax liability at the beginning of 2027 ...................... Deferred tax benefit for 2027 (decrease in deferred tax liability) .............................................................
$ (4,000)
Deferred tax benefit for 2027 ................................................. Current tax expense for 2027 (Income taxes payable) ......... Income tax expense for 2027 .................................................
$ (4,000) 18,000 $14,000
December 31, 2025 Non-Current liabilities Deferred tax liability ........................................................
$16,000
December 31, 2026 Non-Current liabilities Deferred tax liability ........................................................ December 31, 2027 There is no deferred tax liability to be reported at this date.
$ 4,000
Problem 18.7 (Continued) (c)
2025 Income before income taxes ....................................... $130,000 Income tax expense Current .................................................................. $36,000 Deferred ................................................................ 16,000 52,000 Net income ................................................................... $ 78,000 2026 Income before income taxes ....................................... $70,000 Income tax expense Current .................................................................. $18,000 Deferred ................................................................ (4,000) Adjustment due to decrease in tax rate .......................................................... (8,000) 6,000 Net income ................................................................... $64,000 2027 Income before income taxes ....................................... $70,000 Income tax expense Current .................................................................. $18,000 Deferred ................................................................ (4,000) 14,000 Net income ................................................................... $56,000
LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 45-50, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Problem 18.8 (a) Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$(60,000)*
20%
$(12,000)
*(Computation shown on next page.) Other assets (noncurrent) Deferred tax asset ...........................................................
$12,000
This answer may differ from what is expected. Usually, depreciation is faster for tax purposes; in this situation, there is excess depreciation for book purposes in the first year of depreciation (2025). (b) Income Tax Expense ............................................ Deferred Tax Asset ............................................... Income Taxes Payable ..................................
118,000 12,000 130,000
$130,000 taxes due for 2025 ÷ .20 2025 tax rate = $650,000 taxable income for 2025. Current tax expense for 2025 (Income taxes payable) .........
$ 130,000
Taxable income for 2025 ................................................................ Tax rate.................................................................................... Income taxes payable for 2025 (also given data) ................. Deferred tax asset at the end of 2025 .................. $ 12,000 Deferred tax asset at the beginning of 2025 ....... –0– Deferred tax benefit for 2025 (increase in deferred tax asset) .............................................................. Income tax expense for 2025 .................................................
$650,000 X .20 $130,000
(c) Income before income taxes ................................ Income tax expense Current ........................................................... Deferred ......................................................... Net income ............................................................
$590,000a
a
$130,000 (12,000)
Pretax financial income ......................................................... Excess depreciation per books ............................................. Taxable income [from (b) above] ..........................................
(12,000) $118,000
118,000 $472,000 $
X 60,000b $650,000
Solving for x; x + $60,000 = $650,000; x = $590,000f pretax financial income.
Problem 18.8 (Continued)
2025 2026 2027 2028 2029 2030 Totals
Book Depreciation $120,000 120,000 120,000 120,000 120,000 0 $600,000
Tax Depreciation $ 60,000* 120,000 120,000 120,000 120,000 60,000 $600,000
b
Difference ($ 60,000 0 0 0 0 ( (60,000) ($ 0
*($600,000 ÷ 5) x 1/2 (d) Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation Unearned rent Totals
$ (60,000) (150,000) $(210,000)
20% 20%
$(12,000) (30,000) $(42,000)
Noncurrent asset Deferred tax asset ($30,000 + $12,000) ..........................
$42,000
Problem 18.8 (Continued) (e) Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable ....................................
(f)
l
74,000 30,000 104,000*
*Taxable income for 2026 ....................................................... Tax rate for 2026 ..................................................................... Income taxes payable for 2026 (also given data) .................
$520,000 20% $104,000
Deferred tax asset at the end of 2026 .................................... Deferred tax asset at the beginning of 2026 ......................... Deferred tax benefit for 2026 (increase in deferred tax asset) ..............................................................
$ 42,000 12,000 $ (30,000)
Current tax expense for 2026 (Income taxes payable) ......... Deferred tax benefit for 2026 ................................................. Income tax expense for 2026 .................................................
$ 104,000 (30,000) $ 74,000
Income before income taxes .................................. Income tax expense Current ............................................................. $104,000 Deferred ........................................................... (30,000) Net income ..............................................................
$370,000
Pretax financial income .......................................................... Excess rent collected over rent recognized ......................... Taxable income [from (e) above] .......................................... Solving for x: X + $150,000 = $520,000 X = $370,000 pretax financial income.
LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
74,000 $ 296,000 $
X 150,000 $520,000
Problem 18.9
(a) Pretax financial income .......................................................... Permanent differences: Fine for pollution ............................................................. Tax-exempt interest ........................................................ Originating temporary differences: Excess warranty expense per books ($7,000 – $2,000) .......................................................... Excess construction profits per books ($92,000 – $67,000) ...................................................... Excess depreciation per tax return ($80,000 – $60,000) ...................................................... Taxable income .......................................................................
$100,000 3,500 (1,500) 5,000 (25,000) (20,000) $ 62,000
(b) Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Warranty costs Construction profits Depreciation Totals
$ (5,000) 25,000 ( 20,000 ($40,000
20% 20% 20%
$(1,000) * $(1,000) *
$5,000 4,000 *$9,000*
*Because of a flat tax rate, these totals can be reconciled: $40,000 x .20 = $(1,000) + $9,000. (c) Income Tax Expense ............................................... Deferred Tax Asset .................................................. Deferred Tax Liability ....................................... Income Taxes Payable .....................................
20,400 1,000 9,000 12,400
Taxable income for 2026 [answer part (a)] ............................ Tax rate .................................................................................... Income taxes payable for 2026 ..............................................
$62,000 20% $12,400
Deferred tax liability at the end of 2026 [part (b)] ................. Deferred tax liability at the beginning of 2026 ...................... Deferred tax expense for 2026 ...............................................
$9,000 0 $9,000
Problem 18.9 (Continued) Deferred tax asset at the end of 2026 .................................... Deferred tax asset at the beginning of 2026 ......................... Deferred tax benefit for 2026 .................................................
$
1,000 –0– $ (1,000)
Deferred tax expense for 2026 ............................................... Deferred tax benefit for 2026 ................................................. Net deferred tax expense for 2026.........................................
$ 9,000 (1,000) $ 8,000
Current tax expense for 2026 (Income taxes payable) ......... Deferred tax expense for 2026 ............................................... Income tax expense for 2026 .................................................
$ 12,400 8,000 $ 20,400
(d) Income before income taxes .................................. Income tax expense Current ............................................................. Deferred ........................................................... Net income ..............................................................
$100,000 $12,400 8,000
LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
20,400 $ 79,600
UYJ 18.1 Financial Reporting Problem (a) 1. 2.
Per P&G’s 2020 income statement: Income taxes on continuing operations ........
$2,731 million
Per P&G’s June 30, 2020 balance sheet: In noncurrent liabilities: Deferred income taxes ..............................
$6,199 million
Note: Classification of deferred tax amounts is in accordance with prior GAAP-all non-current. 3.
Per P&G’s 2020 statement of cash flows: In cash flows provided by operating activities: Deferred income taxes .............................. In supplemental disclosure: Cash payments for income taxes ............
$ (596) million $3,550 million
(b) P&G’s effective tax rates (per Note 5): 2018: (26.00%) 2019: (34.70%) 2020: (17.2%) (c) Income taxes (Per Note 5): Current..................................................................... Deferred ................................................................... Total ...................................................................
$3,327 596 $2,731
(d) Significant components of P&G’s deferred tax assets and liabilities at June 30, 2020 were as follows (per Note 5):
Financial Reporting Problem (Continued) Deferred tax assets Pension and postretirement benefits .................................... Loss and other carryforwards ............................................... Stock-based compensation ................................................... Lease Liabilities ..................................................................... Accrued marketing and promotion ...................................... Fixed assets ............................................................................ Unrealized loss on financial and foreign exchange transactions ........................................................ Accrued interest and taxes .................................................... Inventory ................................................................................. Other ........................................................................................ Valuation allowances ............................................................. Total ......................................................................................... Deferred tax liabilities Goodwill and other intangible assets.................................... Fixed assets ............................................................................ Unrealized gain on financial and foreign exchange transactions ......................................................................... Lease right-of-use assets....................................................... Foreign Withholding tax on earnings to be repatriated ....... Other ........................................................................................ Total .........................................................................................
$ 1,602 875 398 190 353 218 64 20 27 829 (486) $ 4,090 $ 5,775 1,485 169 185 118 366 $8,098
LO: 1, 2, 4, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 18.2 Comparative Analysis Case (a) 2020 provision for income taxes (In Millions): Coca-Cola:
Current portion .......................................... Deferred portion ........................................ Total expense ....................................
$1,999 (18) $1,981
PepsiCo:
Current portion .......................................... Deferred portion ........................................ Total expense ....................................
$1,757 137 $1,894
(b) 2020 income tax payments (In Millions): Coca-Cola (Note 14) ............................................................... PepsiCo (Note 5) ....................................................................
$1,268 $1,757
(c) The 2020 U.S. Federal statutory tax rate was 21.0%. Coca-Cola’s effective tax rate in 2020 was 20.3%. PepsiCo’s effective tax rate in 2020 was 20.9%. Their effective tax rates differ due to the items listed in the reconciliation of U.S. Federal statutory tax rate and effective tax rates. Both Coca-Cola’s and Pepsi’s effective rates are slightly lower than the statutory rates due to several adjustments for a variety of items on prior year tax returns. (d)
(In Millions) 1. Gross deferred tax assets Gross deferred tax liabilities
Coca-Cola $6,366 5,333
PepsiCo $8,237 3,463
(e) At December 31, 2020 Coca-Cola had a $2,669 million NOL carryforward. Loss carryforwards of $687 million must be utilized within the next five years, and the remainder can be utilized over a period greater than five years.
Comparative Analysis Case (Continued) At June 30, 2020 PepsiCo had operating loss carryforwards totaling $2.9 billion at year-end 2020 and they are being carried forward in a number of foreign and state jurisdictions where PepsiCo is permitted to use tax operating losses from prior periods to reduce future taxable income. If unused, approximately $900 million will expire between 2020 and 2039. The remainder, totaling $2.0 billion may be carried forward indefinitely. LO: 1, 3, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 18.3 Financial Statement Analysis Case (a) Of the total provision for income taxes (reported in the income statement) the “current taxes” portion represents the taxes payable in cash while the “deferred taxes” represent the taxes payable in future years (although in this case, because the deferred taxes are a credit, they represent tax benefits receivable in future years). (b) Future taxable amounts increase taxable income relative to pretax financial income in the future due to temporary differences existing at the balance sheet date. Future deductible amounts decrease taxable income relative to pretax financial income in the future due to existing temporary differences. A deferred tax liability should be recorded for the deferred tax consequences attributable to the future taxable amounts scheduled and a deferred tax asset should be recorded for the deferred tax consequences attributable to the future deductible amounts scheduled. (c) The carryforward provisions will affect the amounts to be reported for the resulting deferred tax asset and deferred tax liability. In computing deferred tax account balances to be reported at a balance sheet date, the appropriate enacted tax rate is applied to future taxable and deductible amounts related to temporary differences existing at the balance sheet date. In determining the appropriate tax rate, you must make assumptions about whether the entity will report taxable income or losses in the various future years expected to be affected by the existing temporary differences. Thus, you calculate the taxes payable or refundable in the future due to existing temporary differences. In making these calculations, you apply the provisions of the tax laws and enacted tax rates for the relevant periods. For future taxable amounts: 1.
If taxable income is expected in the year that a future taxable amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax liability.
Financial Statement Analysis Case (Continued) 2.
If an NOL is expected in the year that a future taxable amount is scheduled, use the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax liability.
For future deductible amounts: 1.
If taxable income is expected in the year that a future deductible amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax asset.
2.
If an NOL is expected in the year that a future deductible amount is scheduled, use the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax asset.
LO: 2, 3, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 18.4 Accounting, Analysis, and Principles Accounting Taxable income for 2025: Pretax financial income .......................................................... Permanent differences: Fines and penalties ......................................................... Tax-exempt interest ........................................................ Originating temporary differences: Excess installment gross profit per books ($560,000 – $112,000) .................................................. Taxable income .......................................................................
$500,000 26,000 (28,000) (448,000) $ 50,000
Income taxes payable for 2025: Taxable income ....................................................................... 2025 Income tax rate............................................................... Income taxes payable .............................................................
$ 50,000 30% $ 15,000
DeJohn has future taxable amounts arising from temporary differences as follows: 2026 Future taxable (deductible) amounts Enacted tax rate Deferred tax liability (asset)
$112,000 20% $ 22,400
Future Years 2027 2028 $112,000 20% $ 22,400
$112,000 20% $ 22,400
2029
Total
$112,000 20% $ 22,400
$448,000 $ 89,600
The $89,600 is a deferred tax liability because the temporary difference is from future taxable amounts. The deferred tax liability needed is $89,600. Journal entry: Income Tax Expense ....................................................... Income Taxes Payable ........................................... Deferred Tax Liability.............................................
104,600 15,000 89,600
Accounting, Analysis, and Principles (Continued) Analysis The $89,600d deferred tax liability is classified as noncurrent. Income taxes payable is classified as a current liability. The income tax expense portion of the income statement would look as follows: Income before income taxes ........................................ Income tax expense: Current.................................................................. Deferred ................................................................ Net income ....................................................................
$500,000 $ 15,000 89,600
104,600 $395,400
DeJohn’s 2025 effective tax rate is 20.92% ($104,600 ÷ $500,000).
Principles We can use the conceptual framework to determine that deferred taxes should be reported as assets and liabilities. The conceptual framework provides specific guidance as to how to define assets and liabilities. LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 18.1 (Time 15–20 minutes) Purpose—to provide the student an opportunity to explain the objectives in accounting for income taxes in the financial statements and the basic principles that are applied in meeting the objectives. The student is also required to list the steps involved in the annual computation of deferred income taxes. CT 18.2 (Time 20–25 minutes) Purpose—to provide the student an opportunity to discuss the principles of the asset-liability method, how the deferred tax effects of temporary differences are computed, and how the deferred tax consequences of temporary differences are classified on a balance sheet. CT 18.3 (Time 20–25 minutes) Purpose—to develop an understanding of temporary and permanent differences. The student is required to explain the nature of four differences and to explain why each is a permanent or temporary difference. Two of the four situations are challenging. Also, the nature of and the classification of deferred tax accounts are examined. CT 18.4 (Time 20–25 minutes) Purpose—to develop an understanding of deferred taxes and balance sheet disclosure. This case has two parts. In the first part, the student is required to indicate whether deferred income taxes should be recognized for each of four items. In the second part, the student must discuss how deferred taxes will be classified in the balance sheet. CT 18.5 (Time 20–25 minutes) Purpose—to develop an understanding of how to determine the appropriate tax rate to use in computing deferred taxes when different tax rates are enacted for various years affected by existing temporary differences. CT 18.6 (Time 20–25 minutes) Purpose—to develop an understanding of the concept of future taxable amounts and future deductible amounts. Also, to develop an understanding of how the carryforward provisions affect the computation of deferred tax assets and liabilities when there are multiple tax rates enacted for the various periods affected by existing temporary differences. CT 18.7 (Time 20–25 minutes) Purpose—to provide the student an opportunity to examine the income effects of deferred taxes, including ethical issues.
Solutions to Critical Thinking CT 18.1 (a)
The objectives in accounting for income taxes are: 1. To recognize the amount of taxes payable or refundable for the current year. 2. To recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns.
(b)
To implement the objectives, the following basic principles are applied in accounting for income taxes at the date of the financial statements: 1. A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for the current year. 2. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and loss carryforwards using the enacted marginal tax rate. 3. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. 4. The measurement of deferred tax assets is adjusted, if necessary, to not recognize tax benefits that, based on available evidence, are not expected to be realized.
(c)
The procedures for the annual computation of deferred income taxes are as follows: 1. Identify: (1) the types and amounts of existing temporary differences and (2) the nature and amount of each type of operating loss and tax credit carryforward and the remaining length of the carryforward period. 2. Measure the total deferred tax liability for taxable temporary differences using the enacted tax rate. 3. Measure the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the enacted tax rate. 4. Measure deferred tax assets for each type of tax credit carryforward. 5. Reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.
LO: 1, Bloom: K, Difficulty: Simple, Time: 25-35, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 18.2 (a)
The following basic principles are applied in accounting for income taxes at the date of the financial statements: 1. A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for the current year. 2. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and loss carryforwards using the enacted marginal tax rate. 3. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. 4. The measurement of deferred tax assets is adjusted, if necessary, to not recognize tax benefits that, based on available evidence, are not expected to be realized.
(b)
Dexter should do the following in accounting for the temporary differences. 1. Identify the types and amounts of existing temporary differences. The depreciation policies give rise to a temporary difference that will result in net future taxable amounts (because depreciation for tax purposes exceeds the depreciation for financial statements). Rents are taxed in the year they are received but reported on the income statement in the year earned. The collection of rent revenue in advance will cause future deductible amounts.
CT 18.2 (Continued) 2. 3. 4.
(c)
Measure the total deferred tax liability for the taxable temporary difference using the enacted marginal tax rate. Measure the total deferred tax asset for the deductible temporary difference using the enacted marginal tax rate. Reduce the deferred tax asset by a valuation allowance, if based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized.
Deferred tax accounts are reported as assets and liabilities. Companies should classify these accounts as a net noncurrent amount on the balance sheet. That is, deferred tax assets and deferred tax liabilities are separately recognized and measured and are then offset in the balance sheet. The net deferred tax asset or net deferred tax liability is therefore reported in the noncurrent section of the balance sheet.
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 18.3 (a)
1.
Temporary difference. The full estimated three years of warranty costs reduce the current year’s pretax financial income, but will reduce taxable income in varying amounts each respective year, as paid. Assuming the estimate as to each warranty is valid, the total amounts deducted for accounting and for tax purposes will be equal over the three-year period for a given warranty. This is an example of an expense that, in the first period, reduces pretax financial income more than taxable income and, in later years, reverses. This type of temporary difference will result in future deductible amounts which will give rise to the current recognition of a deferred tax asset. Another way to evaluate this situation is to compare the carrying value of the warranty liability with its tax basis (which is zero). When the liability is settled in a future year an expense will be recognized for tax purposes, but none will be recognized for financial reporting purposes. Therefore, tax benefits for the tax deductions should result from the future settlement of the liability.
2.
Temporary difference. The difference between the tax basis and the reported amount (book basis) of the depreciable property will result in taxable or deductible amounts in future years when the reported amount of the asset is recovered (through use or sale of the asset); hence, it is a temporary difference.
3.
Temporary difference and permanent difference. The investor’s share of earnings of an investee (other than subsidiaries and corporate joint ventures) accounted for by the equity method is included in pretax financial income while only 20% of dividends received from some domestic corporations are included in taxable income. Of the amount included in pretax financial income, 80% (1.00 − .20) is a permanent difference attributable to the dividendsreceived deduction permitted when computing taxable income. Twenty percent of the amount included in pretax financial income is potentially a temporary difference which will reverse as dividends are received. If the investee distributes 10% of its earnings, then one-half of the potential temporary difference is eliminated and 50% of the amount included in pretax financial income is a temporary difference.
4.
Temporary difference. For financial reporting purposes, any gain experienced in an involuntary conversion of a nonmonetary asset to a monetary asset must be recognized in the period of conversion. For tax purposes, this gain may be deferred if the total proceeds are reinvested in replacement property within a certain period of time. When such a gain is deferred, the tax basis of the replacement property is less than its carrying value and this difference will result in future taxable amounts. Hence, this is a temporary difference.
CT 18.3 (Continued) (b)
Deferred tax accounts are reported as assets and liabilities. Companies should classify these accounts as a net noncurrent amount on the balance sheet. That is, deferred tax assets and deferred tax liabilities are separately recognized and measured and are then offset in the balance sheet. The net deferred tax asset or net deferred tax liability is therefore reported in the noncurrent section of the balance sheet.
LO: 1, 2, Bloom: AN, Difficulty: Complex, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 18.4 Part A. (a)
Deferred income taxes are reported in the financial statements when temporary differences exist at the balance sheet date. Deferred taxes are never reported for permanent differences. The tax consequences of most events recognized in the financial statements for a year are included in determining income taxes currently payable. However, tax laws often differ from the recognition and measurement requirements of financial accounting standards, and differences can arise between: (1) the amount of taxable income and pretax financial income for a year and (b) the tax bases of assets or liabilities and their reported amounts in financial statements. An assumption inherent in a company’s balance sheet prepared in accordance with generally accepted accounting principles is that the reported amounts of assets and liabilities will be recovered and settled, respectively. Based on that assumption, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. A deferred tax liability is reported for the increase in taxes payable in future years as a result of taxable temporary differences existing at the balance sheet date. A deferred tax asset is reported for the increase in taxes refundable in future years as a result of deductible temporary differences existing at the balance sheet date. The most common temporary differences arise from including revenues or expenses in taxable income in a period later or earlier than the period in which they are included in pretax financial income.
(b)
1. 2. 3. 4.
Gross profit on installment sales—Deferred income taxes would be recognized when gross profit on installment sales is included in pretax financial income in the year of sale and included in taxable income when later collected. Revenues on long-term construction contracts—Deferred income taxes would be recognized whenever revenues on long-term construction contracts are recognized for financial reporting purposes on the percentage-of-completion basis but deferred for tax purposes. Estimated costs of product warranty contracts—Deferred income taxes should usually be recognized because estimated costs of product warranty contracts should be recognized for financial reporting purposes in the year of sale and reported for tax purposes when paid. Premiums on officers’ life insurance policies with Gumowski as beneficiary—This is a permanent difference and deferred income taxes should not be recognized. Premiums on officers’ life insurance policies with Gumowski as beneficiary should be recognized in Gumowski Company’s income statement but are not a deductible expense for tax purposes.
CT 18.4 (Continued) Part B. Deferred tax accounts are reported as assets and liabilities. Companies should classify these accounts as a net noncurrent amount on the balance sheet. That is, deferred tax assets and deferred tax liabilities are separately recognized and measured and are then offset in the balance sheet. The net deferred tax asset or net deferred tax liability is therefore reported in the noncurrent section of the balance sheet. LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 18.5 (a) (b)
The 35% tax rate would be used in computing income tax payable in 2025 at December 31, 2025. The 30% tax rate would be used in computing the deferred tax liability at December 31, 2025, if taxable income is expected in 2026 (the tax rate enacted for 2026 is 30% and 2026 is the year in which the future taxable amount is expected to occur). (See discussion below.)
(c)
The 20% tax rate would be used in computing the deferred tax liability at December 31, 2025, if a net operating loss (an NOL) is expected in 2026 that is to be carried forward to 2027 (the tax rate enacted for 2027 is 20%). (See discussion below.)
Discussion: In determining the future tax consequences of temporary differences, it is helpful to prepare a schedule which shows in which future years existing temporary differences will result in taxable or deductible amounts. The appropriate enacted tax rate is applied to these future taxable and deductible amounts. In determining the appropriate tax rate, you must make assumptions about whether the entity will report taxable income or losses in the various future years expected to be affected by the reversal of existing temporary differences. Thus, you calculate the taxes payable or refundable in the future due to existing temporary differences. In making these calculations, you apply the provisions of the tax laws and enacted tax rates for the relevant periods. For future taxable amounts: 1. If taxable income is expected in the year that a future taxable amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax liability. 2. If an NOL is expected in the year that a future taxable amount is scheduled, use the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax liability. For future deductible amounts: 1. If taxable income is expected in the year that a future deductible amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax asset. 2. If an NOL is expected in the year that a future deductible amount is scheduled, use the enacted of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax asset. LO: 1,2, Bloom: AP, Difficulty: Complex, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 18.6 (a)
Future taxable amounts increase taxable income relative to pretax financial income in the future due to temporary differences existing at the balance sheet date. Future deductible amounts decrease taxable income relative to pretax financial income in the future due to existing temporary differences. A deferred tax liability should be recorded for the deferred tax consequences attributable to the future taxable amounts scheduled and a deferred tax asset should be recorded for the deferred tax consequences attributable to the future deductible amounts scheduled.
(b)
The carryforward provision will affect the amounts to be reported for the resulting deferred tax asset and deferred tax liability. In computing deferred tax account balances to be reported at a balance sheet date, the appropriate enacted tax rate is applied to future taxable and deductible amounts related to temporary differences existing at the balance sheet date. In determining the appropriate tax rate, you must make assumptions about whether the entity will report taxable income or losses in the various future years expected to be affected by the existing temporary differences. Thus, you calculate the taxes payable or refundable in the future due to existing temporary differences. In making these calculations, you apply the provisions of the tax laws and enacted tax rates for the relevant periods. For future taxable amounts: 1. If taxable income is expected in the year that a future taxable amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax liability. 2. If an NOL is expected in the year that a future taxable amount is scheduled, use the enacted rate of the future year to which the carryforward would apply to calculate the related deferred tax liability. For future deductible amounts: 1. If taxable income is expected in the year that a future deductible amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax asset. 2. If an NOL is expected in the year that a future deductible amount is scheduled, use the enacted rate of the future year to which the carryforward would apply, to calculate the related deferred tax asset.
LO: 1, 2, 3, Bloom: AN, Difficulty: Complex, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 18.7 (a)
To realize a sizable, deferred tax liability, Acme must have used an accelerated depreciation method for tax purposes while using straight-line depreciation for its financial statements. Once the temporary difference reversed, taxable income would exceed financial accounting income. Acme would be required to pay the taxes it “deferred” from the years when tax depreciation exceeded book depreciation. To stop this from happening, Acme would have to sell these plant assets. It probably would have to report a gain on sale, but possibly be taxed at the favorable capital gains rates. If Acme buys new plant assets and again uses accelerated depreciation for tax purposes and straight-line for financial reporting purposes, it will perpetuate a “deferral” of income taxes.
(b)
The deferral of income taxes means that due to temporary differences caused by the difference in financial accounting principles and tax laws, a company will be able to defer paying its income taxes (or reaping an income tax benefit) until future periods. The practice of selling-off assets before the temporary difference reverses means that the company may pay a lesser amount of taxes to the government. Although some might be concerned that Acme is not paying its “fair share,” Acme appears to be minimizing its taxes through a tax strategy plan which is perfectly legal. The federal government has chosen to provide these incentives and there is nothing wrong with Acme deferring the payable.
(c)
The primary stakeholders who could be harmed by Acme’s income tax practice are the federal government, which receives fewer taxes as a result of this practice. Ultimately, other taxpayers have to pay more. In addition, if replacement plant assets are very costly to acquire, positive cash flow is reduced. Though the impact should not be great, investors and creditors are affected negatively.
(d)
As a CPA, Stephanie is obligated to uphold objectivity and integrity in the practice of financial reporting. If she thinks that this practice is unethical, then she needs to communicate her concerns to the highest levels of management within Acme, including members of the Board of Directors and/or the Audit Committee. However, it would appear here that Acme is simply trying to minimize its income taxes which should not be considered unethical.
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Ethics, Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication, Professional Behavior
Codification Exercises CE18.1 Master Glossary (a)
The deferred tax consequences attributable to deductible temporary differences and carryforwards. A deferred tax asset is measured using the applicable enacted tax rate and provisions of the enacted tax law. A deferred tax asset is reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized.
(b)
The excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority.
(c)
The portion of a deferred tax asset for which it is more likely than not that a tax benefit will not be realized.
(d)
The deferred tax consequences attributable to taxable temporary differences. A deferred tax liability is measured using the applicable enacted tax rate and provisions of the enacted tax law.
LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE18.2 According to FASB ASC 740-10-30-2 (Income Taxes—Initial Measurement): The following basic requirements are applied to the measurement of current and deferred income taxes at the date of the financial statements: (a)
The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated.
(b)
The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Measurement, Reporting, Research, Technology and Tools, AICPA PC: Communication
CE18.3 According to FASB ASC 740-10-S99-2 (Income Taxes—SEC Materials): Yes. In such an event, a note must (1) disclose the aggregate dollar and per share effects of the tax holiday and (2) briefly describe the factual circumstances including the date on which the special tax status will terminate. LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE18.4 According to FASB ASC 740-10-25-6 (Income Taxes—Recognition): An entity shall initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. For example, if an entity determines that it is certain that the entire cost of an acquired asset is fully deductible, the morelikely-than-not recognition threshold has been met. The more-likely-than-not recognition threshold is a positive assertion that an entity believes it is entitled to the economic benefits associated with a tax position. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold shall consider the facts, circumstances, and information available at the reporting date. The level of evidence that is necessary and appropriate to support an entity’s assessment of the technical merits of a tax position is a matter of judgment that depends on all available information. LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a) According to FASB ASC 740-10-30-18 (Income Taxes, Overall, Initial Measurement), future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback, carryforward period available under the tax law. (b) According to FASB ASC 740-10-30-18 (Income Taxes, Overall, Initial Measurement): The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards: a. Future reversals of existing taxable temporary differences b. Future taxable income exclusive of reversing temporary differences and carryforwards c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law d. Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for example: (1) Accelerate taxable amounts to utilize expiring carryforwards (2) Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss (3) Switch from tax-exempt to taxable investments. Evidence available about each of those possible sources of taxable income will vary for different tax jurisdictions and, possibly, from year to year. To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of the valuation allowance that is recognized for deferred tax assets.
Codification Research Case (Continued) (c) According to FASB ASC 740-10-30 (Income Taxes, Overall, Initial Measurement): 30-19 In some circumstances, there are actions (including elections for tax purposes) that: a. Are prudent and feasible. b. An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused. c. Would result in realization of deferred tax assets. This Subtopic refers to those actions as tax-planning strategies. An entity shall consider tax-planning strategies in determining the amount of valuation allowance required. Significant expenses to implement a tax-planning strategy or any significant losses that would be recognized if that strategy were implemented (net of any recognizable tax benefits associated with those expenses or losses) shall be included in the valuation allowance. See paragraphs 740-10-55-39 through 55-48 for additional guidance. Implementation of the tax-planning strategy shall be primarily within the control of management but need not be within the unilateral control of management. 30-22 Examples (not prerequisites) of positive evidence that might support a conclusion that a valuation allowance is not needed when there is negative evidence include, but are not limited to, the following: a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures. b. An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient to realize the deferred tax asset.
Codification Research Case (Continued) c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition. 30-23 An entity shall use judgment in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence shall be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed for some portion or all of the deferred tax asset. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome. 30-24 Future realization of a tax benefit sometimes will be expected for a portion but not all of a deferred tax asset, and the dividing line between the two portions may be unclear. In those circumstances, application of judgment based on a careful assessment of all available evidence is required to determine the portion of a deferred tax asset for which it is more likely than not a tax benefit will not be realized. From the information given, it is not obvious whether a tax planning strategy could be employed. More information is needed from the client. LO: 1, 2, 3, Bloom: K, Difficulty: Simple, Time: 35-40, AACSB: Analytic, Communication, Technology, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, Technology and Tools, AICPA PC: Communication
CHAPTER 19 Accounting for Pensions and Postretirement Benefits Assignment Classification Table (By Topic) Topics 1. Basic definitions and concepts related to pension plans.
Brief Questions Exercises Exercises 1, 2, 3, 4, 5, 6, 7, 8, 9, 12, 24, 30
2. Worksheet preparation.
Problems
16
Critical Thinking 1, 2, 3, 4, 5, 7
3
3, 4, 7, 10, 14, 18
1, 2, 4, 7, 8, 9, 10, 11, 12
9, 10, 11, 13, 16, 17
1, 2, 4
1, 2, 3, 6, 11, 12, 13, 14, 15, 16, 17, 18
1, 2, 3, 4, 5, 6, 9, 11, 12
4. Balance sheet recognition, 15, 19, 20, computation of pension 22, 23 expense.
6, 10
3, 9, 11, 12, 1, 2, 3, 4, 13, 14 5, 6, 7, 8, 9, 11, 12
2, 5, 7
5. Corridor calculation.
18
7
8, 13, 14, 16, 17, 18
2, 3, 5, 6, 7, 8, 11, 12
3, 4, 5, 6
6. Prior service cost.
12, 13, 20
5, 6, 8
1, 2, 3, 5, 9, 11, 12, 13, 14
1, 2, 3, 4, 6, 7, 8, 9, 11, 12
1, 4
7. Gains and losses.
14, 17, 21, 22
7, 9
8, 9, 13, 14, 1, 2, 3, 4, 5, 6, 16, 17 7, 8, 9, 11, 12
4, 5, 6
8. Disclosure issues.
23
9, 11, 12
11, 12
3, 4
9. Special Issues.
25 19, 20, 21, 22, 23, 24
13, 14
3. Income statement recognition, computation of pension expense.
*10. Postretirement benefits.
26, 27, 28, 29
10, 11
*This material is dealt with in an Appendix to the chapter.
4, 5
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1.
Discuss the fundamentals of pension plan accounting.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 15, 24
1, 2,
1, 2, 3, 4, 6, 7, 10, 11, 12, 13, 14, 15, 17, 18
1, 2, 3, 4, 8, 9, 10,11, 12
1, 2, 3, 4
2.
Use a worksheet for employer’s pension plan entries.
16
3, 4
1, 2, 3, 4, 7, 10, 11, 12, 13, 14, 15, 18
1, 2, 3, 4, 5, 7, 8, 9, 10, 11, 12
3.
Describe the 20 accounting and amortization of prior service costs.
5, 6
2, 3, 5, 7, 10, 11, 12, 18
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12
4.
Explain the accounting and amortization for unexpected gains and losses.
14, 17, 18, 19, 21, 22
7
8, 10, 11, 12, 13, 14, 16, 17, 18
1, 2, 3, 4, 5, 6, 7, 8, 9,10, 11, 12
6, 7
5.
Describe the requirements for reporting pension plans in financial statements.
19, 23, 25
8, 9
9, 11,12,15, 17
2, 3, 8, 9, 11, 12
5
*6.
Identify the differences between pensions and postretirement healthcare benefits.
27, 28
10, 11
19, 20, 21, 22, 23, 24
13, 14
*7.
Contrast accounting for pensions to accounting for other postretirement benefits.
26, 29
10, 11
19, 20, 21, 22, 23, 24
13, 14
Assignment Characteristics Table Item E19.1 E19.2 E19.3 E19.4 E19.5 E19.6 E19.7 E19.8 E19.9 E19.10 E19.11 E19.12 E19.13 E19.14 E19.15 E19.16 E19.17 E19.18 *E19.19 *E19.20 *E19.21 *E19.22 *E19.23 *E19.24 P19.1 P19.2 P19.3 P19.4 P19.5 P19.6 P19.7 P19.8 P19.9 P19.10 P19.11 P19.12 *P19.13 *P19.14
Description Pension expense, journal entries. Computation of pension expense. Preparation of pension worksheet. Basic pension worksheet. Application of years-of-service method. Computation of actual return. Basic pension worksheet. Application of the corridor approach. Disclosures: pension expense and other comprehensive income. Pension worksheet. Pension expense, journal entries, statement presentation. Pension expense, journal entries, statement presentation. Computation of actual return, gains and losses, corridor test, and pension expense. Worksheet for E19.13. Pension expense, journal entries. Amortization of accumulated OCI (G/L), corridor approach, pension expense computation. Amortization of accumulated OCI balances. Pension worksheet—missing amounts. Postretirement benefit expense computation. Postretirement benefit worksheet. Postretirement benefit expense computation. Postretirement benefit expense computation. Postretirement benefit worksheet. Postretirement benefit worksheet—missing amounts. 2-year worksheet. 3-year worksheet, journal entries, and reporting. Pension expense, journal entries, amortization of loss. Pension expense, journal entries for 2 years. Computation of pension expense, amortization of net gain or loss-corridor approach, journal entries for 3 years. Computation of prior service cost amortization, pension expense, journal entries, and net gain or loss. Pension worksheet. Comprehensive 2-year worksheet. Comprehensive 2-year worksheet. Pension worksheet—missing amounts. Pension worksheet. Pension worksheet. Postretirement benefit worksheet. Postretirement benefit worksheet—2 years.
Level of Time Difficulty (minutes) Simple 15–20 Simple 10–15 Moderate 15–25 Simple 10–15 Moderate 15–25 Simple 10–15 Moderate 15–25 Moderate 20–25 Moderate 25–35 Moderate 20–25 Moderate 20–30 Moderate 20–30 Complex 35–45 Complex Moderate Moderate
40–50 15–20 25–35
Moderate Moderate Moderate Moderate Simple Simple Moderate Moderate
30–40 20–25 5–10 25–30 10–12 10–12 15–20 25–30
Moderate Complex Complex Moderate Complex
40–50 45–55 40–50 30–40 45–55
Complex
45–60
Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate
35–45 45–60 40–45 25–30 35–45 35–45 30–35 40–45
Assignment Characteristics Table (Continued) Item CT19.1 CT19.2 CT19.3 CT19.4 CT19.5 CT19.6 CT19.7
Description Pension terminology and theory. Pension terminology. Basic terminology. Major pension concepts. Implications of GAAP rules on pensions. Gains and losses, corridor amortization. Nonvested employees—an ethical dilemma.
Level of Difficulty Moderate Moderate Simple Moderate Complex Moderate Moderate
Time (minutes) 30–35 25–30 20–25 30–35 50–60 30–40 20–30
Answers to Questions **1. A private pension plan is an arrangement whereby a company undertakes to provide its retired employees with benefits that can be determined or estimated in advance from the provisions of a document or from the company’s practices. In a contributory pension plan the employees bear part of the cost of the stated benefits whereas in a noncontributory plan the employer bears the entire cost. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
**2. A defined contribution plan specifies the employer’s contribution to the plan usually based on a formula, which may consider such factors as age, length of service, employer’s profit, or compensation levels. A defined benefit plan specifies a determinable pension benefit that the employee will receive at a time in the future. The employer must determine the amount that should be contributed now to provide for the future promised benefits.4 In a defined contribution plan, the employer’s obligation is simply to make a contribution to the plan each year based on the plan formula. The benefit of gain or risk of loss from assets contributed to the plan is borne by the employee. In a defined benefit plan, the employer’s obligation is to make sufficient contributions each year to provide for the promised future benefits. Therefore, the employer is at risk to the extent that contributions will not be adequate to meet the promised benefits. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
**3. The employer is the organization sponsoring the pension plan. The employer incurs the costs and makes contributions to the pension fund. Accounting for the employer involves: (1) allocating the cost of the pension plan to the proper accounting periods, (2) measuring the amount of pension obligation resulting from the plan, and (3) disclosing the status and effects of the plan in the financial statements. The pension fund or plan is the entity which receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the pension recipients. Accounting for the fund involves identifying receipts as contributions from the employer sponsor, income from fund investments, and computing the amounts due to individual pension recipients. Accounting for the pension costs and obligations of the employer is the topic of this chapter; accounting for the pension fund is not. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
**4. When the term “fund” is used as a noun, it refers to assets accumulated in the hands of a funding agency for the purpose of meeting pension benefits when they become due. When the term “fund” is used as a verb, it means to pay over to a funding agency (as to fund future pension benefits or to fund pension cost). LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 19 (Continued) **5. An actuary’s role is to ensure that the company has established an appropriate funding pattern to meet its pension obligations, to make predictions and assumptions about future events and conditions that affect pension costs, and to assist the accountant in measuring facets of the pension plan that must be reported (costs, liabilities and assets). In order to determine the company’s pension obligation, the actuary must first determine the expected benefits that will be paid in the future. To accomplish this requires the actuary to make actuarial assumptions, which are estimates of the occurrence of future events affecting pension costs, such as mortality, withdrawals, disablement and retirement, changes in compensation, and changes in discount rates to reflect the time value of money. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
**6. In measuring the amount of pension benefits under a defined benefit pension plan, an actuary must consider such factors as mortality rates, employee turnover, interest and earnings rates, early retirement frequency, and future salaries. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
**7. One measure of the pension obligation is the vested benefit obligation. This measure uses only current salary levels and includes only vested benefits; that is, benefits the employee is already entitled to receive even if the employee renders no additional services under the plan. A company’s accumulated benefit obligation is the actuarial present value of benefits attributed by the pension benefit formula to service before a specified date and is based on vested and unvested employee service and compensation prior to that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels. The projected benefit obligation is based on vested and nonvested services using expected future salaries. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
**8. Cash-basis accounting recognizes pension cost as being equal to the amount of cash paid by the employer to the pension fund in any period; pension funding serves as the basis for expense recognition under the cash basis. Accrual-basis accounting recognizes pension cost as it is incurred and attempts to recognize pension cost in the same period in which the company receives benefits from the services of its employees. Frequently, the amount which an employer must fund for pension purposes during a particular period is unrelated to the economic benefits derived from the pension plan in that period. Cashbasis accounting recognizes the amount funded as periodic pension cost and the amount funded may be discretionary and vary widely from year to year. Funding is a matter of financial management, based on working capital availability, tax considerations, and other matters unrelated to accounting considerations. LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
**9. The five components of pension expense are: (1) Service cost—the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. (2) Interest cost—the increase in the projected benefit obligation as a result of the passage of time. (3) Actual return on plan assets—the reduction in pension cost for actual investment income from plan assets and the change in the market value of plan assets.
Questions Chapter 19 (Continued) (4)
Amortization of prior service cost—the cost of retroactive benefits granted in a plan amendment (including initiation of a plan).
(5)
Gains and losses—a change in the value of either the projected benefit obligation or the plan assets resulting from experience different from that assumed or expected or from a change in an actuarial assumption.
Note to instructor: Regarding return on plan assets, the final component is expected rate of return. We are assuming above that an adjustment is made to the actual return to determine expected return. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
10. The service cost component of net periodic pension expense is determined as the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. The plan’s benefit formula provides a measure of how much benefit is earned and, therefore, how much cost is incurred in each individual period. The FASB concluded that future compensation levels had to be considered in measuring the present obligation and periodic pension expense if the plan benefit formula incorporated them. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
11. The interest component is the interest for the period on the projected benefit obligation outstanding during the period. The assumed discount rate should reflect the rates at which pension benefits could be effectively settled (settlement rates). Companies should look to rates of return on high-quality fixed-income investments currently available whose cash flows match the timing and amount of the expected benefit payments. LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*12. Service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during the current period. Actuaries compute service cost at the present value of the new benefits earned by employees during the current year. Prior service cost is the cost of retroactive benefits for prior years granted in a plan amendment or initiation of a pension plan. The cost of the retroactive benefits is the increase in the projected benefit obligation at the date of the amendment. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*13. When a defined benefit plan is either initiated or amended, credit is often given to employees for years of service provided before the date of initiation or amendment. The cost of these retroactive benefits is referred to as prior service cost. Employers grant retroactive benefits because they expect to receive benefits in the future. As a result, prior service cost should not be recognized as pension expense entirely in the year of amendment or initiation. It is recognized as an adjustment to other comprehensive income. It should be recognized during the service periods of those employees who are expected to receive benefits under the plan. Consequently, prior service cost is amortized over the service life of employees who will receive benefits and is a component of net periodic pension expense each period. LO: 1, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*14. Liability gains and losses are unexpected gains or losses from changes in the projected benefit obligation. Liability gains (resulting from unexpected decreases) and liability losses (resulting from unexpected increases) are recognized in other comprehensive income. The accumulated gains and losses are then amortized to expense over the remaining service lives of active employees expected to receive benefits. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 19 (Continued)
*15. If pension expense recognized in a period exceeds the current amount funded, a liability account referred to as Pension Asset /Liability arises; the account would be reported either as a current or long-term liability, depending on the ultimate date of payment. If the current amount funded exceeds the amount recognized as pension expense, an asset account referred to as Pension Asset/Liability arises; the account would be reported as a non-current asset. Because these assets are used to fund the pension obligation, noncurrent classification is appropriate. LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*16. Computation of actual return on plan assets Fair value of plan assets at end of period ................................. Deduct: Fair value of plan assets at beginning of period .......... Increase in fair value of assets.................................................. Deduct: Contributions to plan during the period ....................... Add: Benefits paid during the period ................................... Actual return on plan assets .....................................................
$10,150,000 9,500,000 650,000 $1,000,000 1,400,000
400,000 $ 1,050,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*17. An asset gain occurs when the actual return on the plan assets is greater than the expected return on plan assets while an asset loss occurs when the actual return is less than the expected return on the plan assets. A liability gain results from unexpected decreases in the pension obligation and a liability loss results from unexpected increases in the pension obligation. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*18. Corridor amortization occurs when the Accumulated OCI balance related to gains and losses gets too large. The gain or loss is too large when it exceeds the arbitrarily selected FASB criterion of 10% of the larger of the beginning balances of the projected benefit obligation or the marketrelated value of the plan assets. The excess gain or loss balance may be amortized using any systematic method, but the amortization cannot be less than the amount computed using the straight-line method over the average remaining service-life of active employees expected to receive benefits. LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*19. The amount of the pension asset/liability to be reported on the company’s balance sheet is as follows: Projected benefit obligation.......................................................... Pension plan assets..................................................................... Pension liability ............................................................................
$(400,000) 350,000 $ (50,000)
In the financial statements, the company will report a pension liability of $50,000. This amount is also referred to as the funded status of the plan. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*20. The prior service cost arising in the year of the amendment (which increases the projected benefit obligation) is recognized by an offsetting debit to Other Comprehensive Income (PSC). In subsequent periods, the $9,150,000 will be amortized into periodic pension expense over the remaining service lives of the employees. This approach is consistent with the treatment for actuarial gains and losses. LO: 3, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 19 (Continued) *21.
Actuarial gains or losses arise from (1) asset gains or losses (when the expected return is different than the actual return on plan assets) and (2) a liability gain or loss (when actuarial assumptions do not coincide with actual experiences related to computation of the projected benefit obligation.) In the period that they arise, these gains and losses are not recognized as part of pension expense, but are recognized as increases or decreases in other comprehensive income. In subsequent periods, these amounts are amortized into periodic pension expense over the remaining service lives of the employees, using corridor amortization.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*22. (a) Other Comprehensive Income for 2026 is as follows: Actuarial liability gain ....................................................................... Asset loss ........................................................................................ Other comprehensive loss ...............................................................
$10,000 14,000 $ 4,000
(b) The computation of comprehensive income for 2026 is as follows: Net income ...................................................................................... Other comprehensive loss ............................................................... Comprehensive income ...................................................................
$25,000 4,000 $21,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*23. Multiple plans may be combined and shown as one amount on the balance sheet, only if they are in the same under or overfunded position. For example, if the company has two or more underfunded (overfunded) plans, the underfunded (overfunded) plans are combined and shown as one amount as a liability (asset) on the balance sheet. The FASB rejected the alternative of combining all plans and representing the net amount as a single net asset or net liability. The rationale: A company does not have the ability to offset the excess of one plan against underfunded obligations of another plan. Furthermore, netting all plans is inappropriate because offsetting assets and liabilities is not permitted under GAAP unless a right of offset exists. LO: 5, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*24. (a)
(b) (c)
(d)
A contributory plan is a pension plan under which employees contribute part of the cost. In some contributory plans, employees wishing to be covered must contribute; in other contributory plans, employee contributions result in increased benefits. Vested benefits are benefits for which the employee’s right to receive a present or future pension benefit is no longer contingent on remaining in the service of the employer. Retroactive benefits are benefits granted in a plan amendment (or initiation) that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment. The years-of-service method is used to allocate prior service cost to the remaining years of service of the affected employees. Each year receives a fraction of the original cost with the fraction depicting the number of service-years received out of the total service-years to be worked by the affected employees.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 19 (Continued) *25. The accounting issue that arises from these terminations is whether a gain should be recognized by the corporation when these assets revert (often called asset reversion transactions) to the company. The profession requires that these gains or losses be reported immediately in most situations. LO: 5, Bloom: C, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*26. Postretirement benefits other than pensions include healthcare and other welfare benefits provided to retirees, their spouses, dependents, and beneficiaries. The other welfare benefits include life insurance offered outside a pension plan, dental care as well as medical care, eye care, legal and tax services, tuition assistance, day care, and housing activities. LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*27. The FASB did not cover both pensions and healthcare benefits in the earlier pension accounting rules because of the significant differences between the two types of postretirement benefits. These differences are listed in the following schedule: Differences between Postretirement Healthcare Benefits and Pensions Item Funding Benefit
Pensions Generally funded. Well-defined and level dollar amount.
Beneficiary
Retiree (maybe some benefit to surviving spouse). Monthly. Variables are reasonably predictable.
Benefit Payable Predictability
Healthcare Benefits Generally NOT funded. Generally uncapped and great variability. Retiree, spouse, and other dependents. As needed and used. Utilization difficult to predict. Level of cost varies geographically and fluctuates over time.
LO: 6, Bloom: AN, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*28. The major differences between pension benefits and postretirement benefits are listed below: Differences between Postretirement Healthcare Benefits and Pensions Item
Pensions
Healthcare Benefits
Funding Benefit
Generally funded. Well-defined and level dollar amount.
Beneficiary
Retiree (maybe some benefit to surviving spouse). Monthly. Variables are reasonably predictable.
Generally NOT funded. Generally uncapped and great variability. Retiree, spouse, and other dependents. As needed and used. Utilization difficult to predict. Level of cost varies geographically and fluctuates over time.
Benefit Payable Predictability
Additionally, although healthcare benefits are generally covered by the fiduciary and reporting standards for employee benefit funds under ERISA, the stringent minimum vesting, participation, and funding standards that apply to pensions do not apply to healthcare benefits. LO: 6, Bloom: AN, Difficulty: Simple, Time: 5-7, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 19 (Continued)
*29. EPBO (expected postretirement benefit obligation) is the actuary’s present value of all benefits expected to be paid after retirement, while APBO (accumulated postretirement benefit obligation) is the actuarial present value of future benefits attributed to employees’ services rendered to a particular date. The components of postretirement expense are service cost, interest cost, expected return on plan assets, amortization of prior service cost, and gains and losses. LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 19.1 Service cost ........................................................... Interest on PBO ..................................................... Return on plan assets ........................................... Amortization of prior service cost........................ Amortization of net loss ........................................ Pension expense ...................................................
$ 366,000,000 737,000,000 (593,000,000) 13,000,000 154,000,000 $ 677,000,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.2 Ending plan assets ................................................ Beginning plan assets .......................................... Increase in plan assets ......................................... Deduct: Contributions .......................................... Less: Benefits paid ................................ Actual return on plan assets ................................
$ $120,000 200,000 $
2,000,000 (1,780,000) 220,000 (80,000) 300,000
In this case, the difference is added, because the benefits paid exceed the contributions. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.3 HENNEIN COMPANY General Journal Entries
Items
Pension Expense
Cash
Bal. 1/1/25 Service cost 27,500 Dr. Interest costa 28,000 Dr. Actual return* 25,000 Cr. Contributions 20,000 Cr. Benefits Journal entry 30,500 Dr. 20,000 Cr. Bal. 12/31/25
Memo Record Projected Pension Benefit Plan Asset /Liability Obligation Assets 280,000 Cr. 280,000 Dr. 27,500 Cr. 28,000 Cr. 25,000 Dr. 20,000 Dr. 17,500 Dr. 17,500 Cr. 10,500 Cr. 10,500 Cr.
318,000 Cr. 307,500 Dr.
Brief Exercise 19.3 (continued) *Note: We show actual return on the worksheet to ensure that plan assets are properly reported. If expected and actual returns differ, then an additional adjustment is made to compute the proper amount of pension expense. a $280,000 x 0.10 LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.4 Pension Expense.................................................... Pension Asset/Liability................................... Cash.................................................................
73,000,000 2,000,000 71,000,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.5 Cost per service year: $160,000/2,000 = $80 2025 amortization: 350 X $80 = $28,000 LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.6 Project benefit obligation ....................................................... Plan assets at fair value .......................................................... Pension liability .......................................................................
$(560,000) 322,000 $(238,000)
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.7 Net loss in accumulated OCI .................................................. Corridor (.10 X $3,300,000) ..................................................... Excess...................................................................................... Average remaining service life ............................................... Minimum amortization ............................................................ LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.8
$465,000 (330,000) 135,000 ÷ 7.5 $ 18,000
Projected benefit obligation ................................................... Fair value of plan assets ......................................................... Pension liability (classified short-term or long-term depending on when due) ...................................
$2,600,000 (2,000,000) $ 600,000
Prior service cost is reported as a component of accumulated other comprehensive income in stockholders’ equity. LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 19.9 (a) Other Comprehensive Loss for 2025 is as follows: Actuarial liability loss .............................................. Unexpected asset gain ............................................ Other comprehensive loss ......................................
($ 28,000) 18,000 ($ 10,000)
(b) The computation of comprehensive income for 2025 is as follows: Net income ............................................................... Other comprehensive loss ...................................... Comprehensive income........................................... LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 26,000 10,000 $ 16,000
*Brief Exercise 19.10 Service cost ............................................................................... Interest cost ............................................................................... Expected return on plan assets ............................................... Postretirement expense ............................................................
$40,000 47,400 (26,900) $60,500
LO: 6, 7, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 19.11 Postretirement Expense .............................................. Cash....................................................................... Postretirement Asset /Liability .............................
240,900
LO: 6, 7, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
180,000 60,900
Solutions to Exercises Exercise 19.1 (15-20 minutes) (a) Computation of pension expense: Service cost ..................................................... Interest cost ($500,000 X .10) ......................... Expected return on plan assets ..................... Prior service cost amortization ...................... Pension expense for 2025 .............................. (b) Pension Expense .................................................... Cash ................................................................. Pension Asset /Liability ................................... Other Comprehensive Income (PSC) .............
$ 60,000 50,000 (15,000) 8,000 $103,000 103,000 90,000 5,000 8,000
LO: 1, 2, Bloom: AN, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.2 (10–15 minutes) Computation of pension expense: Service cost............................................................. Interest cost ($700,000 X .10) ................................. Expected return on plan assets ............................. Prior service cost amortization .............................. Pension expense for 2025 ...................................... LO: 1, 2, 3, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 90,000 70,000 (64,000) 10,000 $106,000
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, January 1, 2025 Service cost 90,000 Dr. Interest cost* 70,000 Dr. Actual return** 64,000 Cr. Amortization of PSC 10,000 Dr. 10,000 Cr. Contributions 105,000 Cr. Benefits Journal entry for 2025*** 106,000 Dr. 105,000 Cr. 10,000 Cr. 150,000 Dr. Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025 140,000 Dr.
60,000 Cr.
Memo Record Projected Benefit Obligation Plan Assets 700,000 Cr. 90,000 Cr. 70,000 Cr.
640,000 Dr. 64,000 Dr.
40,000 Dr.
105,000 Dr. 40,000 Cr.
820,000 Cr.
769,000 Dr.
9,000 Dr. 51,000 Cr.
*$70,000 = $700,000 X .10. **Note: We show actual return on the worksheet to ensure that plan assets are properly reported. If expected and actual return differ, then an additional adjustment is made to compute the proper amount of pension expense.
(For Instructor Use Only)
***Pension Expense ................................................. ***Pension Asset/Liability ........................................ Other Comprehensive Income (PSC) ......... Cash .............................................................
106,000 9,000 10,000 105,000
LO: 1, 2, 3, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.3 (15–25 minutes)
Copyright © 2022 WILEY
Items
VELDRE COMPANY Pension Worksheet—2025 General Journal Entries Annual OCI Pension Prior Service Pension Expense Cash Cost Asset/Liability
19-17
Copyright © 2022 WILEY Kieso, Intermediate Accounting, 18/e, Solutions Manual
40,000 Dr. 39,200 Dr. 49,700 Cr. 25,000 Cr. 29,500 Dr.
25,000 Cr.
4,500 Cr. 4,500 Cr.
Memo Record Projected Benefit Plan Obligation Assets 490,000 Cr. 490,000 Dr. 40,000 Cr. 39,200 Cr. 49,700 Dr. 25,000 Dr. 33,400 Dr. 33,400 Cr. 535,800 Cr.
531,300 Dr.
*$39,200 = $490,000 X .08.
(For Instructor Use Only)
**Note: We show actual return on the worksheet to ensure that plan assets are properly reported. If expected and actual return differ, then an additional adjustment is made to compute the proper amount of pension expense. Pension Expense .................................................. Pension Asset/Liability................................ Cash ..............................................................
29,500 4,500 25,000
LO: 1, 2, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.4 (10–15 minutes)
19-18
Items Balance, January 1, 2025 Service cost Interest cost* Actual return** Contributions Benefits Journal entry, December 31 Balance, December 31, 2025
BOUDREAU INC. Pension Worksheet—2025 General Journal Entries Annual Pension Pension Asset/ Expense Cash Liability
Exercise 19.5 (15–25 minutes) Computation of Service-Years Year 2025 2026 2027 2028 2029 2030
Jim 1 1 1
Paul 1 1 1 1
Nancy 1 1 1 1 1
3
4
5
Dave 1 1 1 1 1 1 6
Kathy 1 1 1 1 1 1 6
Total 5 5 5 4 3 2 24
Cost per service-year: $72,000 ÷ 24 = $3,000 Computation of Annual Prior Service Cost Amortization Year
Total Service-Years
Cost Per Service-Year
Annual Amortization
2025 2026 2027 2028 2029 2030
5 5 5 4 3 2
$3,000 3,000 3,000 3,000 3,000 3,000
$15,000 15,000 15,000 12,000 9,000 6,000 $72,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.6 (10–15 minutes) Computation of Actual Return on Plan Assets Fair value of plan assets at 12/31/25 ....................... Fair value of plan assets at 1/1/25 ........................... Increase in fair value of plan assets ....................... Deduct: Contributions to plan during 2025 ........... Less benefits paid during 2025 ................ Actual return on plan assets for 2025 .....................
$2,725,000 (2,400,000) 325,000 $280,000 350,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
(70,000) $ 395,000
Copyright © 2022 WILEY Kieso, Intermediate Accounting, 18/e, Solutions Manual (For Instructor Use Only))
Items Balance, Dec. 31, 2024 Prior service cost Balance, Jan. 1, 2025 Service cost 58,000 Dr. Interest cost* 61,200 Dr. Actual return** 52,280 Cr. Amortization of PSC 17,000 Dr. Contributions Benefits Journal entry for 2025 83,920 Dr. Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
Pension Asset/ Liability 13,800 Cr.
Memo Record Projected Benefit Plan Obligation Assets 560,000 Cr. 546,200 Dr. 120,000 Cr. 680,000 Cr. 546,200 Dr. 58,000 Cr. 61,200 Cr. 52,280 Dr.
17,000 Cr. 65,000 Cr. 65,000 Cr. 103,000 Dr. 0 103,000 Dr.
40,000 Dr.
65,000 Dr. 40,000 Cr.
759,200 Cr.
623,480 Dr.
121,920 Cr. 135,720 Cr.
*$61,200 = $680,000 X .09. **Note: We show actual return on the worksheet to ensure that plan assets are properly reported. If expected and actual returns differ, then an additional adjustment is made to compute the proper amount of pension expense. LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.7 (15–25 minutes)
19-20
RYDELL CORP. Pension Worksheet—2025 General Journal Entries Annual OCI–Prior Pension Service Expense Cash Cost 0 120,000 Dr.
Exercise 19.8 (20–25 minutes) Corridor and Minimum Loss Amortization
Year
Projected Benefit Obligation (a)
Plan Assets
10% Corridor
Accumulated OCI (G/L) (a)
Minimum Amortization of Loss
2024 2025 2026 2027
$2,000,000 2,400,000 2,950,000 3,600,000
$1,900,000 2,500,000 2,600,000 3,000,000
$200,000 250,000 295,000 360,000
$ 0 280,000 367,000(c) 372,000(e)
$ 0 3,000(b) 6,000(d) 1,000(f)
(a) (b) (c) (d) (e) (f)
As of the beginning of the year. ($280,000 – $250,000) ÷ 10 years = $3,000 $280,000 – $3,000 + $90,000 = $367,000 ($367,000 – $295,000) ÷ 12 years = $6,000 $367,000 – $6,000 + $11,000 = $372,000 ($372,000 – $360,000) ÷ 12 years = $1,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
EXERCISE 19.9 (25–35 minutes) (a) Note to financial statements disclosing components of 2025 pension expense: Note X: Net pension expense for 2025 is composed of the following components of pension cost: Service cost .............................................................. Interest cost.............................................................. Expected return on plan assets .............................. Prior service cost amortization ............................... Pension expense ..............................................
$ 94,000 253,000 (175,680) 42,000 $213,320
(b) Comprehensive income, 2025 Amortization of prior service cost .......................... Actuarial loss ........................................................... Other comprehensive loss ......................................
$ (42,000) 45,680 $ 3,680
Comprehensive income, 2025 Net income ............................................................... Other comprehensive loss ...................................... Comprehensive income...........................................
$ 35,000 3,680 $ 31,320
Exercise 19.9 (Continued) (c)
Accumulated OCI at December 31, 2025 is $255,680; this amount is comprised of the following:
Balance Jan. 1, 2025* Amortization of PSC Unexpected loss Balance Dec. 31, 2025
PSC $252,000 Dr. 42,000 Cr. $210,000 Dr.
Gain/Loss $ 0 — 45,680 Dr. $45,680 Dr.
*$210,000 + $42,000 While not required, the pension worksheet on the next page could be prepared.
Annual Pension Expense
Cash
OCI—Prior Service Cost
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2025 Service cost 94,000 Dr. Interest cost 253,000 Dr. Actual return 130,000 Cr. Unexpected gain 45,680 Cr. Amortization of PSC 42,000 Dr. 42,000 Cr. Contributions 93,329 Cr. Benefits Journal entry for 2025 213,320 Dr. 93,329 Cr. 42,000 Cr. Accumulated OCI, Dec. 31, 2024 252,000 Dr. Balance, Dec. 31, 2025 210,000 Dr.
OCI— Gain/Loss
Memo Record Pension Asset/ Liability
Projected Benefit Obligation
Plan Assets
335,000 Cr. 2,530,000 Cr.1 2,195,000 Dr.2 94,000 Cr. 253,000 Cr. 130,000 Dr. 45,680 Dr.
45,680 Dr. 0 45,680 Dr.
140,000 Dr.
93,329 Dr. 140,000 Cr.
458,671 Cr. 2,737,000 Cr.
2,278,329 Dr.
123,671 Cr.
$2,737,000 + $140,000 – $253,000 – $94,000. $2,278,329 + $140,000 – $93,329 – $130,000.
1 2
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.9 (Continued)
Copyright © 2022 WILEY
General Journal Entries
(For Instructor Use Only)
19-23
Copyright © 2022 WILEY Kieso, Intermediate Accounting, 18/e, Solutions Manual
Items
Annual Pension Expense
WEBB CORP. Pension Worksheet General Journal Entries OCI—Prior Service OCI— Cash Cost Gain/Loss
Balance, Jan. 1, 2025 Service cost 90,000 Dr. Interest cost* 54,000 Dr. Actual return 55,000 Cr. Unexpected gain** 3,000 Dr. Amortization of PSC 19,000 Dr. 19,000 Cr. Liability increase Contributions 99,000 Cr. Benefits Journal entry for 2025 111,000 Dr. 99,000 Cr. 19,000 Cr. Accumulated OCI, Dec. 31, 2024 100,000 Dr. Balance, December 31, 2025 81,000 Dr.
Pension Asset/ Liability 120,000 Cr.
(For Instructor Use Only)
Journal Entry Pension Expense .................................................................. Other Comprehensive Income (G/L) ................................... Cash .......................................................................... Other Comprehensive Income (PSC) .................... Pension Asset /Liability ...........................................
600,000 Cr. 90,000 Cr. 54,000 Cr.
480,000 Dr.
55,000 Dr. 3,000 Cr. 76,000 Dr.
73,000 Dr. 0 73,000 Dr.
76,000 Cr. 85,000 Dr.
99,000 Dr. 85,000 Cr.
735,000 Cr.
549,000 Dr.
66,000 Cr. 186,000 Cr.
*$54,000 = $600,000 X .09. **Expected return = $52,000. Unexpected gain = Actual return minus expected return; $3,000 = $55,000 – $52,000. (b)
Memo Record Projected Benefit Obligation Plan Assets
111,000 73,000 99,000 19,000 66,000
LO: 1, 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.10 (20–25 minutes)
19-24 (a)
Exercise 19.11 (20–30 minutes) (a) Pension expense for 2025 composed of the following: Service cost ....................................................... $ 56,000 Interest on projected benefit obligation (.09 X $900,000) ............................................. 81,000 Expected return on plan assets ....................... (54,000) Amortization of prior service cost ................... 50,000 Pension expense ....................................... $133,000 (b) Pension Expense ...................................................... 133,000 Pension Asset /Liability ............................................ 62,000 Cash ................................................................... 145,000 Other Comprehensive Income (PSC) ............... 50,000 (c) Income Statement – Operating Expense Pension expense ............................................... $56,000 Income Statement – Other Income or expense Pension Expense (Other components)............ $77,000a a $81,000 + $50,000 - $54,000
Comprehensive Income Statement Net income ................................................................ Other comprehensive income Amortization of PSC .............................................. Comprehensive income ........................................... Balance Sheet Liabilities Pension liability ................................................. *Projected benefit obligation Plan assets Pension liability Partial worksheet Bal. January 1, 2025 Service cost Interest on PBO Actual return Contribution Bal. December 31, 2025
$ XXXX 50,000 $ XXXX
$238,000*
$1,037,000 (799,000) $ 238,000 Projected Benefit Obligation $ 900,000 56,000 81,000
Plan Assets $600,000 54,000 145,000 $799,000
Stockholders’ equity Accumulated OCI (PSC) Jan. 1, 2025 Amortization of prior service cost Accumulated OCI (PSC) Dec. 31, 2025
$1,037,000 400,000 (50,000) 350,000
LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.12 (20–30 minutes) (a) Pension expense for 2025 composed of the following: Service cost ................................................... Interest on projected benefit obligation (.10 X $1,500,000)....................................... Expected return on plan assets (.10 X $800,000).......................................... Amortization of prior service cost ............... Pension expense ................................... (b) Pension Expense .................................................. Pension Asset /Liability ........................................ Cash ............................................................... Other Comprehensive Income (PSC) ........... Other Comprehensive Income (G/L) ............ (To record pension expense and employer’s contribution) (c) Income Statement: Operating expense Pension expense (Service cost) ................... Other Income or expense Pension expense (Other components) ........ ($267,000 – $77,000)
$ 77,000 150,000 (80,000) 120,000 $267,000
267,000 303,000 250,000 120,000 200,000
$ 77,000 $190,000
Comprehensive Income Statement Net income ..................................................... $ XXXX Other comprehensive income (loss) Amortization of PSC ............................... $120,000 Liability gain ............................................ 200,000 320,000 Comprehensive income........................................ $ XXXX Balance Sheet: Liabilities Pension liability .....................................
$ 397,000*
Stockholders’ Equity Accumulated OCI (PSC) ................................ Accumulated OCI (G/L) .................................
$1,080,000** 200,000
Exercise 19.12 (Continued)
*Projected benefit obligation, Dec. 31, 2025 Plan assets, Dec. 31, 2025 Pension liability **$1,200,000 – $120,000
$1,527,000 (1,130,000) $ 397,000
Copyright © 2022 WILEY Kieso, Intermediate Accounting, 18/e, Solutions Manual
General Journal Entries
Items
Annual Pension Expense
Cash
OCI—Prior Service Cost
Balance, Jan. 1, 2025 Service cost 77,000 Dr. Interest cost* 150,000 Dr. Actual return** 80,000 Cr. Amortization of PSC 120,000 Dr. 120,000 Cr. Liability gain Contributions 250,000 Cr. Journal entry, for 2025 267,000 Dr. 250,000 Cr. 120,000 Cr. Accumulated OCI, Dec. 31, 2024 1,200,000 Dr. Balance, Dec. 31, 2025 1,080,000 Dr.
OCI— Gain/Loss
Memo Record Pension Asset/Liability
Projected Benefit Obligation
700,000 Cr. *1,500,000 Cr. 77,000 Cr. 150,000 Cr.
Plan Assets 800,000 Dr.
80,000 Dr. 200,000 Cr.
200,000 Dr. 250,000 Dr.
200,000 Cr. 0 200,000 Cr.
303,000 Dr. 397,000 Cr.
1,527,000 Cr. 1,130,000 Dr.
(For Instructor Use Only)
*$1,500,000 X 10%. **Note: We show actual return on the worksheet to ensure that plan assets are properly reported. If expected and actual returns differ, then an additional adjustment is made to compute the proper amount of pension expense. LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.12 (Continued)
19-28 Note to instructor: To prove the amounts reported, a worksheet might be prepared as follows:
Exercise 19.13 (35–45 minutes) (a) Actual Return = (Ending – Beginning fair value of assets) – (Contributions – Benefits) Fair value of plan assets, December 31, 2025 ........................................ Deduct: Fair value of plan assets, January 1, 2025 ............................................. Increase in fair value of plan assets ................ Deduct: Contributions ...................................... $700 Less benefits paid .............................. 200 Actual return on plan assets in 2025 ...............
$2,620 1,700 920 500 $ 420
(b) Computation of pension liability gains and losses and pension asset gains and losses. 1.
Difference between 12/31/25 actuarially computed PBO and 12/31/25 recorded projected benefit obligation (PBO): PBO at end of year ............................. $3,300 PBO per memo records: 1/1/25 PBO ...................................... $2,500 Add interest (10%) ......................... 250 Add service cost ............................ 400 Less benefits paid.......................... 200 2,950 Liability loss ................................... $350
2.
Difference between actual fair value of plan assets and expected fair value: 12/31/25 actual fair value of plan assets ............................. Expected fair value 1/1/25 fair value of plan assets...... 1,700 Add expected return ($1,700 X .10) .............................. 170 Add contributions .......................... 700 Less benefits paid.......................... 200 Asset gain....................................... Net (gain) or loss................................
2,620
(2,370) 250 ($100)
(c) Because no net gain or loss existed at the beginning of the period, no amortization occurs. Therefore, the corridor calculation is not needed. An example of how the corridor would have been computed is illustrated on the next page, assuming a net loss of $240 at the beginning of the year.
Exercise 19.13 (Continued) Beginning-of-the-Year Accumulated OCI (G/L) $240
Loss Amortization –0–
(d) Pension expense for 2025: Service cost ................................................................. Interest cost ($2,500 X .10) ......................................... Actual return on plan assets [from (a)] ...................... Unexpected gain [from (b) 2.] ..................................... Pension expense .........................................................
$ 400 250 (420)* 250 $ 480
Year 2025
Plan PBO Assets (FV) $2,500 $1,700
10% Corridor $250
*Expected return + Asset gain = $170 + 250 = $420. LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 35-45, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Items Balance, Jan. 1, 2025 Service cost Interest cost(a) Actual return(b) Unexpected gain(c) Contributions Benefits Liability increase(d) Journal entry for 2025 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
Annual Pension Expense
Cash
OCI— Gain/Loss
Pension Asset/Liability 800 Cr.
400 Dr. 250 Dr. 420 Cr. 250 Dr.
Memo Record Entries Projected Benefit Plan Obligation Assets 2,500 Cr. 400 Cr. 250 Cr.
420 Dr. 250 Cr. 700 Cr.
480 Dr.
700 Cr.
(a)
(For Instructor Use Only)
$2,500 X 10% $420 = ($2,620 – $1,700) – ($700 – $200) (c) Actual return Expected return ($1,700 X .10) Asset gain (d) $350 = $3,300 – ($2,500 + $400 + $250 – $200)
1,700 Dr.
(b)
$420 (170) $250
350 Dr. 100 Dr. 0 100 Dr.
200 Dr. 350 Cr.
700 Dr. 200 Cr.
120 Dr. 680 Cr.
3,300 Cr.
2,620 Dr.
Exercise 19.14 (40–50 minutes)
Copyright © 2022 WILEY
ERICKSON COMPANY Pension Worksheet—2025 General Journal Entries
19-31
Exercise 19.14 (Continued) Journal entries 12/31/25 Other Comprehensive Income (G/L) ..................... Pension Expense ................................................... Pension Asset /Liability ......................................... Cash ................................................................
100 480 120 700
Balance Sheet at December 31, 2025 Liabilities Pension liability ..............................................
$680
Stockholders’ equity Accumulated other comprehensive loss (G/L) ....................................................
$100
LO: 1, 2, 4, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.15 (15–20 minutes) (a) Computation of pension expense: Service cost ................................................... Interest cost ($700,000 X .10) ....................... Expected return on plan assets ................... Pension expense for 2025 ............................ Pension Expense .................................................. Pension Asset /Liability ........................................ Cash ............................................................... (b) Income Statement: Operating expenses Pension expense (Service cost) ............. Other revenues or expense Pension expense (Other components) ... ($140,000 – $80,000) Balance Sheet: Liabilities Pension liability .................................... *$25,000 – $10,000
$ 80,000 70,000 (10,000) $140,000 140,000 10,000 150,000
$ 80,000 $60,000
$ 15,000*
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Annual Pension Expense Balance, Jan. 1, 2025 Service cost Interest cost Actual return Contributions Benefits Journal entry for 2025 Balance, Dec. 31, 2025
Cash
Pension Asset/Liability 25,000 Cr.
80,000 Dr. 70,000 Dr. 10,000 Cr.
Memo Record Entries Projected Benefit Plan Obligation Assets 700,000 Cr. 80,000 Cr. 70,000 Cr.
35,000 Dr.
10,000 Dr. 150,000 Dr. 35,000 Cr.**
815,000 Cr.
800,000 Dr.
150,000 Cr. 140,000 Dr.
150,000 Cr.
10,000 Dr. 15,000 Cr.
675,000 Dr.*
*$700,000 – $25,000. **$800,000 – ($675,000 + $10,000 + $150,000) = $35,000. LO: 1, 2, 5, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 19.15 (Continued)
Copyright © 2022 WILEY
General Journal Entries
(For Instructor Use Only)
19-33
Exercise 19.16 (25–35 minutes) The excess of the cumulative net gain or loss over the corridor amount is amortized by dividing the excess by the average remaining service period of employees. The average remaining service period is computed as follows: Expected future years of service = Average remaining service life per employee Number of employees Average remaining service life per employee = 14 (5,600 / 400)
Amortization of Net (Gain) or Loss (Gain) or Loss For the Year Ended December 31,
Amount
2025 2026 2027 2028
(300,000 (480,000 (210,000) (290,000)
Year
Projected Benefit Obligation (a)
Plan Assets (a)
Corridor (b)
Accumulated OCI (G/L) (a)
2025 2026 2027 2028
$4,000,000 4,520,000 5,000,000 4,240,000
$2,400,000 2,200,000 2,600,000 3,040,000
$400,000 452,000 500,000 424,000
$ 0 300,000 780,000 550,000(d)
Minimum Amortization of (Gain) Loss $
0 0 20,000(c) 9,000(e)
(a) As of the beginning of the year. (b) The corridor is 10 percent of the greater of the projected benefit obligation or plan assets. (c) $780,000 – $500,000 = $280,000; $280,000/14 = $20,000. (d) $780,000 – $ 20,000 – $210,000 = $550,000. (e) $550,000 – $424,000 = $126,000; $126,000/14 = $9,000. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 19.17 (30–40 minutes) (a) Year 2025 2026
Prior Service Cost Amortized $120,000 120,000
($1,260,000 ÷ 10.5 years) ($1,260,000 ÷ 10.5 years)
(b) The excess of the accumulated OCI (G/L) over the corridor amount is amortized by dividing the excess by the average remaining service life per employee. The average service life is 10.5 years. Amortization of Net (Gain) or Loss (Gain) or Loss For the Year Ended December 31,
Amount
2025 2026
($198,000 (24,000)
Year
Projected Benefit Obligation (a)
Plan Assets(a)
10% Corridor(b)
Accumulated OCI (G/L)(a)
2025 2026
$2,800,000 3,650,000
$1,700,000 2,900,000
$280,000 365,000
($ 0 198,000
Minimum Amortization of (Gain) Loss $ –0– –0–(c)
(a) As of the beginning of the year. (b) The corridor is 10 percent of the greater of the projected benefit obligation or plan assets. (c) $365,000 is greater than $198,000; therefore, no amortization.
(c) Pension expense for 2025 is composed of the following: Service cost ................................................................. Interest on projected benefit obligation ($2,800,000 X .09) .................................................... Expected return on plan assets ($1,700,000 X .10) .................................................... Amortization of prior service cost ............................. Pension expense .................................................
$ 400,000 252,000 (170,000) 120,000 $ 602,000
Exercise 19.17 (Continued) Pension expense for 2026 is composed of the following: Service cost ..................................................................... Interest on projected benefit obligation ($3,650,000 X .08)......................................................... Expected return on plan assets ($2,900,000 X .10)......................................................... Amortization of prior service cost ................................. Pension expense .....................................................
$475,000 292,000 (290,000) 120,000 $597,000
Annual Pension Expense
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2025 Service cost Interest cost Actual return Amortization of PSC Contributions Actuarial loss Journal entry for 2025
Cash
OCI— Gain/Loss
Pension Asset/ Liability
Projected Benefit Obligation
120,000 Cr. 1,030,000 Cr.
602,000 Dr. 1,030,000 Cr.
1,030,000 Dr. 120,000 Cr.
198,000 Dr. 198,000 Dr.
350,000 Dr.
198,000 Cr.
1,260,000 Dr. 1,140,000 Dr.
0 198,000 Dr.
750,000 Cr. 3,650,000 Cr. 2,900,000 Dr.
475,000 Dr. 292,000 Dr. 290,000 Cr.
475,000 Cr. 292,000 Cr. 290,000 Dr. 222,000 Cr.*
120,000 Dr.
(For Instructor Use Only)
597,000 Dr.
Plan Assets
1,100,000 Cr. 2,800,000 Cr. 1,700,000 Dr. 400,000 Cr. 252,000 Cr. 170,000 Dr.
400,000 Dr. 252,000 Dr. 170,000 Cr. 120,000 Dr.
Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025 Service cost Interest cost Actual return Actuarial gain Amortization of PSC Contributions Journal entry for 2026 Accumulated OCI, Dec. 31, 2025 Balance, Dec. 31, 2026
OCI—Prior Service Cost
Memo Record
222,000 Dr.
120,000 Cr. 600,000 Cr. 600,000 Cr.
600,000 Dr. 120,000 Cr. 1,140,000 Dr. 1,020,000 Dr.
222,000 Cr. 198,000 Dr. 24,000 Cr.
345,000 Dr. 405,000 Cr. 4,195,000 Cr. 3,790,000 Dr.
*$198,000 + $24,000. LO: 1, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 19.17 (Continued)
Copyright © 2022 WILEY
General Journal Entries
19-37
Exercise 19.18 (20–25 minutes) (a) Below is the completed worksheet, indicating debit and credit entries. Annual Pension Expense Balance, Jan. 1, 2025 Service cost Interest cost Actual return Unexpected gain Amortization of PSC Contributions Benefits Liability increase Journal entry Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
General Journal Entries OCI—Prior Service OCI—Gain/ Cash Cost Loss
Pension Asset/Liability 1,100 Cr.
500 Dr. 280 Dr. 220 Cr. 150 Dr. 55 Dr.
Memo Record Projected Benefit Plan Obligation Assets 2,800 Cr. 500 Cr. 280 Cr.
220 Dr. 150 Cr. 55 Cr. 800 Cr.
765 Dr.
1,700 Dr.
800 Cr.
55 Cr. 1,100 Dr. 1,045 Dr.
365 Dr. 215 Dr. 0 215 Dr.
(b) Pension Expense ......................................... Other Comprehensive Income (G/L) .......... Pension Asset/Liability ........................... Cash ......................................................... Other Comprehensive Income (PSC) .....
200 Dr. 365 Cr.
800 Dr. 200 Cr.
125 Cr. 1,225 Cr.
3,745 Cr.
2,520 Dr.
765 215 125 800 55
(c) Usher records no amortization of gain or loss in 2025, because there were no gains or losses at the beginning of the year. For 2026, the corridor is $374.50 (10% of the PBO). Since the balance of the Other Comprehensive Income (G/L) at the beginning of 2026 ($215) is less than the corridor, there will be no gain or loss amortization in 2026 either. LO: 1, 2, 3, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
*Exercise 19.19 (5–10 minutes) Postretirement benefit expense is comprised of the following: Service cost ............................................................. Interest on the liability (.08 X $330,000) ................. Actual and expected return on plan assets ........... Postretirement expense .......................................... LO: 6, 7, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$45,000 26,400 (11,000) $60,400
*Exercise 19.20 (25–30 minutes) General Journal Entries Annual Postretirement Postretirement Expense Cash Asset/Liability Balance, Jan. 1, 2025 Service cost Interest cost Actual return Contributions Benefits Journal entry for 2025 Balance, Dec. 31, 2025
220,000 Cr. 45,000 Dr. 26,400 Dr. 11,000 Cr. 10,000 Cr. 60,400 Dr.
10,000 Cr.
50,400 Cr. 270,400 Cr.
Postretirement Expense ........................................ Postretirement Asset/Liability ....................... Cash ................................................................
Memo Record
APBO
Plan Assets
330,000 Cr. 110,000 Dr. 45,000 Cr. 26,400 Cr. 11,000 Dr. 10,000 Dr. 20,000 Dr. 20,000 Cr. 381,400 Cr. 111,000 Dr.
60,400 50,400 10,000
LO: 6, 7, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 19.21 (10–12 minutes) Service cost ................................................................... Interest on accumulated postretirement benefit obligation (.10 X $710,000) ............................ Expected return on plan assets ................................... Amortization of prior service cost ............................... Postretirement expense ................................................
$ 83,000 71,000 (34,000) 21,000 $141,000
LO: 6, 7, Bloom: AP, Difficulty: Simple, Time: 10-12, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
*Exercise 19.22 (10–12 minutes) Service cost ................................................................... Interest on accumulated postretirement benefit obligation (.09 X $760,000) ............................ Expected return on plan assets ................................... Amortization of prior service cost ............................... Postretirement expense ................................................ LO: 6, 7, Bloom: AP, Difficulty: Simple, Time: 10-12, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 90,000 68,400 (62,000) 3,000 $ 99,400
*Exercise 19.23 (15–20 minutes) See worksheet on next page.
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Items Balance, Jan. 1, 2025 Service cost Interest cost Actual return Contributions Benefits Amortization of PSC Journal entry for 2025 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
Annual Postretirement Expense
Cash
OCI—Prior Postretirement Service Cost Asset/Liability 50,000 Cr.
90,000 Dr. *68,400 Dr. 62,000 Cr. 56,000 Cr. 3,000 Dr. 99,400 Dr. 56,000 Cr.
Memo Record
3,000 Cr. 3,000 Cr. 100,000 Dr. 97,000 Dr.
APBO
760,000 Cr. 710,000 Dr. 90,000 Cr. 68,400 Cr. 62,000 Dr. 56,000 Dr. 40,000 Dr. 40,000 Cr.
40,400 Cr. 90,400 Cr.
878,400 Cr. 788,000 Dr.
(For Instructor Use Only)
*($760,000 X .09)
Postretirement Expense ................................................ Other Comprehensive Income (PSC) ............ Postretirement Asset/Liability ....................... Cash ................................................................
Plan Assets
99,400
LO: 6, 7, Bloom: AP, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
LO: 6, 7, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
3,000 40,400 56,000
*Exercise 19.23 (15–20 minutes)
Copyright © 2022 WILEY
ENGLEHART CO. Postretirement Benefit Worksheet—2025 General Journal Entries
19-41
*Exercise 19.24 (25–30 minutes) (a) Below is the completed worksheet, indicating debit and credit entries.
General Journal Entries Other Comprehensive Cash Income—PSC
Annual Expense Balance, Jan. 1, 2025 Service cost Interest cost Actual/Expected return Contributions Benefits Amortization of PSC Journal entry for 2025 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
Memo Record Entries Postretirement Asset/Liability 290,000 Cr.
56,000 Dr. 36,900 Dr. 2,000 Cr.
APBO 410,000 Cr. 56,000 Cr. 36,900 Cr.
66,000 Cr.
3,000 Cr. 3,000 Cr. 30,000 Dr. 27,000 Dr.
120,000 Dr.
5,000 Dr.
2,000 Dr. 66,000 Dr. 5,000 Cr.
497,900 Cr.
183,000 Dr.
66,000 Cr. 3,000 Dr. 93,900 Dr.
Plan Assets
24,900 Cr. 314,900 Cr.
(b) Postretirement Expense ................................... Cash............................................................ Other Comprehensive Income (PSC) ....... Postretirement Asset/Liability ..................
93,900 66,000 3,000 24,900
(c) The discount (settlement) rate can be determined by dividing the interest cost by the beginning APBO: $36,900 ÷ $410,000 = 9% LO: 6, 7, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Time and Purpose of Problems Problem 19.1 (Time 40–50 minutes) Purpose—to provide a problem that requires preparation of a pension worksheet for two years’ pension transactions. Included in the problem are an unexpected loss and prior service cost amortization. Problem 19.2 (Time 45–55 minutes) Purpose—to provide a problem that requires preparation of a pension worksheet for three years’ pension transactions, three years of general journal entries for the pension plan, and reporting in financial statements for the third year. Problem 19.3 (Time 40–50 minutes) Purpose—to provide a problem that requires computation of the annual pension expense, preparation of the pension journal entries, measurement of gains and losses and their amortization, and presentation in financial statements. Problem 19.4 (Time 30–40 minutes) Purpose—to provide a problem that requires computation of pension expense and preparation of the pension journal entries for two years. Problem 19.5 (Time 45–55 minutes) Purpose—to provide a problem that requires computation of the pension expense for three years and the preparation of the pension journal entries for those three years. Problem 19.6 (Time 45–60 minutes) Purpose—to provide a problem that requires computation and amortization of prior service cost, computation of pension expense, and preparation of pension journal entries. Problem 19.7 (Time 35–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet. Problem 19.8 (Time 45–60 minutes) Purpose—to provide a problem that requires preparation of a comprehensive worksheet for two years, covering all facets of pension accounting. Problem 19.9 (Time 40–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet for two years, journal entries, and indicates financial statement presentation. Problem 19.10 (Time 25–30 minutes) Purpose—to provide a problem to understand elements of a pension worksheet. Problem 19.11 (Time 35–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet, journal entries, and indicates financial statement presentation (year 2 of P19.10).
Time and Purpose of Problems (Continued) Problem 19.12 (Time 35–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet, journal entries, and indicates financial statement presentation. *Problem 19.13 (Time 30–35 minutes) Purpose—to provide a problem that requires preparation of a worksheet and entries for postretirement benefit expense. *Problem 19.14 (Time 40–45 minutes) Purpose—to provide a problem that requires a worksheet for two years, journal entries, and indicates financial statement presentation.
Copyright © 2022 WILEY
(a)
Items
HARRINGTON COMPANY Pension Worksheet—2025 and 2026 General Journal Entries Annual OCI—Prior Pension Service OCI—Gain/ Pension Expense Cash Cost Loss Asset/Liability
108,000 Cr. 408,000 Cr.
4,900,000 Cr. 4,492,000 Dr. 500,000 Cr. 5,400,000 Cr. 180,000 Cr. 540,000 Cr. 260,000 Dr.
280,000 Dr.
285,000 Dr. 280,000 Cr.
675,000 Cr.
0 0 410,000 Dr. 99,360 Dr. 1,083,000 Cr.
(For Instructor Use Only)
*$450,000 = $4,500,000 X .10. **$540,000 = $5,400,000 X .10. ***$99,360 = ($4,492,000 X .08) – $260,000.
(b) Journal Entry (2026) Pension Expense ............................................................... Other Comprehensive Income (PSC) .............................. Other Comprehensive Income (G/L) ................................ Cash ........................................................................... Pension Asset/Liability ............................................
4,500,000 Cr. 4,200,000 Dr. 150,000 Cr. 450,000 Cr. 252,000 Dr. 240,000 Dr. 200,000 Dr. 200,000 Cr.
450,640 410,000 99,360 285,000 675,000
LO: 1, 2, 3, 4, Bloom: AN, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
5,840,000 Cr. 4,757,000 Dr.
Solutions to Problems
Accumulated OCI, Dec. 31, 2025 Balance, Dec. 31, 2026
300,000 Cr.
Problem 19.1
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2025 Service cost 150,000 Dr. Interest cost* 450,000 Dr. Actual return 252,000 Cr. Contributions 240,000 Cr. Benefits Journal entry for 2025 348,000 Dr. 240,000 Cr. 0 0 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025 Additional PSC, 1/1/2026 500,000 Dr. Balance, Jan. 1, 2026 Service cost 180,000 Dr. Interest cost** 540,000 Dr. Actual return 260,000 Cr. Unexpected loss*** 99,360 Cr. 99,360 Dr. Amortization of PSC 90,000 Dr. 90,000 Cr. Contributions 285,000 Cr. Benefits Journal entry for 2026 450,640 Dr. 285,000 Cr. 410,000 Dr. 99,360 Dr.
Memo Record Projected Benefit Plan Obligation Assets
19-45
19-46 (a) Copyright © 2022 WILEY
JACKSON COMPANY Pension Worksheet—2024, 2025, 2026 Annual Pension Expense
(For Instructor Use Only)
Additional PSC, 1/1/2025 Balance, Jan. 1, 2025 Service cost Interest cost(c) Actual return(d) Amortization of PSC Contributions Benefits Journal entry for 2025 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025 Service cost Interest cost(e) Actual return Unexpected loss(f) Amortization of PSC Contributions Benefits Liability gain(g) Journal entry for 2026 Accumulated OCI, Dec. 31, 2025 Balance, Dec. 31, 2026
Memo Record Projected Pension Benefit Plan Asset/Liability Obligation Assets 50,000 Cr.
16,000 Dr. 25,000 Dr. 18,000 Cr. 2,000 Cr.
250,000 Cr. 16,000 Cr. 25,000 Cr.
18,000 Dr. 2,000 Dr. 16,000 Cr.
21,000 Dr.
16,000 Cr.
2,000 Dr. 0 2,000 Dr.
19,000 Dr. 43,700 Dr. 22,000 Cr. 54,400 Dr.
14,000 Dr.
16,000 Dr. 14,000 Cr.
277,000 Cr.
220,000 Dr.
7,000 Cr. 57,000 Cr.
160,000 Dr.
160,000 Cr. 437,000 Cr. 19,000 Cr. 43,700 Cr. 22,000 Dr.
54,400 Cr. 40,000 Cr.
95,100 Dr.
40,000 Cr. 105,600 Dr. 0 105,600 Dr.
26,000 Dr. 48,330 Dr. 24,000 Cr. 2,560 Cr. 41,600 Dr.
0 2,000 Dr. 2,000 Dr.
16,400 Dr.
40,000 Dr. 16,400 Cr.
483,300 Cr.
265,600 Dr.
160,700 Cr. 217,700 Cr.
26,000 Cr. 48,330 Cr. 24,000 Dr. 2,560 Dr. 41,600 Cr. 48,000 Cr.
89,370 Dr.
200,000 Dr.
48,000 Cr.
41,600 Cr. 105,600 Dr. 64,000 Dr.
16,630 Cr. 14,070 Cr. 2,000 Dr. 12,070 Cr.
21,000 Dr. 16,630 Dr.
48,000 Dr. 21,000 Cr.
14,300 Dr. 203,400 Cr.
520,000 Cr.
316,600 Dr.
Problem 19.2
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2024 Service cost Interest cost(a) Actual return Unexpected loss(b) Contributions Benefits Journal entry for 2024 Accumulated OCI, Dec. 31, 2023 Balance, Dec. 31, 2024
General Journal Entries OCI—Prior Service OCI— Cash Cost Gain/Loss
Problem 19.2 (Continued) Worksheet computations: (a)
$25,000 = $250,000 X .10 $2,000 = ($200,000 X .10) – $18,000; expected return exceeds actual return. (c) $43,700 = $437,000 X .10 (d) Expected return and actual return are the same. (e) $48,330 = $483,300 X .10 (f) $2,560 = ($265,600 X .10) – $24,000; expected return exceeds actual return. (g) $16,630 = ($483,300 + $26,000 + $48,330 – $21,000 – $520,000) (b)
(Note to instructor: Because the amount of net gain or loss does not exceed 10% of the larger of the projected benefit obligation or the fair value of the plan assets at the beginning of any of the years, no amortization is recorded. (b) Journal entries: 2024 Other Comprehensive Income (G/L) ....................... Pension Expense ..................................................... Cash .................................................................. Pension Asset /Liability ...................................
2,000 21,000
2025 Other Comprehensive Income (PSC) ..................... Pension Expense ..................................................... Cash .................................................................. Pension Asset /Liability ...................................
105,600 95,100
2026 Pension Expense ..................................................... Pension Asset /Liability ........................................... Other Comprehensive Income (G/L) ............... Other Comprehensive Income (PSC) .............. Cash .................................................................. *$16,630 – $2,560 = $14,070
16,000 7,000
40,000 160,700 89,370 14,300 14,070* 41,600 48,000
Problem 19.2 (Continued) (c) Financial Statements—2026 Income Statement Operating expenses Operating expense (Service cost)............... Other income or expense Pension expense (Other components) ....... ($89,370 – $26,000)
$ 26,000
$ 63,370
Comprehensive Income Statement Net Income ........................................................ $ XXXX Other comprehensive income (loss) Asset gain (loss)............................................... $ (2,560) Liability gain (loss) ........................................... 16,630 Prior service cost amortization ....................... 41,600 (55,670) Comprehensive income........................................... $ XXXX Balance Sheet Liabilities Pension liability ............................................ Stockholders’ equity Accumulated other comprehensive loss (PSC) ...................................................... Accumulated other comprehensive income (G/L) ..................................................
$203,400
$ 64,000
LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
12,070
Problem 19.3
(a) Pension expense for 2025 comprises the following: Service cost ........................................................... Interest on projected benefit obligation (.10 X $380,000) .................................................. Actual return on plan assets ................................. Unexpected loss .................................................... Amortization of gain or loss in 2025 .................... Amortization of prior service cost ........................ ($150,000 ÷ 10 years) ......................................... Pension expense ............................................
$52,000 38,000 (11,000) (9,000)* 0 15,000 $85,000
*([.10 X $200,000] – $11,000) (b)
Journal Entries—2025 Other Comprehensive Income (G/L) ...................... Pension Expense .................................................... Cash ................................................................. Pension Asset /Liability .................................. Other Comprehensive Income (PSC) .............
29,000** 85,000 65,000 34,000 15,000
**Computed in part (c) – $9,000 unexpected loss (plan assets) + $20,000 (liability loss) (c) 2025 Increase/Decrease in Gains/Losses (1) 12/31/25 new actuarially computed PBO Less: Projected benefit obligation per memo record: 1/1/25 PBO $380,000 Add interest (.10 X $380,000) 38,000 Add service cost (given) 52,000 Less benefit payments 0
$490,000
470,000 Liability loss
$20,000
Problem 19.3 (Continued) (2) 12/31/25 fair value of plan assets Less: Expected fair value 1/1/25 fair value of plan assets Add expected return (.10 X $200,000) Add pension plan contribution Less benefit payments Asset loss Net loss at 12/31/25 ($20,000 liability loss + $9,000 asset loss)
$276,000 $200,000 20,000 65,000 0
285,000 9,000 $29,000
No amortization occurs in 2025 because no balance existed in the accumulated OCI (G/L) account at the beginning of 2025. The $29,000 net loss in the accumulated OCI (G/L) account becomes the beginning balance in 2026. The corridor at 1/1/26 is 10% of the greater of $490,000 (PBO) or $276,000 (market-related asset value). Since the corridor of $49,000 is greater than the balance in the accumulated OCI (G/L) account of $29,000, there will be no gain/loss amortization in 2026. (d) Financial Statements—2025 Income Statement Operating expenses Pension expense (service cost) .......... Other income or expense Pension expense (other components) Comprehensive Income Statement Net Income .............................................................. Other comprehensive income (loss) Asset gain (loss).............................................. Liability gain (loss) .......................................... Prior service cost amortization ...................... Comprehensive income.......................................... Balance Sheet Liabilities Pension asset /liability..........................
$ 52,000 $33,000 $ XXXX $ (9,000) (20,000) 15,000
(14,000) $ XXXX
$214,000*
Problem 19.3 (Continued) Stockholders’ equity Accumulated other comprehensive loss (PSC) ......................................... Accumulated other comprehensive loss .......................... *($380,000 – $200,000) + $34,000 **($150,000 – $15,000)
$135,000** $ 29,000
Copyright © 2022 WILEY Kieso, Intermediate Accounting, 18/e, Solutions Manual
Annual Pension Expense Balance, Jan. 1, 2025 Service cost Interest cost Actual return Unexpected loss Liability loss Contributions PSC amortization Journal entry for 2025 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
Cash
OCI—Prior Service Cost
Memo Record OCI— Gain/Loss
Projected Pension Benefit Asset/Liability Obligation 180,000 Cr.
52,000 Dr. 38,000 Dr. 11,000 Cr. 9,000 Cr.
380,000 Cr. 52,000 Cr. 38,000 Cr.
Plan Assets 200,000 Dr.
11,000 Dr. 9,000 Dr. 20,000 Dr.
20,000 Cr.
65,000 Cr. 15,000 Dr. 85,000 Dr. 65,000 Cr.
65,000 Dr. 15,000 Cr. 15,000 Cr. 150,000 Dr. 135,000 Dr.
29,000 Dr. 0 29,000 Dr.
34,000 Cr. 214,000 Cr.
490,000 Cr.
LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Complex, Time: 5-10, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
276,000 Dr.
Problem 19.3 (Continued)
19-52
General Journal Entries
(For Instructor Use Only)
Problem 19.4
(a) Computation of pension expense: 2025 Service cost ...................................................... ($ 60,000 Interest cost ($700,000 X .09) and ($800,000 X .09) .................................... 63,000 Expected return on plan assets ...................... (24,000) Amortization of prior service cost .................. 10,000 Pension expense.............................................. ($109,000 (b) Pension Asset/Liability ..................................... Pension Expense .............................................. Other Comprehensive Income (PSC) ......... Other Comprehensive Income (G/L) .......... Cash .............................................................
Pension Expense ............................................. Cash ............................................................ Pension Asset / Liability.............................. Other Comprehensive Income (PSC) ........
2026 $ 90,000 72,000 (30,000) 12,000 ($144,000
2025 (39,000 109,000 10,000 23,000* (115,000 2026 144,000 120,000 12,000 12,000
*($700,000 + $60,000 + $63,000) − $800,000 Note to instructors: Although not required, students could be encouraged to prepare a 2-year pension worksheet, as shown on the following page.
Copyright © 2022 WILEY Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2025 Service cost Interest cost Actual return Unexpected loss Amortization of PSC Contributions Increase in PBO Journal entry for 2025 Accumulated OCI, Jan. 1, 2025 Balance, Dec. 31, 2025
Cash
OCI—Prior Service Cost
Memo Record OCI— Gain/Loss
Projected Pension Benefit Asset/Liability Obligation 140,000 Cr.
60,000 Dr. 63,000 Dr. 24,000 Cr.
700,000 Cr. 60,000 Cr. 63,000 Cr.
Plan Assets 560,000 Dr.*
24,000 Dr.
10,000 Dr.
10,000 Cr. 115,000 Cr.
109,000 Dr. 115,000 Cr.
115,000 Dr. 10,000 Cr. 250,000 Dr. 240,000 Dr.
Service cost 90,000 Dr. Interest cost 72,000 Dr. Actual return 30,000 Cr. Unexpected gain Amortization of PSC 12,000 Dr. 12,000 Cr. Amortization of loss Contributions 120,000 Cr. Journal entry for 2026 144,000 Dr. 120,000 Cr. 12,000 Cr. Accumulated OCI, Dec. 31, 2025 240,000 Dr. Balance, Dec. 31, 2026 228,000 Dr.
23,000 Cr. 23,000 Cr. 0 23,000 Cr.
23,000 Dr.** 39,000 Dr. 101,000 Cr.
800,000 Cr.
699,000 Dr.
90,000 Cr. 72,000 Cr. 30,000 Dr.
120,000 Dr. 0 23,000 Cr. 23,000 Cr.
12,000 Cr. 113,000 Cr.
(For Instructor Use Only)
*($700,000 – $140,000) **($700,000 + $60,000 + $63,000) – $800,000 LO: 1, 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
962,000 Cr.
849,000 Dr.
Problem 19.4 (Continued)
19-54
General Journal Entries Annual Pension Expense
Problem 19.5
(a) Pension expense for 2025 consisted only of the service cost component amounting to $60,000. There were no prior service cost, net gain or loss, plan assets, or projected benefit obligation as of January 1, 2025. Pension expense for 2026 comprised the following: Service cost .................................................................... Interest on projected benefit obligation ($60,000 X .11) ............................................................. Expected return on plan assets ($50,000 X .10) ............................................................. Amortization of net gain or loss .................................... Amortization of prior service cost ................................. Pension expense .....................................................
$ 85,000 6,600 (5,000) 0 0 $ 86,600
Pension expense for 2027 comprised the following: Service cost .................................................................... Interest on projected benefit obligation ($200,000 X .08) ........................................................... Expected return on plan assets ($85,000 X .10) ............................................................. Amortization of net gain or loss (1) ............................... Amortization of prior service cost ................................. Pension expense .....................................................
$119,000 16,000 (8,500) 4,867 0 $131,367
Problem 19.5 (Continued) (1) Year 2025 2026 2027
Projected Benefit Plan Assets Obligation (a) (a)
Corridor (b)
$
$
0 60,000 200,000
$ 0 50,000 85,000
0 6,000 20,000
Accumulated OCI (G/L) (a)
Minimum Amortization of (Gain) Loss
$(
0 0 78,400
$(
0 0 4,867 (c)
(a) As of the beginning of the year. (b) The corridor is 10 percent of the greater of the projected benefit obligation or plan assets. (c) $78,400 – $20,000 = $58,400; $58,400/12 = $4,867
(b)
Journal Entries—2025 Pension Expense ..................................................... Cash .................................................................. Pension Asset /Liability ....................................
60,000
Journal Entries—2026 Pension Expense ..................................................... Other Comprehensive Income (G/L) ....................... Cash .................................................................. Pension Asset /Liability ....................................
86,600 78,400
Journal Entries—2027 Pension Expense ...................................................... Other Comprehensive Income (G/L) ........................ Cash ................................................................... Pension Asset /Liability .....................................
131,367 2,633*
50,000 10,000
60,000 105,000
105,000 29,000
*Note: The debit to Other Comprehensive Income (G/L) is a plug figure. It equals the corridor amortization credit ($4,867) netted against an additional loss in 2027 of $7,500. Note to instructors: Although not required, students could be encouraged to prepare a 3-year worksheet, as presented on the following page.
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2025 Service cost Interest cost Expected return Contributions Journal entry for 2025 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
(For Instructor Use Only)
Service cost Interest cost Actual return Contributions Increase in liability Benefits Journal entry for 2026 Accumulated OCI, Dec. 31, 2025 Balance, Dec. 31, 2026
60,000 Dr.
Memo Record Projected Benefit Plan Obligation Assets 60,000 Cr.
50,000 Cr. 60,000 Dr. 50,000 Cr.
50,000 Dr. 10,000 Cr. 10,000 Cr.
85,000 Dr. 6,600 Dr. 5,000 Cr.
60,000 Cr.
50,000 Dr.
85,000 Cr. 6,600 Cr. 5,000 Dr. 60,000 Dr.
60,000 Cr. 78,400 Dr. 86,600 Dr. 60,000 Cr.
Service cost 119,000 Dr. Interest cost 16,000 Dr. Expected return 8,500 Cr. Amortization of loss 4,867 Dr. Contributions 105,000 Cr. Benefits Liability loss* Journal entry for 2027 131,367 Dr. 105,000 Cr. Accumulated OCI, Dec. 31, 2026 Balance, Dec. 31, 2027
78,400 Dr. 0 78,400 Dr.
78,400 Cr. 30,000 Dr.
30,000 Cr.
200,000 Cr.
85,000 Dr.
105,000 Cr. 115,000 Cr.
119,000 Cr. 16,000 Cr. 8,500 Dr. 4,867 Cr.
7,500 Dr. 2,633 Dr. 78,400 Dr. 81,033 Dr.
18,500 Dr. 7,500 Cr.
105,000 Dr. 18,500 Cr.
29,000 Cr. 144,000 Cr.
324,000 Cr.
*$324,000 – ($200,000 + $119,000 + $16,000 – $18,500). 19-57
LO: 2, 3, 4, Bloom: AP, Difficulty: Complex, Time: 45-55, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
180,000 Dr.
Problem 19.5 (Continued)
Copyright © 2022 WILEY
General Journal Entries Annual Pension OCI— Pension Expense Cash Gain/Loss Asset/Liability
Problem 19.6
(a) Prior Service Cost Amortization 2025 2026 2027
$166,667 166,667 166,667
($2,000,000 ÷ 12 years) ($2,000,000 ÷ 12 years) ($2,000,000 ÷ 12 years)
(b) Pension expense for 2025 comprised the following: Service cost........................................................................ Interest on projected benefit obligation* .......................... Actual return on plan assets** .......................................... Unexpected gain*** ............................................................ Amortization of prior service cost .................................... Pension expense ........................................................
$200,000 500,000 (325,000) 25,000 166,667 $566,667
***($5,000,000 X .10 = $500,000) ***[$4,100,000 – $3,000,000 – ($775,000 – $0)] ***(Expected return of $300,000 – actual return of $325,000 = $25,000 unexpected gain) (c) 12/31/25 Fair value of plan assets Less: Expected fair value of assets 1/1/25 fair value of plan assets Add expected return (.10 X $3,000,000) Add contributions to the plan Less benefits Asset gain (increase) 12/31/25 Actuarially computed PBO Less: 1/1/25 PBO $5,000,000 Add interest (.10 X $5,000,000) 500,000 Add service cost 200,000 Less benefits 0 Liability gain (decrease) Net gain 12/31/25
$4,100,000 $3,000,000 300,000 775,000 0
4,075,000 25,000 Dr.
4,850,000
5,700,000 850,000 Dr. $ 875,000
Problem 19.6 (Continued) Amortization in 2025: None because there was no beginning balance. Amortization in 2026 (corridor approach): $32,500, as shown below. Projected Benefit Fair Value Year Obligation of Plan Assets Corridor 2025 2026
$5,000,000 4,850,000
$3,000,000 4,100,000
$500,000 485,000
Accumulated OCI (G/L) Amortization $( 0 (875,000)
*$ 0 *32,500*
*$875,000 – $485,000 = $390,000; $390,000 ÷ 12 = $32,500
(d) Pension liability, beginning of year .................................. Less: Pension liability, end of year .................................. Decrease in liability ...................................................
$2,000,000* 750,000** $1,250,000
*$5,000,000 – $3,000,000 **$4,850,000 – $4,100,000 Journal Entries—2025 Pension Expense .................................................. 566,667 Pension Asset /Liability ........................................ 1,250,000 Other Comprehensive Income (G/L) ............ Other Comprehensive Income (PSC) ........... Cash ...............................................................
875,000 166,667 775,000
Copyright © 2022 WILEY Kieso, Intermediate Accounting, 18/e, Solutions Manual
Cash
OCI—Prior Service Cost
Memo Record OCI— Pension Gain/Loss Asset/Liability
Balance, Jan. 1, 2025 Service cost 200,000 Dr. Interest cost* 500,000 Dr. Actual return 325,000 Cr. Unexpected gain 25,000 Dr. 25,000 Cr. Amortization of PSC 166,667 Dr. 166,667 Cr. Contributions 775,000 Cr. Decrease in PBO 850,000 Cr. Journal entry for 2025 566,667 Dr. 775,000 Cr. 166,667 Cr. 875,000 Cr. Accumulated OCI, Dec. 31, 2024 2,000,000 Dr. 0 Balance, Dec. 31, 2025 1,833,333 Dr. 875,000 Cr.
2,000,000 Cr.
Projected Benefit Obligation
Plan Assets
5,000,000 Cr. 3,000,000 Dr. 200,000 Cr. 500,000 Cr. 325,000 Dr.
775,000 Dr. 850,000 Dr. 1,250,000 Dr. 750,000 Cr.
(For Instructor Use Only
*$5,000,000 X .10 LO: 3, 4, Bloom: AP, Difficulty: Complex, Time: 45-55, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
4,850,000 Cr. 4,100,000 Dr.
Problem 19.6 (Continued)
19-60
General Journal Entries Annual Pension Expense
Copyright © 2022 WILEY
Items
Balance, Jan. 1, 2025 Service cost 108,000 Dr. Interest cost* 63,000 Dr. Actual return 48,000 Cr. Unexpected loss** 4,000 Cr. 4,000 Dr. Amortization of PSC 25,000 Dr. 25,000 Cr. Amortization of loss*** 2,100 Dr. 2,100 Cr. Contributions 133,000 Cr. Benefits Journal entry for 2025 146,100 Dr. 133,000 Cr. 25,000 Cr. 1,900 Dr. Accumulated OCI, Dec. 31, 2024 81,000 Dr. 91,000 Dr. Balance, Dec. 31, 2025 56,000 Dr. 92,900 Dr.
180,000 Cr.
700,000 Cr. 520,000 Dr. 108,000 Cr. 63,000 Cr. 48,000 Dr.
133,000 Dr. 85,000 Dr. 85,000 Cr. 10,000 Dr. 170,000 Cr.
786,000 Cr. 616,000 Dr.
(For Instructor Use Only)
*$63,000 = $700,000 X .09. **$4,000 = ($520,000 X .10) – $48,000. *** Year
1/1 Projected Benefit Obligation
Value of 1/1 Plan Assets
10% Corridor
Accumulated OCI (G/L), 1/1
Minimum Amortization of Loss for 2025
2025
$700,000
$520,000
$70,000
$91,000
*$2,100****
****$91,000 – $70,000 = $21,000; $21,000 ÷ 10 = $2,100. 19-61
LO: 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Problem 19.7
Kieso, Intermediate Accounting, 18/e, Solutions Manual
HANSON CORP. Pension Worksheet—2025 General Journal Entries Memo Record Annual OCI—Prior Projected Pension Service OCI— Pension Benefit Plan Expense Cash Cost Gain/Loss Asset/Liability Obligation Assets
19-62 Copyright © 2022 WILEY
(a)
Items
LEMKE COMPANY Pension Worksheet—2025 and 2026 General Journal Entries Annual OCI—Prior Pension Service OCI— Expense Cash Cost Gain/Loss
(For Instructor Use Only
Accumulated OCI, Dec. 31, 2025 Balance, Dec. 31, 2026
190,000 Cr.
600,000 Cr. 410,000 Dr. 40,000 Cr. 60,000 Cr. 36,000 Dr.
5,000 Dr. 70,000 Cr. 97,000 Cr.
97,000 Cr.
70,000 Cr. 160,000 Dr. 90,000 Dr.
87,000 Dr. 92,000 Dr. 54,000 Cr. 0 92,000 Dr. 244,000 Cr.
31,500 Dr. 87,000 Cr.
755,500 Cr. 59,000 Cr. 75,550 Cr.
97,000 Dr. 31,500 Cr.
511,500 Dr.
61,000 Dr. 9,850 Cr. 50,000 Cr. 823 Cr. 81,000 Cr. 81,000 Cr.
50,000 Cr.
10,673 Cr.
90,000 Dr. 40,000 Dr.
92,000 Dr. 81,327 Dr. 236,550 Cr.
54,000 Dr.
81,000 Dr. 54,000 Cr.
836,050 Cr.
599,500 Dr.
7,450 Dr.
Problem 19.8
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2025 Service cost 40,000 Dr. Interest cost(a) 60,000 Dr. Actual return 36,000 Cr. Unexpected loss(b) 5,000 Cr. Amortization of PSC 70,000 Dr. Contributions Benefits Increase in PBO Journal entry for 2025 129,000 Dr. Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025 Service cost 59,000 Dr. (c) Interest cost 75,550 Dr. Actual return 61,000 Cr. (d) Unexpected gain 9,850 Dr. Amortization of PSC 50,000 Dr. Amortization of loss(e) 823 Dr. Contributions Benefits Journal entry for 2026 134,223 Dr.
Pension Asset/ Liability
Memo Record Projected Benefit Obligation Plan Assets
Problem 19.8 (Continued) Worksheet computations: $60,000 = $600,000 X .10.
(a)
$5,000 = ($410,000 X .10) – $36,000; expected return exceeds actual return.
(b)
(c)
$75,550 = $755,500 X .10.
(d) (e)
$9,850 = ($511,500 X .10) – $61,000; actual return exceeds expected return.
2026 Corridor Test: Accumulated net (gain) or loss at beginning of year ................. 10% of larger of PBO or fair value of plan assets ...................... Amortizable amount .....................................................................
$92,000 (75,550) $16,450
2026 amortization ($16,450 ÷ 20 years) .......................................
$
(b)
2025 Pension Expense ....................................................... Other Comprehensive Income (G/L) ......................... Cash .................................................................... Pension Asset /Liability...................................... Other Comprehensive Income (PSC) ................ 2026 Pension Asset /Liability ............................................ Pension Expense ...................................................... Cash ................................................................... Other Comprehensive Income (PSC) ............... Other Comprehensive Income (G/L) ................
823
129,000 92,000 97,000 54,000 70,000 7,450 134,223 81,000 50,000 10,673
Problem 19.8 (Continued) (c) Financial Statements—2026 Income Statement Operating expenses Pension expense (service costs) ............
$ 59,000
Other income or expense Pension expense (other components) ... ($134,223 – $59,000)
$75,223
Comprehensive Income Statement Net Income ............................................................. Other comprehensive income (loss) Asset gain (loss)............................................. Amortization of loss ....................................... Prior service cost amortization ..................... Comprehensive income
$ XXXX $ 9,850 823 50,000
Balance Sheet Liabilities Pension liability .......................................
60,673 $ XXXX
$236,550
Stockholders’ equity Accumulated other comprehensive loss (PSC) ............................................ Accumulated other comprehensive loss (G/L) ..............................................
$ 40,000 81,327
LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Complex, Time: 45-60, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
19-64
Copyright © 2022 WILEY
Kieso, Intermediate Accounting, 18/e, Solutions Manual
(For Instructor Use Only
Problem 19.9
(a) See worksheet on next page. (b)
December 31, 2025 Other Comprehensive Income (G/L) ...................... Pension Expense .................................................... Cash ................................................................. Pension Asset /Liability...................................
24,000 334,000 200,000 158,000
(c) See worksheet on next page. The entry is below. December 31, 2026 Other Comprehensive Income (PSC) .................... Other Comprehensive Income (G/L) ...................... Pension Expense .................................................... Cash ................................................................. Pension Asset/Liability ................................... (d)
510,000 36,560 432,440 184,658 794,342
Financial Statements—2026 Income Statement Operating expenses Pension expense (service costs)............ Other income or expense Pension expense (other components) ... ($432,440 – $170,000) Balance Sheet Liabilities Pension liability ........................................ Stockholders’ equity Accumulated other comprehensive loss (PSC) ............................................... Accumulated other comprehensive loss (G/L) ................................................
$ 170,000 $262,440
$ 952,342
$ 510,000 60,560
Copyright © 2022 WILEY
HOBBS COMPANY Pension Worksheet—2025 and 2026 General Journal Entries
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Items
Annual Pension Expense
(For Instructor Use Only
Balance, Jan. 1, 2025 Service cost 150,000 Dr. Interest cost(a) 460,000 Dr. Actual return 252,000 Cr. Unexpected loss(b) 24,000 Cr. Contributions Benefits Journal entry for 2025 334,000 Dr. Accumulated OCI Dec. 31, 2024 Balance, Dec. 31, 2025 Additional PSC, 1/1/2026 Balance, Jan. 1, 2026 Service cost 170,000 Dr. Interest cost(c) 559,000 Dr. Actual return 350,000 Cr. Unexpected loss(d) 36,560 Cr. Amortization of PSC 90,000 Dr. Contributions Benefits Journal entry for 2026 432,440 Dr. Accumulated OCI, Dec. 31, 2026 Balance, Dec. 31, 2026
Cash
OCI—Prior OCI— Pension Service Cost Gain/Loss Asset/Liability
Memo Record Projected Benefit Plan Obligation Assets 4,600,000 Cr. 4,600,000 Dr. 150,000 Cr. 460,000 Cr. 252,000 Dr.
24,000 Dr. 200,000 Cr. 220,000 Dr. 200,000 Cr.
24,000 Dr. 0 24,000 Dr.
200,000 Dr. 220,000 Cr.
158,000 Cr. 158,000 Cr.
600,000 Dr.
4,990,000 Cr. 4,832,000 Dr. 600,000 Cr. 5,590,000 Cr. 170,000 Cr. 559,000 Cr. 350,000 Dr.
36,560 Dr. 90,000 Cr. 184,658 Cr. 280,000 Dr. 184,658 Cr.
510,000 Dr. 36,560 Dr. 0 24,000 Dr. 510,000 Dr. 60,560 Dr.
184,658 Dr. 280,000 Cr.
794,342 Cr. 952,342 Cr.
(a)
$460,000 = $4,600,000 X .10. $24,000 = ($4,600,000 X .06) – $252,000. (c) $559,000 = ($4,990,000 + $600,000) X .10. (d) $36,560 = ($4,832,000 X .08) – $350,000. (b)
LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
6,039,000 Cr. 5,086,658 Dr.
Problem 19.9 (Continued)
19-66
(a)
Copyright © 2022 WILEY
KRAMER COMPANY (a)
Completed Worksheet—2025 Annual Pension Expense
General Journal Entries Memo Record OCI—Prior Projected Service OCI— Pension Benefit Plan Cash Cost Gain/Loss Asset/Liability Obligation Assets
(For Instructor Use Only)
(b)
(c)
120,000 Cr.
41,000 Dr. 15,000 Dr. 15,000 Cr. 43,500 Cr. 30,500 Cr. 150,500 Cr.
2025 Pension Expense .............................................................................. Other Comprehensive Income (G/L) ................................................ Cash ....................................................................................... Pension Asset/Liability ......................................................... Other Comprehensive Income (PSC) ................................... 1. 2.
325,000 Cr. 205,000 Dr. 20,000 Cr. 26,000 Cr. 18,000 Dr.
Settlement Rate: $26,000 ÷ $325,000 = 8% Expected return on assets: ($18,000 + $2,500) ÷ $205,000 = 10%
19-67
LO: 1, 2, 3, 4, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
399,500 Cr. 249,000 Dr.
60,500 46,000 41,000 30,500 35,000
Problem 19.10
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2025 Service cost 20,000 Dr. Interest cost 26,000 Dr. Actual return 18,000 Cr. Unexpected loss 2,500 Cr. 2,500 Dr. Amortization of PSC 35,000 Dr. 35,000 Cr. Contributions 41,000 Cr. Benefits Increase in PBO 43,500 Dr. Journal entry for 2025 60,500 Dr. 41,000 Cr. 35,000 Cr. 46,000 Dr. Accumulated OCI, Dec. 31, 2024 80,000 Dr. 0 Balance, Dec. 31, 2025 45,000 Dr. 46,000 Dr.
19-68 Copyright © 2022 WILEY
KRAMER COMPANY (a)
Completed Worksheet—2026
(For Instructor Use Only
Balance, Jan. 1, 2026 Service cost 59,000 Dr. Interest cost* 39,950 Dr. Actual return 32,000 Cr. Unexpected gain** 7,100 Dr. 7,100 Cr. Amortization of PSC 28,000 Dr. 28,000 Cr. Amortization of loss*** 242 Dr. 242 Cr. Contributions 51,000 Cr. Benefits Journal entry for 2026 102,292 Dr. 51,000 Cr. 28,000 Cr. 7,342 Cr. Accumulated OCI, Dec. 31, 2025 45,000 Dr. 46,000 Dr. Balance, Dec. 31, 2026 17,000 Dr. 38,658 Dr.
150,500 Cr. 399,500 Cr. 249,000 Dr. 59,000 Cr. 39,950 Cr. 32,000 Dr.
51,000 Dr. 27,000 Dr. 27,000 Cr. 15,950 Cr. 166,450 Cr.
471,450 Cr. 305,000 Dr.
Problem 19.11
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Annual Pension Expense
General Journal Entries Memo Record OCI—Prior Projected Service OCI— Pension Benefit Plan Cash Cost Gain/Loss Asset/Liability Obligation Assets
Problem 19.11 (Continued) Worksheet computations: *Interest cost: $39,950 = $399,500 X .10 **Unexpected gain: $7,100 = ($249,000 X .10) – $32,000; actual return exceeds expected return. ***2026 Corridor Test: Accumulated net (gain) or loss at beginning of year ... Less: 10% of larger of PBO or fair value of plan assets .............................................................. Amortizable amount....................................................
(b)
$46,000 39,950 $ 6,050
2026 amortization ($6,050 ÷ 25 years) .......................
$
2026 Pension Expense ........................................................ 102,292 Pension Asset/Liability........................................ Other Comprehensive Income (PSC) ................. Other Comprehensive Income (G/L) ................... Cash......................................................................
15,950 28,000 7,342 51,000
(c) Financial Statements—2026 Income Statement Operating expenses Pension expense (service costs)............
$
Other income or expense Pension expense (other components) ... ($102,292 – $59,000) Comprehensive Income Statement Net Income .................................................................. Other comprehensive income (loss) Asset gain (loss) .................................................. Amortization of loss ............................................ Prior service cost amortization........................... Comprehensive income ..............................................
Kieso, Intermediate Accounting, 18/e, Solutions Manual
59,000 $ 43,292
$ XXXX 7,100 242 28,000
Balance Sheet Liabilities Pension liability ....................................................... Copyright © 2022 WILEY
242
(For Instructor Use Only)
35,342 $ XXXX
$166,450 19-69
Problem 19.11 (Continued) Stockholders’ equity Accumulated other comprehensive loss (PSC) ... Accumulated other comprehensive loss (G/L) .....
$ 17,000 38,658
LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
19-70
Copyright © 2022 WILEY
Kieso, Intermediate Accounting, 18/e, Solutions Manual
(For Instructor Use Only
Copyright © 2022 WILEY
(a)
Annual Pension Expense
LARSON CORP. Pension Worksheet—2026 General Journal Entries Memo Record OCI—Prior Projected Service OCI— Pension Benefit Plan Cash Cost Gain/Loss Asset/Liability Obligation Assets 70,000 Cr.
340,000 Cr. 270,000 Dr. 45,000 Cr. 23,800 Cr. 27,000 Dr.
65,000 Dr. 41,000 Dr. 41,000 Cr. 23,200 Dr. 46,800 Cr.
367,800 Cr. 321,000 Dr.
(For Instructor Use Only)
*$23,800 = $340,000 X .07. **$5,400 = ($270,000 X .08) – $27,000. *** Year
1/1 Projected Benefit Obligation
Value of 1/1 Plan Assets
2026 $340,000 $270,000 ****($39,000 – $34,000) = $5,000 ÷ 10 = $500.
10% Corridor
Accumulated OCI (G/L), 1/1
Minimum Amortization of Loss for 2026
$34,000
$39,000
*$500****
Problem 19.12
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Balance, Jan. 1, 2026 Service cost 45,000 Dr. Interest cost* 23,800 Dr. Actual return 27,000 Cr. Unexpected gain** 5,400 Dr. 5,400 Cr. Amortization of PSC 12,000 Dr. 12,000 Cr. Amortization of loss*** 500 Dr. 500 Cr. Contributions 65,000 Cr. Benefits Journal entry for 2026 59,700 Dr. 65,000 Cr. 12,000 Cr. 5,900 Cr. Accumulated OCI, Dec. 31, 2025 90,000 Dr. 39,000 Dr. Balance, Dec. 31, 2026 78,000 Dr. 33,100 Dr.
19-71
Problem 19.12 (Continued) 2026 Pension Expense ..................................................... Pension Asset/Liability ............................................ Other Comprehensive Income (PSC)............... Other Comprehensive Income (G/L) ................ Cash ...................................................................
59,700 23,200 12,000 5,900 65,000
(b) Financial Statements—2026 Income Statement Operating expenses Pension expense (service costs) ............ Other income or expense Pension expense (other components) ... ($59,700 – $45,000) Comprehensive Income Statement Net Income ................................................................ Other comprehensive income (loss) Asset gain (loss) ............................................... Amortization of loss ......................................... Prior service cost amortization ........................ Comprehensive income ...........................................
$
45,000
$
14,700
$ XXXX 5,400 500 12,000
17,900 $ XXXX
Balance Sheet Liabilities Pension liability ......................................................
$ 46,800
Stockholders’ equity Accumulated other comprehensive loss (PSC) ... Accumulated other comprehensive loss (G/L) .....
$ 78,000 33,100
LO: 1, 2, 3, 4, 5, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
19-72
Copyright © 2022 WILEY
Kieso, Intermediate Accounting, 18/e, Solutions Manual
(For Instructor Use Only
(a) Copyright © 2022 WILEY
70,000 Dr. 20,000 Dr. 15,000 Cr. 5,000 Dr.
Memo Record APBO Plan Assets 200,000 Cr. 200,000 Dr. 70,000 Cr. 20,000 Cr. 15,000 Dr.
5,000 Cr. 65,000 Cr. 44,000 Dr.
80,000 Dr.
65,000 Cr.
5,000 Cr. 0 5,000 Cr.
10,000 Cr. 10,000 Cr.
*$200,000 X .10 = $20,000 **$15,000 – $10,000 = $5,000 (b) Journal Entry Postretirement Expense ................................................. Other Comprehensive Income (G/L) ....................... Postretirement Asset/Liability................................. Cash ..........................................................................
(For Instructor Use Only)
Financial Statements Income Statement Operating expenses Postretirement expense (service costs) ................. Other income or expense Postretirement (other components) ....................... ($80,000 - $70,000)
65,000 Dr. 44,000 Cr.
80,000 5,000 10,000 65,000
$
70,000
$
10,000
19-73
Comprehensive Income Net income ........................................................................... Asset gain (loss).............................................................. Comprehensive income ......................................................
$ XXXX 5,000 $ XXXX
Balance Sheet Liabilities Postretirement asset/liability ...................................
$10,000
Stockholders’ Equity Accumulated other comprehensive income ..........
$ 5,000
LO: 6, 7, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
246,000 Cr. 236,000 Dr.
*Problem 19.13
Kieso, Intermediate Accounting, 18/e, Solutions Manual
Items Balance, Jan. 1, 2025 Service cost Interest cost* Actual return Unexpected gain** Contributions Benefits Journal entry, for 2025 Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025
HOLLENBECK FOODS INC. Postretirement Benefit Worksheet—2025 General Journal Entries Annual Postretirement OCI—Gain/ Postretirement Expense Cash Loss Asset/Liability
*Problem 19.14 (a) See worksheet on next page. (b)
December 31, 2025 Postretirement Expense ..................................... Other Comprehensive Income (G/L) .................. Cash .............................................................. Postretirement Asset/Liability.....................
120,000 40,000 45,000 115,000
(c) See worksheet on next page. The entry is below. December 31, 2026 Other Comprehensive Income (PSC) ................. Other Comprehensive Income (G/L) .................. Postretirement Expense ..................................... Cash .............................................................. Postretirement Asset/Liability.....................
163,000 23,700 221,800 35,000 373,500
(d) Financial Statements—2026 Income Statement Operating expenses Postretirement expense (service costs).
$
Other income or expense Postretirement (other components) ....... ($221,800 – $85,000) Comprehensive Income Statement Net Income ........................................................... Other comprehensive income (loss) Asset gain (loss) .......................................... Plan amendment (PSC)................................ Prior service cost amortization ................... Comprehensive income ......................................
19-74
85,000
$136,800
$ $ (23,700) (175,000) 12,000
XXXX
(186,700) $ XXXX
Balance Sheet Liabilities Postretirement liability ...........................................
$488,500
Stockholders’ equity Accumulated other comprehensive loss (PSC) ... Accumulated other comprehensive loss (G/L) .....
$163,000 63,700
Copyright © 2022 WILEY
Kieso, Intermediate Accounting, 18/e, Solutions Manual
(For Instructor Use Only
Kieso, Intermediate Accounting, 18/e, Solutions Manual (For Instructor Use Only)
Balance, Jan. 1, 2025 Service cost 75,000 Dr. Interest costa 225,000 Dr. Actual return 140,000 Cr. Unexpected lossb 40,000 Cr. Contributions Benefits Journal entry for 2025 120,000 Dr. Accumulated OCI, Dec. 31, 2024 Balance, Dec. 31, 2025 Additional PSC, 1/1/2026 Balance, Jan. 1, 2026 Service cost 85,000 Dr. Interest costc 268,500 Dr. Actual return 120,000 Cr. Unexpected lossd 23,700 Cr. Amortization of PSC 12,000 Dr. Contributions Benefits Journal entry for 2026 221,800 Dr. Accumulated OCI, Dec. 31, 2025 Balance, Dec. 31, 2026
General Journal Entries OCI—Prior OCI— Postretirement Cash Service Cost Gain/Loss Asset/Liability 0
Memo Record Plan APBO Assets 2,250,000 Cr. 2,250,000 Dr. 75,000 Cr. 225,000 Cr. 140,000 Dr.
40,000 Dr. 45,000 Cr. 40,000 Dr. 45,000 Cr.
0 0
40,000 Dr. 0 40,000 Dr.
45,000 Dr. 40,000 Cr.
115,000 Cr. 115,000 Cr.
175,000 Dr.
2,510,000 Cr. 2,395,000 Dr. 175,000 Cr. 2,685,000 Cr. 85,000 Cr. 268,500 Cr. 120,000 Dr.
23,700 Dr. 12,000 Cr. 35,000 Cr. 45,000 Dr. 35,000 Cr.
163,000 Dr. 0 163,000 Dr.
23,700 Dr. 40,000 Dr. 63,700 Dr.
35,000 Dr. 45,000 Cr.
373,500 Cr. 488,500 Cr.
a
$2,250,000 X .10 ($2,250,000 X .08) – $140,000. c $2,685,000 X .10 d ($2,395,000 X .06) – $120,000.
b
LO: 6, 7, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
2,993,500 Cr. 2,505,000 Dr.
*Problem 19.14 (Continued)
Copyright © 2022 WILEY
Annual Expense
19-75
UYJ 19.1 Financial Reporting Problem (a)
P&G offers various postretirement benefits to its employees. Defined Contribution Retirement Plans We have defined contribution plans, which cover the majority of our U.S. employees, as well as employees in certain other countries. These plans are fully funded. We generally make contributions to participants' accounts based on individual base salaries and years of service. Total global defined contribution expense was $317, $272, and $292 in 2020, 2019 and 2018, respectively. The primary U.S. defined contribution plan (the U.S. DC plan) comprises the majority of the expense for the Company's defined contribution plans. For the U.S. DC plan, the contribution rate is set annually. Total contributions for this plan approximated 14% of total participants' annual wages and salaries in 2020, 2019 and 2018. Defined Benefit Retirement Plans and Other Retiree Benefits We offer defined benefit retirement pension plans to certain employees. These benefits relate primarily to plans outside the U.S. and, to a lesser extent, plans assumed in previous acquisitions covering U.S. employees. We also provide certain other retiree benefits, primarily health care, for the majority of our U.S. employees, who become eligible for these benefits when they meet minimum age and service requirements. Generally, the health care plans require cost sharing with retirees and pay a stated percentage of expenses, reduced by deductibles and other coverages. These benefits are primarily funded by ESOP Series B shares and certain other assets contributed by the Company.
(b)
2020 2019
Pension expense Pension expense
$166,000,000 $139,000,000
(c)
In 2020, P&G reports various items related to its pension plan including: June 30 Pension Benefits Classification of net amount recognized 2020 2019 Noncurrent assets $ 12 $ 19 Current liabilities (66) (52) Noncurrent liabilities (6,223) (5,622) Net amount recognized (6,277) (5,655) Amounts recognized in accumulated other comprehensive income (AOCI) Net amounts recognized in AOCI $5,860 $5,276
Financial Reporting Problem (Continued) (d)
P&G provides the following disclosure of its asset allocations for the pension fund and the fund for Other Retiree Benefits. Plan Assets. Our investment objective for defined benefit retirement plan assets is to meet the plans' benefit obligations and to improve plan selfsufficiency for future benefit obligations. The investment strategies focus on asset class diversification, liquidity to meet benefit payments and an appropriate balance of long-term investment return and risk. Target ranges for asset allocations are determined by assessing different investment risks and matching the actuarial projections of the plans' future liabilities and benefit payments with current as well as expected long-term rates of return on the assets, taking into account investment return volatility and correlations across asset classes. Plan assets are diversified across several investment managers and are generally invested in liquid funds that are selected to track broad market equity and bond indices. Investment risk is carefully controlled with plan assets rebalanced to target allocations on a periodic basis and with continual monitoring of investment managers' performance relative to the investment guidelines established with each investment manager.
Financial Reporting Problem (Continued) Plan Assets. The Company’s target asset allocation for the year ending June 30, 2020 and actual asset allocation by asset category as of June 30, 2020, are as follows:
Asset Category Cash Debt securities Equity securities Total
Target Asset Allocation Pension Benefits Other Retiree Benefits 2020 2020 0% 2% 67% 3% 33% 95% 100% 100%
Asset Category Cash Debt securities Equity securities Total
Asset Allocation at June 30 Pension Benefits Other Retiree Benefits 2020 2020 1% 3% 66% 2% 33% 95% 100% 100%
These allocations appear in-line with the expected return assumptions for these two funds: 2020 Assumptions used to determine net periodic cost Expected return on plan assets
Pensions 6.6%
Other Retiree 8.4%
LO: N/A, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 19.2 Comparative Analysis Case (a) Coca-Cola sponsors and/or contributes to pension plans covering substantially all U.S. employees and certain employees in international locations. Coca-Cola also sponsors nonqualified, unfunded defined benefit plans for certain officers and other employees. In addition, CocaCola and its subsidiaries have various pension plans and other forms of postretirement arrangements outside the United States. PepsiCo sponsors defined benefit pension plans covering substantially all full-time U.S. employees and certain international employees. (b) Coca-Cola reported “net periodic benefit income” of $44 million in 2020. PepsiCo reported “pension expense” of $380 million in 2020 for U.S. and international plans. (c)
2020 Funded Status ($millions) Coca-Cola PepsiCo U.S. and international plans
Pensions ($775) ($6,277)
(d) Relevant rates used to compute pension information: Coca-Cola PepsiCo Discount rate (expense) Rate of increase in compensation levels (expense) Expected long-term rate of return on plan assets
2.5% 3.75%
2.5% 3.0%
7.5%
6.8%
(e) Coca-Cola and PepsiCo provide the following disclosures on expected contributions and benefit payments (amounts in millions):
Comparative Analysis Case (Continued) Coca-Cola Cash Flows The estimated future benefit payments for our pension and other postretirement benefit plans are as follows (in millions): Year Ended December 31, Benefit payments for pension plans
2021 $657
2022 $437
2023 $472
2024 $483
2025 2026–2030 $491 $2,492
Benefit payments for OPEB plans
60
56
54
51
50
226
Total estimated benefit payments
$717
$493
$526
$534
$541
$2,718
The Company anticipates making pension contributions in 2021 of $25 million, all of which will be allocated to our international plans. The majority of these contributions are required by funding regulations or law. PepsiCo Future Benefit Payments Our estimated future benefit payments are as follows:
Pension Retiree medical (a) (a)
2021
2022
$
925 $
1,080 $
915
$
$
$
95
95
2023
90
2024
2025
$
$
960 $
85
2026–2030
990 $
80
$ 5,270 $
370
Expected future benefit payments for our retiree medical plans do not reflect any estimated subsidies expected to be received under the 2003 Medicare Act. Subsidies are expected to be approximately $1 million for each of the years from 2021 through 2025 and approximately $4 million in total for 2026 through 2030.
These future benefit payments to beneficiaries include payments from both funded and unfunded plans. Comparative Analysis Case (Continued)
Funding Contributions to our pension and retiree medical plans were as follows: Pension
Discretionary Non-discretionary Total
2020
2019
2018
$ 339
$ 417
$ 1,417
168
255
198
$ 507
$ 672
$ 1,615
Includes $325 million contribution in 2020, $400 million contribution in 2019 and $1.4 billion contribution in 2018 to fund Plan A in the United States. PepsiCo appears to have a much higher cash claim related to its pension plans with expected benefit payments than Coca-Cola’s ($567 million compared to $25 million). Thus, these disclosures provide information related to the cash outflows of the company. With this information, financial statement users can better understand the potential cash outflows related to the pension plan. As a result, users can better assess the liquidity and solvency of the company, which helps in assessing the company’s overall financial flexibility. LO: N/A, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 19.3 Financial Statement Analysis Case (a)
The components of postretirement expense are service cost, interest cost, return on plan assets, amortization of prior service cost, and gains and losses. The expense for these plans is reported in income from operations. Similar to pensions, the net pension asset or liability for the postemployment benefit plan will be reported in Peake’s balance sheet, depending on whether there is a net debit or credit balance in the memorandum accounts related to the plan.
(b)
The accounting for defined-benefit plans and OPEBs is very similar. For example, the measures of the obligation are similar and the components of expense and their calculation are the same (with similar smoothing mechanisms employed for both types of plans with respect to gains and losses.) There are, however, a number of differences between Postretirement Healthcare Benefits and Pensions: Item Funding Benefit
Pensions Healthcare Benefits Generally funded. Generally NOT funded. Well-defined and level Generally uncapped and dollar amount. great variability. Beneficiary Retiree (maybe some Retiree, spouse, and benefit to surviving other dependents. spouse). Benefit Payable Monthly. As needed and used. Predictability Variables are reasonably Utilization difficult to predictable. predict. Level of cost varies geographically and fluctuates over time. Additionally, although healthcare benefits are generally covered by the fiduciary and reporting standards for employee benefit funds under ERISA, the stringent minimum vesting, participation, and funding standards that apply to pensions do not apply to healthcare benefits. The lack of required funding is particularly relevant for OPEB plans compared to pensions. Generally, this results in a much higher unfunded OPEB obligation reported in the balance sheet. In addition, with fewer assets in OPEB plan, there is a lower credit associated with the return-on-asset component of OPEB expense. LO: N/A, Bloom: AN, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 19.4 Accounting, Analysis, and Principles Accounting Balance in PBO at 12/31/2026 Balance at 1/1/2026 Interest cost: ($820.5 X 0.10) = Service cost Increase from actuarial assumptions Benefits paid Amount of plan assets at 12/31/2026 Balance at 1/1/2026 Actual return on plan assets in 2026 Contributions in 2026 Benefits paid in 2026 Corridor test and amortization of net gain/loss Corridor limit: 10% times greater of $820.5 and $476.5 = Excess of net G/L over corridor limit = $92.0 – $82.1 = Amortization = $9.9 ÷ 15 = Pension expense: Interest cost = ($820.5 X 0.10) = Service cost Amortization of unamortized prior service cost = Amortization of unamortized net loss Expected return on plan assets: ($476.5 X 0.12) = Balance in pension liability Projected benefit obligation Plan assets Pension liability Balance in Unamortized Prior Service Cost at 12/31/2026 Balance at 1/1/2026 Amortization in 2026
$820.5 82.1 42.0 0.0 (40.0) $904.6 $476.5 10.4 70.0 (40.0) $516.9 $ 82.1 9.9 0.7 $ 82.1 42.0 15.0 0.7 (57.2) $ 82.6 $904.6 (516.9) $387.7
($150.0) 15.0 ($135.0)
Accounting, Analysis, and Principles (Continued) Balance in Unamortized Net Gain or Loss at 12/31/2026 Balance at 1/1/2026 Gain (loss) due to actual return on plan assets below expected return Amortization
($ 92.0) (46.8) 0.7 ($138.1)
Journal entry: Pension Expense...................................................... Other Comprehensive Income (G/L) ....................... Pension Asset/Liability ................................... Other Comprehensive Income (PSC) ............ Cash .................................................................
82.6 46.1 43.7 15.0 70.0
PENCOMP, INC. Income Statement for the year ended Dec. 31, 2026 Revenues: Sales .......................................................................... Expenses: Cost of goods sold ................................................... Salary expense* ........................................................ Pension expense (other components) ................... Depreciation expense .............................................. Interest expense ....................................................... Total expenses and losses............................. Net income ................................................................
$3,000.0 $2,000.0 742.0 40.6 80.0 100.0
*Service cost component included in salary expense is $42.
2,962.6 $ 37.4
Accounting, Analysis, and Principles (Continued) PENCOMP, INC. Balance Sheet at Dec. 31, 2026 Assets: Cash................................................................................ Inventory ........................................................................ Plant and equipment. .................................................... Accumulated depreciation ........................................... Total Assets .....................................................
$ 368.0 1,800.0
$2,168.0
$2,000.0 (320.0) 1,680.0 $3,848.0
Liabilities: Note payable .................................................................. Pension liability ............................................................. Total Liabilities ................................................
$1,000.0 387.7
Stockholders’ Equity: Common stock .............................................................. Retained earnings ......................................................... Accumulated other comprehensive income ............... Total Stockholders’ Equity ............................. Total Liabilities and Stockholders’ Equity ....
$2,000.0 733.4 (273.1)
$1,387.7
2,460.3 $3,848.0
Plant and equip. = no change from previous balance sheet. Accumulated depreciation = [$240 + ($2,000 ÷ 25)] = $320 Inventory = $1,800 given Cash = $438 – $700 + $3,000 – $2,000 – $100 – $200 – $70 = $368 Note payable = no change from previous balance sheet = $387.7 per above analysis Common stock = no change from previous balance sheet. Retained earnings = $896.0 + $37.4 – $200 = $733.4 Accumulated other comprehensive income = $135.0 + $138.1 = $273.1
Accounting, Analysis, and Principles (Continued) Analysis ROE = $37.4 ÷ $2,460.3 = 0.0152 or 1.52%. In this example, the unexpected return on plan assets ‘skipped’ the income statement and went to other comprehensive income. Had this item been included in income, ROE would have been = ($37.4 – $46.8) ÷ $2,460.3 = –0.0038 or –0.38 percent. Whether this ‘should’ be included in a return on equity calculation is debatable. The rationale for excluding this from current period income (and therefore from ROE) is that a defined benefit pension plan is a long-term contract and so it is the long term expected return on the plan’s assets that is relevant to measuring the cost of sponsoring the plan. Some people believe that a particularly high or low return in a given year is not indicative of the long-term return. Others argue that all returns, high or low, accrue to the plan sponsor and so pension expense should reflect all returns. Principles The effects of plan amendments and actuarial gains and losses in a given year can be thought of as fairly transitory items with respect to income. In other words, these are items that are not likely to repeat at the same dollar amount year in and year out. Including these items in income arguably makes identifying the company’s ‘permanent’ income more difficult. Therefore, the FASB (and the IASB) have (so far!) decided to keep those items out of the income statement. LO: N/A, Bloom: SYN, Difficulty: Moderate, Time: 35-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking Cases CT 19.1 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to discuss some of the more traditional issues related to pension reporting. Specifically, the student is asked to define a pension plan, distinguish between a funded and unfunded plan, and differentiate between accounting for the employer and the pension fund. In addition, justification for accrual accounting must be developed, as well as a determination of the relative objectivity of the accrual versus the cash basis. CT 19.2 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to discuss the terminology employed in GAAP related to pension accounting. CT 19.3 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to discuss the reasons why accrual accounting is followed for pension reporting. In addition, certain terms are required to be explained and the proper footnote disclosures identified. CT 19.4 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to study some of the implications of GAAP as it relates to pensions. The student is required to identify the five components of pension expense, the major differences between the accumulated benefit obligation and the projected benefit obligation, and how to report actuarial gains and losses. CT 19.5 (Time 50–60 minutes) Purpose—to provide the student with the opportunity to discuss the implications of GAAP given a number of different factual situations related to pensions. This case is quite thought-provoking and should stimulate a great deal of class discussion. CT 19.6 (Time 30–40 minutes) Purpose—to provide the student with the opportunity to explain gains and losses, including the use of corridor amortization. CT 19.7 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to consider the ethical implications of the impact of pension benefits and their impact on financial statements.
Solutions to Critical Thinking Cases CT 19.1 (a)
A private pension plan is an arrangement whereby a company undertakes to provide its retired employees with benefits that can be determined or estimated in advance from the provisions of a document or from the company’s practices. In a contributory pension plan, the employees bear part of the cost of the stated benefits whereas in a noncontributory plan the employer bears the entire cost.
(b)
The employer is the organization sponsoring the pension plan. The employer incurs the costs and makes contributions to the pension fund. Accounting for the employer involves: (1) allocating the cost of the pension plan to the proper accounting periods, (2) measuring the amount of pension obligation resulting from the plan, and (3) disclosing the status and effects of the plan in the financial statements. The pension fund or plan is the entity which receives the contributions from the employer, administers the pension assets, and makes the benefit payments to the pension recipients. Accounting for the fund involves identifying receipts as contributions from the employer sponsor and as income from fund investments and computing the amounts due to individual pension recipients.
(c)
(d)
(1)
Relative to the pension fund the term “funded” refers to the relationship between pension fund assets and the present value of expected future pension benefit payments; thus, the pension fund may be fully funded or underfunded. Relative to the employer, the term “funded” refers to the relationship of the contributions made by the employer to the pension fund and the pension expense accrued by the employer; if the employer contributes annually to the pension fund an amount equal to the pension expense, the employer is fully funded.
(2)
Relative to the pension fund, the pension liability is an actuarial concept representing an economic liability under the pension plan for future cash payments to retirees. From the viewpoint of the employer, the pension liability is an accounting credit that results from an excess of amounts expensed over amounts contributed (funded) to the pension fund.
(1)
The theoretical justification for accrual recognition of pension costs is based on the matching concept. Pension costs are incurred during the period over which an employee renders services to the enterprise; these costs may be paid upon the employee’s retirement, over a period of time after retirement, as incurred through funding or insurance plans, or through some combination of any or all of these methods.
(2)
Although cash (pay-as-you-go) accounting is highly objective for the final determination of actual pension costs, it provides no measurement of annual pension costs as they are incurred. Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting if actuarial funding methods are applied to actuarial valuations to determine the provision for pension costs. While cash accounting provides a more precise determination of the final cost, accrual accounting provides a more objective measure of the annual cost.
CT 19.1 (Continued) (e)
Terms and their definitions as they apply to accounting for pension plans follow: (1)
Service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during that period. The service cost component is a portion of the projected benefit obligation and is unaffected by the funded status of the plan.
(2)
Prior service costs are the retroactive benefits granted in a plan amendment (or initiation). Retroactive benefits are benefits granted in a plan amendment (or initiation) that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment.
(3)
Vested benefits are benefits that are not contingent on the employee continuing in the service of the employer. In some plans the payment of the benefits will begin only when the employee reaches the normal retirement date; in other plans the payment of the benefits will begin when the employee retires (which may be before or after the normal retirement date). The actuarially computed value of vested benefits represents the present value of: (a) the benefits expected to become payable to former employees who have retired, or who have terminated service with vested rights, at the date of determination; and (b) the benefits (based on service rendered prior to the date of determination) expected to become payable at future dates to present employees, taking into account the probable time that employees will retire.
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT 19.2 1.
Pension asset/liability in the asset section is the excess of the fair value of pension plan assets over the projected benefit obligation.
2.
Pension asset/liability in the liability section is the excess of the projected benefit obligation over the fair value of the pension plan assets.
3.
Accumulated OCI—PSC arises when an additional liability is recognized in the PBO due to prior service cost. Prior service costs are the retroactive benefits granted in a pension plan amendment (or initiation). This account should be reported in the stockholders’ equity section as a component of accumulated other comprehensive income. In addition, it should be shown as part of other comprehensive income.
4.
Pension expense is the amount recognized in an employer’s financial statements as the expense for a pension plan for the period. Components of pension expense are service cost, interest cost, expected return on plan assets, amortization of gain or loss, and amortization of prior service cost. It should be noted that GAAP uses the term net periodic pension cost instead of pension expense because the service cost recognized in a period may be capitalized along with other costs as part of an asset such as inventory.
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT 19.3 (a)
(b)
(c)
(1)
The theoretical justification for accrual recognition of pension costs is based on the matching concept. Pension costs are incurred during the period over which an employee renders services to the enterprise; these costs may be paid upon the employee’s retirement, over a period of time after retirement, as incurred through funding or insurance plans, or through some combination of any or all of these methods. The expense should be recognized when incurred.
(2)
Although cash (pay-as-you-go) accounting is highly objective for the final determination of actual pension costs, it provides no measurement of annual pension costs as they are incurred. Accrual accounting provides greater objectivity in the annual measurement of pension costs than does cash accounting.
Terms and their definitions as they apply to accounting for pensions follow: (1)
Market-related asset value, when based on a calculated value, is a moving average of pension plan asset values over a period of time. Considerable flexibility is permitted in computing this amount. In many cases, companies will undoubtedly use the actuarial asset value employed by the actuary as their market-related asset value for purposes of applying this concept to pension reporting.
(2)
The projected benefit obligation is the present value of vested and nonvested employee benefits accrued to date based on employees’ expected future salary levels. This is the pension liability required by GAAP.
(3)
The corridor approach was developed by the FASB as the method for determining when to amortize the balance in the Accumulated OCI (G/L) account. The net gain or loss balance is amortized when it exceeds the arbitrarily selected FASB criterion of 10% of the larger of the beginning-of-the-year balances of the projected benefit obligation or the market-related value of the plan assets.
The following disclosures about a company’s pension plans should be made in financial statements or their notes: 1.
A description of the plan including employee groups covered, type of benefit formula, funding policy, types of assets held, and the nature and effect of significant matters affecting comparability of information for all periods presented.
2.
The components of net periodic pension expense for the period.
3.
A reconciliation showing how the projected benefit obligation and the fair value of the plan assets changed from the beginning to the end of the period.
4.
Pension-related amounts recorded in Accumulated OCI and the impact of amortization of these items on pension expense in the current and next year.
5.
A table is required indicating the allocation of pension plan assets by category (equity securities, debt securities, real estate, and other assets), and showing the percentage of the fair value to total plan assets. In addition, a narrative description of investment policies and strategies, including the target allocation percentages (if used by the company), must be disclosed.
6.
The company must disclose the expected benefit payments to be paid to current plan participants for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter, based on the same assumptions used to measure the company’s benefit obligation at the end of the year. Also required is disclosure of a company’s best estimate of expected contributions to be paid to the plan during the next year.
LO: 1, Bloom: AN, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, AICPA PC: Communication
CT 19.4 (a)
(b)
Pension benefits are part of the compensation received by employees for their services. The actual payment of these benefits is deferred until after retirement. The net periodic pension expense measures this compensation and consists of the following five elements: 1.
The service cost component is the present value of the benefits earned by the employees during the current period.
2.
Since a pension represents a deferred compensation agreement, a liability is created when the plan is adopted. The interest cost component is the increase in that liability, the projected benefit obligation, due to the passage of time.
3.
In order to discharge the pension liability, an employer contributes to a pension fund. The return on the fund assets serves to reduce the interest element of the pension expense. Specifically, the expected return reduces pension expense. Expected return is the expected rate of return times the market-related value of plan assets.
4.
When a pension plan is adopted or amended, credit is often given for employee service rendered in prior years. This retroactive credit, or prior service cost, is charged to other comprehensive income (PSC) in the year the plan is adopted or amended, and then is recognized as pension expense over the time that the employees who benefited from this credit worked.
5.
The gains and losses component arises from a change in the amount of either the projected benefit obligation or the plan assets. This component is amortized via corridor amortization.
The major similarity between the accumulated benefit obligation and the projected benefit obligation is that they both represent the present value of the benefit attributed by the pension benefit formula to employee service rendered prior to a specific date. All things being equal, when an employee is about to retire, the accumulated benefit obligation and the projected benefit obligation would be the same. The major difference between the accumulated benefit obligation and the projected benefit obligation is that the former is based on present salary levels and the latter is based on estimated future salary levels. Assuming salary increases over time, the projected benefit obligation should be higher than the accumulated benefit obligation.
(c)
(1)
Pension gains and losses, sometimes called actuarial gains and losses, result from changes in the value of the projected benefit obligation or the fair value of the plan assets. These changes arise from the deviations between the estimated conditions and the actual experience, and from changes in assumptions. The volatility of these gains and losses may reflect an unavoidable inability to predict compensation levels, length of employee service, mortality, retirement ages, and other relevant events accurately for a period, or several periods. Therefore, fully recognizing the gains or losses on the income statement may result in volatility that does not reflect actual changes in the funded status of the plan in that period.
(2)
In order to decrease the volatility of the reporting of the pension gains or losses, the FASB had adopted what is referred to as the “corridor approach.” This approach achieves the objective by amortization of the accumulated OCI (G/L) in excess of 10% of the greater of the projected benefit obligation or the market-related asset value of the plan assets.
LO: 1, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 19.5 1.
This situation can exist because companies vary as to which assumption they are using when interest rates are disclosed. GAAP requires yet more consistency in discount rates. It requires companies to use rates on high quality fixed income investments currently available whose cash flows match the timing and amount of the expected benefit payments. As a result, this large variance in interest rates will probably disappear to some extent. However, it should be noted that companies will have some leeway in establishing settlement rates. In addition, the expected return on assets will also be different among companies.
2.
This situation will occur because the net funded position of the plan is required to be reported. That is, companies are required to report as a liability the excess of their projected benefit obligation over the fair value of plan assets. In the past, the basic liability companies reported was the excess of the amount expensed over the amount funded.
3.
This statement is questionable. If a financial measure purports to represent a phenomenon that is volatile, the measure must show that volatility or it will not be representationally faithful. Nevertheless, many argue that volatility is inappropriate when dealing with such long-term measures as pensions. A good example of where dampening might be useful is the recognition of gains and losses. If assumptions prove to be accurate estimates of experience over a number of years, gains or losses in one year will be offset by losses or gains in subsequent periods, and amortization of gains and losses would be unnecessary. The main point is that volatility per se should not be considered undesirable when establishing accounting principles. Although some managements may consider volatility bad, this belief should not influence standard-setting. However, it is clear from some of the compromises made in GAAP that certain procedures were provided to dampen the volatility effect.
4.
(a)
(b)
(c)
(d)
5.
In a defined-contribution plan, the amount contributed is the amount expensed. No significant reporting problems exist here. On the other hand, defined benefit plans involve many difficult reporting issues which may lead to additional expense and liability recognition. Significant amendments will generally increase prior service cost which may lead to significant adjustments to pension expense in the future. Plan participants are of importance, because the expected future years of service computation can have an impact on the amortization of the prior service cost and gains and losses. If the plan is underfunded, pension expense will generally increase (all other factors constant). If the plan is overfunded, pension expense will generally decrease (all other factors constant). The reason is that the expected return on plan assets will be less if the plan is underfunded and vice versa. If the company is using an actuarial funding method different than the one prescribed in GAAP (benefits/years-of-service approach), some changes in the computation of pension expense will occur for the company.
The corridor method is an approach which requires that only gains and losses in excess of 10% of the greater of the projected benefit obligation or market related plan asset value be allocated. This excess is then amortized over the average remaining service period of current employees expected to participate in the plan. The corridor’s purpose is to only recognize gains and losses above a certain amount, on the theory that gains and losses within the corridor will offset one another over time.
LO: 5, Bloom: AN, Difficulty: Complex, Time: 50-60, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 19.6 To:
Vickie Plato, Accounting Clerk
From:
Good Student, Manager of Accounting
Date:
January 3, 2027
Subject:
Amortization of gains and losses in pension expense
Pension expense includes several components; one occasionally included is the amortization of cumulative gains/losses. These gains/losses occur for two reasons. First, the plan assets may provide a return that is either greater or less than what was expected. Second, changes in actuarial assumptions may create increases or decreases in the pension liability. If these gains/losses are small in relation to the projected benefit obligation (PBO) or the market related value of the plan assets (PA), then do not include them in annual pension expense. If, in any given year, the gains or losses become too great, then at least a portion must be included in pension expense so as not to understate or overstate the annual obligation. This is done through a process called amortization. To decide whether or not you should include gains/losses in annual pension expense, calculate 10 percent of either the PBO or the PA opening balance (whichever is greater) as a “corridor.” Amortize the amount of any gain or loss falling outside the corridor over the average remaining service life of the active employees. Note: these gains/losses must exist at the beginning of the year for which amortization takes place [see (a) on the schedule below]. Thus, in the attached schedule, no amortization of the $280,000 loss in 2024 was required because the balance in the gain/loss account at the beginning of that year was zero. However, at the beginning of 2025, the balance in that account was $280,000. The 10 percent corridor is $250,000, so the loss exceeds this corridor by $30,000. Since the remaining service life of employees is 10 years, you derive the amortized portion by dividing $30,000 by 10: $3,000 [see (b) on the schedule below]. Note that the unamortized portion of the gain/loss from the previous year is combined with the current gain/loss. Check this new sum against a newly calculated 10 percent corridor. If the sum exceeds this corridor, then amortize the excess. In the attached schedule, the unamortized loss from prior years ($277,000) was added to the 2025 loss of $85,000, resulting in a cumulative loss of $362,000 (see (c) below). This amount exceeds the new corridor ($290,000) by $72,000. However, the remaining service life has been changed to 12 years, resulting in annual amortization of only $6,000 [see (d) below]. Finally, if the losses from 2026 are added to the unamortized portion of the loss from prior years, the sum ($368,000) falls within the 2027 corridor ($390,000) and does not need to be amortized at all. Corridor and Minimum Loss Amortization Schedule
Year 2024 2025 2026 2027
Projected Benefit Obligation (a) $2,200,000 2,400,000 2,900,000 3,900,000
Plan Assets Value (a) $1,900,000 2,500,000 2,600,000 3,000,000
10% Corridor $220,000 250,000 290,000 390,000
Accumulated OCI (G/L) (a) $ 0 280,000 362,000 (c) 368,000 (e)
Minimum Amortization of Loss $ 0 3,000 (b) 6,000 (d) 0
CT 19.6 (Continued) (a) (b) (c) (d) (e)
As of the beginning of the year. ($280,000 – $250,000) ÷ 10 years = $3,000 $280,000 – $3,000 + $85,000 = $362,000 ($362,000 – $290,000) ÷ 12 years = $6,000 $362,000 – $6,000 + $12,000 = $368,000
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, Reflective Thinking, AICPA PC: Professional Behavior, AICPA AC: Reporting, AICPA PC: Communication
CT 19.7 While Habbe may be correct in assuming that the termination of nonvested employees would decrease its pension-related liabilities and associated expenses, she is callous to suggest that firing employees is a reasonable approach to correcting the underfunding of College Electronix’s pension plan. Arbitrarily dismissing productive employees on the basis of being vested or not vested in the pension plan in order to avoid capitalizing a liability and recognizing expenses is a capricious and unsound business decision. Gerald Ott should discuss the ethical, legal, and financial implications of the alternatives available as well as the accounting requirements relating to this situation. This obligation and its effect on the financial statements should have been known to Thinken Technology when it performed its due diligence audit of CE at the time of merger negotiations. Thinken Technology should capitalize the pension obligations of CE as required by GAAP. LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, Reflective Thinking, AICPA PC: Professional Behavior, AICPA AC: Reporting, AICPA PC: Communication
Codification Exercises CE19.1 Master Glossary (a)
The actuarial present value of benefits (whether vested or nonvested) attributed, generally by the pension benefit formula, to employee service rendered before a specified date and based on employee service and compensation (if applicable) before that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels. For plans with flat-benefit or non-pay-related pension benefit formulas, the accumulated benefit obligation and the projected benefit obligation are the same.
(b)
A plan that defines postretirement benefits in terms of monetary amounts (for example, $100,000 of life insurance) or benefit coverage to be provided (for example, up to $200 per day for hospitalization, or 80 percent of the cost of specified surgical procedures). Any postretirement benefit plan that is not a defined contribution postretirement plan is, for purposes of Subtopic 715– 60, a defined benefit postretirement plan. (Specified monetary amounts and benefit coverage are collectively referred to as benefits).
(c)
The value, as of a specified date, of an amount or series of amounts payable or receivable thereafter, with each amount adjusted to reflect the time value of money (through discounts for interest) and the probability of payment (for example, by means of decrements for events such as death, disability, or withdrawal) between the specified date and the expected date of payment.
(d)
The cost of retroactive benefits granted in a plan amendment. Retroactive benefits are benefits granted in a plan amendment (or initiation) that are attributed by the pension benefit formula to employee services rendered in periods before the amendment.
LO: N/A, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE19.2 According to FASB ASC 715-30-35-43 (Defined-Benefit Plans – Pension – Discount Rates): Assumed discount rates shall reflect the rates at which the pension benefits could be effectively settled. It is appropriate in estimating those rates to look to available information about rates implicit in current prices of annuity contracts that could be used to effect settlement of the obligation (including information about available annuity rates published by the Pension Benefit Guaranty Corporation). In making those estimates, employers may also look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits. Assumed discount rates are used in measurements of the projected, accumulated, and vested benefit obligations and the service and interest cost components of net periodic pension cost. LO: N/A, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE19.3 According to FASB ASC 715-30-35-4 (Defined-Benefit Plans – Pension – Components of Net Periodic Cost): All of the following components shall be included in the net pension cost recognized for a period by an employer sponsoring a defined-benefit pension plan: (a)
Service cost
(b)
Interest cost
(c)
Actual return on plan assets, if any
(d)
Amortization of any prior service cost or credit included in accumulated other comprehensive income
(e)
Gain or loss (including the effects of changes in assumptions), which includes, to the extent recognized (see paragraph 715-30-35-26), amortization of the net gain or loss included in accumulated other comprehensive income
(f)
Amortization of any net transition asset or obligation existing at the date of initial application of this Subtopic and remaining in accumulated other comprehensive income.
LO: N/A, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE19.4 According to FASB ASC 715-20-50-6 (Defined-Benefit Plans – General – Interim Disclosure Requirements for Publicly Traded Entities): A publicly traded entity shall disclose the following information for its interim financial statements that include a statement of income: (a)
The amount of net benefit cost recognized, for each period for which a statement of income is presented, showing separately each of the following: 1. 2. 3. 4. 5. 6. 7.
(b)
The service cost component The interest cost component The expected return on plan assets for the period The gain or loss component The prior service cost or credit component The transition asset or obligation component The gain or loss recognized due to a settlement or curtailment.
The total amount of the employer’s contributions paid, and expected to be paid, during the current fiscal year, if significantly different from amounts previously disclosed pursuant to paragraph 71520-50-1(g). Estimated contributions may be presented in the aggregate combining all of the following: 1. 2. 3.
Contributions required by funding regulations or laws Discretionary contributions Noncash contributions.
LO: N/A, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a)
According to FASB ASC 715-30-35: 35-22 Asset gains and losses are differences between the actual return on plan assets during a period and the expected return on plan assets for that period. Asset gains and losses include both changes reflected in the market-related value of plan assets and changes not yet reflected in the market-related value (that is, the difference between the fair value of assets and the marketrelated value). Gains or losses on transferable securities issued by the employer and included in plan assets are also included in asset gains and losses. Asset gains and losses not yet reflected in market-related value are not required to be amortized under paragraphs 715-30-35-24 through 35-25. 35-24 As a minimum, amortization of a net gain or loss included in accumulated other comprehensive income (excluding asset gains and losses not yet reflected in market-related value) shall be included as a component of net pension cost for a year if, as of the beginning of the year, that net gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the market-related value of plan assets. If amortization is required, the minimum amortization shall be that excess divided by the average remaining service period of active employees expected to receive benefits under the plan. The amortization must always reduce the beginning-of-the-year balance. Amortization of a net gain results in a decrease in net periodic pension cost; amortization of a net loss results in an increase in net periodic pension cost. If all or almost all of a plan’s participants are inactive, the average remaining life expectancy of the inactive participants shall be used instead of the average remaining service period.
Codification Research Case (Continued) (b) According to FASB ASC 715-30-35: Gains and Losses 35-18 As established in the definition of the term, a gain or loss results from a change in the value of either the projected benefit obligation or the plan assets resulting from experience different from that assumed or from a change in an actuarial assumption. This Subtopic generally does not distinguish between gains and losses that result from experience different from that assumed or from changes in assumptions. Gains and losses include amounts that have been realized, for example by sale of a security, as well as amounts that are unrealized. 35-19 Because gains and losses may reflect refinements in estimates as well as real changes in economic values and because some gains in one period may be offset by losses in another or vice versa, this Subtopic does not require recognition of gains and losses as components of net pension cost of the period in which they arise. (c)
According to FASB ASC 715-30-25: 25-1
If the projected benefit obligation exceeds the fair value of plan assets, the employer shall recognize in its statement of financial position a liability that equals the unfunded projected benefit obligation. If the fair value of plan assets exceeds the projected benefit obligation, the employer shall recognize in its statement of financial position an asset that equals the overfunded projected benefit obligation.
LO: N/A, Bloom: K, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CHAPTER 20 Accounting for Leases Assignment Classification Table (By Topic) Brief Exercises
Exercises
3, 4, 5, 6, 7, 9, 10, 11, 12, 13, 16, 18, 19
5, 9
1
Finance / Sales – Type Leases.
15, 17, 18, 21, 22, 23, 24
1, 2, 3, 4, 6, 7, 8, 10, 11, 12, 13, 14
2, 3, 4, 5,6,7,8,9,10, 11, 12, 13, 14, 15
1, 2, 3, 4, 5, 2, 4, 5 6, 7, 8, 9, 10, 11, 12, 13, 14
4.
Operating leases.
14, 20, 21
15, 16, 17, 18, 19
16, 17, 18, 19, 20, 21, 22
15, 16, 17
5.
Special Issues Residual values; bargainpurchase options; Other lease costs; initial direct costs, presentation, and disclosure.
8, 9, 11, 16, 25, 26, 27, 29, 30
4, 8, 9, 20, 21, 22, 23, 24, 25, 26, 27, 28
1, 2, 3, 4,5, 6,7,8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20,21, 22
1, 2, 3, 4, 5, 1, 2, 3, 4, 6, 7, 8, 9, 5, 6 10, 11, 12, 13, 14
*6.
Sale-leaseback.
31, 32
29, 30
23, 24
*7.
Direct financing lease.
33, 34, 35
31, 32
25
Topics
Questions
1.
Rationale for leasing.
1, 2
2.
Concepts, classification, and measurement of leases.
3.
*This material is dealt with in an Appendix to the chapter.
Problems
Critical Thinking
1
2, 4
7
Assignment Classification Table (By Learning Objective)
Brief Exercises
Critical Exercises Problems Thinking
1. Describe the 1, 2, 3, 4, 5, environment related to 6, 7, 8, 9, leasing transactions. 10, 11, 13, 18, 19
5, 9
1
2. Explain the accounting for finance leases.
15, 17, 18, 22, 23, 24
1, 2, 3, 4, 6, 7, 8, 10, 11, 12, 13, 14
2, 3, 4, 5, 6,7,8,9, 10, 11, 12, 13, 14, 15
1, 2, 3, 5, 2, 4, 7, 5 6, 7, 8, 10, 11, 12, 13, 14, 15
3. Explain the accounting for operating leases.
14, 20, 21
15, 16, 17, 18, 19
16, 17, 18, 19, 20, 21, 22
9, 15, 16, 17
4. Discuss the accounting and reporting for special features of lease arrangements.
8, 9, 11, 12, 16, 25, 26, 27, 28, 29, 30
4, 8, 9, 20, 21, 22, 23, 24, 25, 26, 27, 28
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22
1, 2, 3, 5, 1, 2, 3, 4, 6, 7, 8, 9, 5, 7 10, 11, 12, 13, 14
Learning Objectives
Questions
*5.
Describe the lessee’s accounting for saleleaseback transactions.
31, 32
29, 30
23, 24
*6
Describe the lessor’s accounting for a direct financing lease.
33, 34, 35
31, 32
25
*This material is dealt with in an Appendix to the chapter.
1
2, 4
7
Assignment Characteristics Table
Item E20.1 E20.2 E20.3 E20.4 E20.5 E20.6 E20.7 E20.8 E20.9 E20.10 E20.11 E20.12 E20.13 E20.14 E20.15 E20.16 E20.17 E20.18 E20.19 E20.20 E20.21
Level of Description Difficulty Lessee Entries; Finance Lease with No Residual Moderate Value Lessee Entries; Finance Lease with Moderate Unguaranteed Residual Value Lessee Computations and Entries; Finance Lease Moderate with Guaranteed Residual Value Lessee Entries; Finance Lease and Moderate Unguaranteed Residual Value Computation of Rental; Journal Entries for Lessor Moderate Lessor Entries; Sales-Type Lease with Option to Moderate Purchase Type of Lease; Amortization Schedule Moderate Lessor Entries; Sales-Type Lease Moderate Lessee Entries; Initial Direct Costs Moderate Lessee Entries with Bargain-Purchase Option Moderate Lessor Entries with Bargain-Purchase Option Moderate Lessee-Lessor Entries; Sales-Type Lease with a Moderate Bargain Purchase Option Lessee-Lessor Entries; Sales-Type Lease; Moderate Guaranteed Residual Value Lessee Entries; Initial Direct Costs Moderate Amortization Schedule and Journal Entries for Moderate Lessee. Amortization Schedule and Journal Entries for Moderate Lessee. Accounting for an Operating Lease Moderate Accounting for an Operating Lease Moderate Accounting for an Operating Lease Moderate Accounting for an Operating Lease Moderate Accounting for an Operating Lease Moderate
Time (minutes) 15–20 15–20 20–25 20–30 15–25 20-25 15-20 15-20 20–25 20-30 20–30 20-25 20-25 20-25 20–30 20–30 10-20 15–20 20-25 20–25 20–25
Assignment Characteristics Table (Continued)
Item E20.22 *E20.23 *E20.24 *E20.25 P20.1 P20.2 P20.3 P20.4 P20.5 P20.6 P20.7 P20.8 P20.9 P20.10 P20.11 P20.12 P20.13 P20.14 P20.15 P20.16 P20.17
Description Accounting for an Operating Lease Sale-Leaseback Lessee-Lessor, Sale-Leaseback Direct Financing Lease
Level of Difficulty Moderate Moderate Moderate Moderate
Lessee Entries, Finance Lease. Simple Lessee Entries and Balance Sheet Presentation, Moderate Finance Lease. Lessee Entries and Balance Sheet Presentation, Moderate Finance Lease. Lessee Entries, Finance Lease with Monthly Moderate Payments. Basic Lessee Accounting with Difficult PV Calculation Moderate Lessee-Lessor Entries, Finance Lease with a Moderate Guaranteed Residual Value. Lessor Computations and Entries, Sales-Type Lease Complex with Guaranteed Residual Value. Lessee Computations and Entries, Finance Lease Complex with Guaranteed Residual Value. Lessor Computations and Entries, Sales-Type Lease Complex with Unguaranteed Residual Value. Lessee Computations and Entries, Finance Lease Complex with Unguaranteed Residual Value. Lessee-Lessor Accounting for Residual Values. Complex Lessee-Lessor Entries, Balance Sheet Presentation, Moderate Finance, and Sales-Type Lease. Balance Sheet and Income Statement Disclosure— Moderate Lessee. Balance Sheet and Income Statement Disclosure— Moderate Lessor. Finance and Operating Lease. Moderate Operating lease. Moderate Lessee-Lessor Entries, Operating Lease with an Moderate Unguaranteed Residual Value.
Time (minutes) 25-30 20-30 20–30 20-25 20–25 20–30 35–45 30–40 40-50 25–35 30-40 30–40 30-40 30–40 30–40 35-45 35–45 40-50 30–40 30–40 30–40
Assignment Characteristics Table (Continued)
Item
Description
CA20.1 CA20.2 CA20.3 CA20.4
Lessee accounting and reporting. Lessor and lessee accounting and disclosure. Lessee capitalization tests. Comparison of different types of accounting by the lessee and lessor. Short-Term lease vs. finance lease. Lease capitalization, bargain-purchase option. Sale-Leaseback.
CA20.5 CA20.6 *CA20.7
Level of Difficulty
Time (minutes)
Moderate Moderate Moderate Moderate
15–25 25–35 20–30 15–25
Moderate Moderate Moderate
20–25 20–30 15–25
Answers to Questions 1.
(a)
Possible advantages of leasing for the lessee: 1. Leasing may be more flexible in that the lease agreement may contain less restrictive provisions than the bond indenture. 2. Leasing permits 100% financing of assets, as the lease is often signed without requiring any money down from the lessee. 3. Leasing may permit more rapid changes in equipment, reduce the risk of obsolescence, and pass the risk in residual value to the lessor or a third party. 4. Leasing may have favorable tax advantages.
(b) Assuming that funds are readily available through debt financing, there may not be great advantages (in addition to the above-mentioned) to signing a noncancelable, long-term lease. One additional advantage of leasing is its availability when another debt financing is unavailable. (c) Given the new reporting standard on leasing the financial statement effects of a long-term noncancelable lease versus the purchase of the asset are somewhat similar. That is assets under a long-term lease are capitalized at the present value of the future lease payments and this value is probably equivalent to the purchase price of the assets. On the liability side, the bond payable amount would be equivalent to the present value of the future lease payments. In summary, the amounts presented in the balance sheet would be quite comparable. The description of the leased asset (right-of-use asset) and related liability would however, be different than under a bond financing as would the general classifications; the specific labels (leased assets and lease liability) would be different. LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
2.
Possible advantages of leasing for a lessor: 1. It often provides profitable interest margins. 2. It can stimulate sales of a lessor’s product whether it be from a dealer (lessor) or a manufacturer (lessor). 3. It often provides tax benefits that enhance the return for the lessor and other parties to the lease. 4. It can provide a high residual value to the lessor upon the return of the property at the end of the lease term, which can potentially provide very large profits.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
3.
Lessees generally have two possible lease accounting methods: (a) the finance method and (b) the operating method. Under both methods, the lessee records a right-of-use asset and a related lease liability. However, the subsequent treatment of the right-of-use asset and lease liability differs under each method. For a finance lease, the lessee recognizes interest expense on the lease liability over the life of the lease using the effective interest method and records amortization expense on the right-of-use asset generally on a straight-line basis. A lessee, therefore, reports both interest expense and amortization of the right-of-use asset on the income statement. In an operating lease, the lessee also measures interest expense using the effective interest method. However, the lessee amortizes the right-of-use asset, such that the total lease expense is the same from period to period. In other words, for operating leases, only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement, typically on a straight-line basis.
Questions Chapter 20 (Continued) To determine which method to apply, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset (i.e., if control transfers to the lessee). If the lease meets one of five classification tests to determine whether the arrangement is effectively a purchase of the underlying asset, the lease is treated as a finance lease. Otherwise, if none of the tests are met, the lessee is deemed only to obtain the right to use the asset (not ownership of the asset itself) and accounts for the lease as an operating lease. LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
4.
The five classification tests are the following: 1. Transfer of Ownership Test: if the lease transfers ownership of the asset to the lessee at the end of the lease term, it is a finance lease. 2. Lease Purchase Option Test: if it is reasonably certain that the lessee will exercise the option (i.e., it is a bargain purchase option), it is a finance lease. 3. Lease Term Test: when the lease term is a major part of the remaining economic life of the leased asset (often indicated by a guideline of 75% or more of the economic life of the asset), then the lease is a finance lease. 4. Present Value Test: if the present value of the lease payments (fixed payments + residual value guarantee + bargain-purchase option) is reasonably close to the fair value of the asset (often indicated by a guideline of 90% or more of the fair value of the asset), then the lease is a finance lease. 5. Alternative Use Test: if at the end of the lease term, the lessor does not have an alternative use for the asset, the lease is a finance lease.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
5.
The discount rate used by the lessee in the present value test and for valuing the lease liability is the implicit interest rate used by the lessor. This rate is defined as the discount rate that, at the commencement of the lease, causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset. However, if it is impracticable for the lessee to determine the implicit rate of the lessor, the lessee should use its incremental borrowing rate. The incremental borrowing rate is the rate of interest the lessee would have to pay on a similar lease or incur to borrow over a similar term the funds necessary to purchase the asset.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
6.
(a) If a lease is for a major part of the economic life of the lease, the lease is classified as a finance lease. In practice, 75% of the economic life of the asset is generally used to meet this classification test. That is, if the lease term is 75% or greater of the economic life of the asset, the lease is classified as a finance lease. (b) If the lease term is 12 months or less the lessee may elect to use the short-term lease exception, and thus, the lease would not be classified as a finance lease. The lessee would expense the lease payment in the applicable year. (c) If the lease transfers ownership of the asset at the end of the lease, the lease is classified as a finance lease. This situation meets one of the classification tests for a finance lease.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 20 (Continued) 7.
Paul Singer is for the most part correct. As long as the lease has a lease term of over 12 months, Paul is correct that the lease must be recognized on the balance sheet of the lessee. However, the new lease standard allows for a short-term lease exception. Under the short-term lease exception for lessees, rather than recording a right-of-use asset and a lease liability, lessees may elect to expense the lease payments as incurred. In this case, the lease is not capitalized on the balance sheet as Paul suggested.
LO: 1, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
8.
(a) Residual value is the expected value of the leased asset at the end of the lease term. (b) A guaranteed residual value is a guarantee made to a lessor that the value of the leased asset returned to the lessor at the end of a lease will be at least a specified amount. Any amounts guaranteed under a residual value guarantee should be included in the present value test. (c) Initial direct costs are incremental costs of a lease that would not have been incurred had the lease not been executed. Initial direct costs incurred by the lessee are included in the cost of the right-of-use asset but are not recorded as part of the lease liability.
LO: 1, 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
9.
(a) A bargain purchase option is a lease purchase option in which the lessee can buy the asset for a price that is significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable, thus, making the exercise of the option reasonably certain. A bargain renewal option is essentially the same conceptually as a bargain purchase option, except the option is to renew the lease as opposed to purchasing the asset. That is, a bargain renewal option is an option in which the price of renewal at which the lessee can buy the asset is significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable, thus, making the exercise of the option reasonably certain. (b) A bargain purchase option and a bargain renewal option have similar impacts on the initial classification and measurement of the lease. With respect to classification, the existence of a bargain purchase option is one way a lease can meet the finance/sales-type lease classification criteria. In the case of a bargain renewal option, the additional lease term that would be added by exercising the option should be included in the lease term when assessing whether or not the lease meets the lease term test. The present value of the option price would also be used in assessing whether the lease met the present value test. For measurement purposes, the present value of both a bargain purchase option and a bargain renewal option should be included in the initial value of the lease liability and right-of-use asset.
LO: 1, 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
10.
The lease liability is recorded at the present value of the lease payments. This includes the periodic rental payments made by the lessee, bargain-purchase option if any, and amounts probable to be owed under a residual value guarantee. The present value of the lease payments is recorded as a lease liability by the lessee.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
11.
Wonda Stone is correct in her interpretation. For purposes of lease classification, the present value of the guaranteed residual value is used in determining whether the present value (90%) test is met. However, the amount included in the measurement of the lease liability is only the amount that the lessee expects to owe under the residual value guarantee at the end of the lease. For example, if a lessee guarantees a residual value of $10,000, but it is also probable that the lessee does not expect to owe any additional money at the end of the lease, then the guaranteed residual value would not be included in the initial measurement of the lease liability.
LO: 1, 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 20 (Continued)
12.
The right-of-use asset is initially measured as the same amount as the lease liability (i.e., the present value of lease payments), adjusted for initial direct costs, prepayments, and lease incentives. Initial direct costs paid by the lessee will increase the initial value of the right-of-use asset. Similarly, prepaid rent paid by the lessee will increase the amount of the right-of-use asset recorded. Lease incentives granted to the lessee by the lessor will decrease the initial value of the right-of-use asset.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
13.
Variable lease payments should be included at the level of the index/rate at the commencement date. Increases or decreases in the index should not be assumed when valuing the lease liability. Thus, for the lease in this question, the lessee should not assume any changes in the CPI. The difference in the monthly payment in the second year from the first year of $100 ($5,100 - $5,000) is expensed in the period incurred. Only if the lessee knows the amount of the variable payment in subsequent periods should it include these payments in the lease liability computation. The lease payment in the second year is $5,150 [$5,000 + ($5,000 x 3%)].
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
14.
The lessee records a right-of-use asset and lease liability at the commencement of the lease. The lessee records the same amount for lease expense each period over the lease term (often referred to as the straight-line method). The straight-line amount to be recognized each period is computed by finding the total cost of the lease to the lessee and dividing the total cost by the number of periods in the lease term. To accomplish the goal of achieving a single operating cost that is constant from period to period, companies continue to use the effective interest method for amortizing the lease liability. However, instead of reporting interest expense, a lessee reports interest on the lease liability as Lease Expense. In addition, the lessee no longer reports amortization expenses related to the right-of-use asset. Instead, it “plugs” in an amount that increases the Lease Expense amount so that it is constant from period to period. This plugged amount then reduces the right-of-use asset, such that both the asset and liability are amortized to zero at the end of the lease.
LO: 3, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC: None
15.
For a finance lease, the lessee records a right-of-use asset and lease liability at the commencement of the lease. The lessee then recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and records amortization expense on the right-of-use asset generally on a straight-line basis. A lessee, therefore, reports both interest expense and amortization of the right-of-use asset on the income statement. As a result, the total expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement. The lessee continues to amortize the right-of-use asset and decrease the principal of the lease liability until both are reduced to zero at the end of the lease. The right-of-use asset should be amortized over the lease term unless there is a bargain-purchase option or ownership of the asset transfers to the lessee at the end of the lease. If either of these criteria is met, then the lessee amortizes the right-of-use asset over the economic life of the asset.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC: None
Questions Chapter 20 (Continued) 16.
The income statement presentation differs between the operating and finance lease methods of accounting for the lessee. While both methods amortize the right-of-use asset and reduce the lease liability over the course of the lease, the accounts used, and amounts recognized are different. Under the operating method, a lessee records the same amount for lease expense each period over the lease term, partially made up of interest expense from the lease liability and amortization expense on the right-of-use asset. While the total “Lease Expense” is composed of essentially two different components, only one expense account is used on the income statement to recognize those two components. In contrast, under the finance lease method, a lessee reports both interest expense and amortization of the right-of-use asset on the income statement. In addition, instead of a straight-line, constant expense period to period, the separate treatment of the right-of-use asset and lease liability leads to the total expense for the lease transaction being higher in the earlier years of the lease arrangement than at the end of the lease arrangement. The balance sheet presentation is similar between the two methods, in that both methods require the recognition of a lease liability and related right-of-use asset at the commencement of the lease. However, it is the subsequent amortization and reduction of lease liability and right-of-use asset that differs, as described in the income statement presentation above.
LO: 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
17.
The lease agreement between Dr. Alice Foyle and Brownback Realty, Inc. is in substance a purchase of property. Because the lease has a bargain-purchase option that transfers ownership of the property to the lessee, the lease is a finance lease to Alice Foyle and a sales-type lease to Brownback Realty. As a finance lease, the right-of-use asset and related lease liability should be recorded at the discounted amount of the future lease payments over the economic life of the medical building given the bargain purchase option.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
18.
From the standpoint of the lessor, leases will (with few exceptions) be classified for accounting purposes as either (a) operating leases or (b) sales-type leases. A sales-type lease meets one or more of the following five tests: 1. The lease transfers ownership, 2. The lease contains a bargain-purchase option, 3. The lease term is a major part of the remaining economic life of the underlying asset (i.e., equal to 75% or more of the estimated economic life of the property), 4. The present value of the lease payments equals or exceeds substantially all of the underlying asset’s fair value (i.e., 90% of the fair value of the property), 5. The asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. If none of the above five tests are met, the lease will be treated as an operating lease. The FASB concluded that by meeting any one of the lease classification tests, the lessor transfers control of the leased asset and therefore, satisfies a performance obligation, which is required for revenue recognition under the FASB’s recent standard on revenue. That is, if the lessee takes ownership or consumes a substantial portion of the underlying asset over the lease term, the lessor has in substance transferred control of the right-of-use asset and the lessor has a sales-type lease. On the other hand, if the lease does not transfer control of the asset over the lease term, the lessor generally uses the operating approach in accounting for the lease.
LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 20 (Continued) 19.
A lease receivable is defined as the present value of the periodic rental payments plus any guaranteed residual value. A net investment in the lease includes not only the components of the lease receivable but also any unguaranteed residual value. In other words, the net investment in the lease is equal to the present value of the rental payments, plus any guaranteed residual value plus any unguaranteed residual value. As indicated in the test, for homework problems, we assume that the present value of the unguaranteed residual value should be included as part of the lease receivable.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
20.
Under the operating method, each rental receipt of the lessor is recorded as lease revenue. The underlying leased asset is still recognized on the balance sheet of the lessor and depreciated in the normal manner. In addition to depreciation, any other related costs to the lease arrangement (i.e., insurance, maintenance, taxes, etc.) are recorded in the period incurred.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC: None
21.
Under a sales-type lease, lessors report in the income statement Sales Revenue and Cost of Goods Sold (and resultant gross profit) at the commencement of the lease. During the lease term, Interest Revenue on the Lease Receivable is reported. Under an operating lease, lessors report Lease Revenue (generally when payments are received) and Depreciation Expense on the leased asset.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC: None
22.
Walker Company can use the sales-type lease method if the lease meets one or more of the following five tests: (1) The lease transfers ownership of the property to the lessee, (2) The lease contains a bargain-purchase option, (3) The lease term is a major part of the remaining economic life of the underlying asset (i.e., equal to 75% or more of the estimated economic life of the property), (4) The present value of the lease payments equals or exceeds substantially all of the underlying asset’s fair value (i.e., 90% of the fair value of the property), (5) The asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
23.
Metheny Corporation should recognize the present value of the lease payments (normal sales price) as sales revenue, and the carrying amount (book value) of the asset as cost of goods sold. Thus, the gross profit from the lease should be recognized at the commencement of the lease as the difference between the sales revenue and cost of goods sold. Subsequent to lease commencement, the company will recognize interest revenue on the lease receivable. If an unguaranteed residual value is involved, the lessor should reduce both the sales revenue and cost of goods sold by the present value of the unguaranteed residual value. The gross profit, however, will not change.
LO: 2, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
24.
Although not part of the classification tests, the lessor must also determine whether the collectibility of payments from the lessee is probable, as it has implications for the subsequent accounting of the lease. Because collection of the lease payments is not probable for Packer Company, it should record the receipt of the payments as a deposit liability and not derecognize the leased asset.
LO: 2, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 20 (Continued) 25.
(a) (1) The lessee’s accounting for a lease with an unguaranteed residual value is the same as the accounting for a lease with no residual value. That is, unguaranteed residual values are not included in the lessee’s lease payments, either for classification or measurement purposes. (2) A guaranteed residual value has significance for the lessee in two ways. First, for classification purposes, the full amount of a guaranteed residual value is used in calculating the present value of the lease payments in determining whether or not a lease meets the present value test. In addition, as far as the initial measurement of the lease liability, a guaranteed residual value may be included, depending on how much a lessee expects to owe under the guarantee. (b) The value of the lease liability may be made up of two components—the periodic rental payments and amounts probable to be owed under a guaranteed residual value. That is, if the expected residual value at the end of the lease term is less than the guaranteed residual value, then the lessee will expect to pay in cash a certain amount to the lessor at the end of the lease term. As such, the lessee should include the present value of the difference between the guaranteed residual and expected residual if the expected residual is less than the guarantee. If the residual value at the end of the lease term differs in any way from the expected residual at the commencement of the lease, the lessee recognizes a loss or gain when the final payment of the guaranteed residual is made.
LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
26.
The amount to be recovered by the lessor is the same whether the residual value is guaranteed or unguaranteed. Therefore, the amount of the periodic rental payments is set the same way by the lessor whether the residual value is guaranteed or unguaranteed.
LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
27.
If a bargain-purchase option exists, the lessee must increase the present value of the lease payments by the present value of the option price. This is the case for both classification and initial measurement of the lease liability and right-of-use asset. A bargain purchase option also affects the period over which the right-of-use asset is amortized, since the lessee amortizes the asset over its economic life rather than the term of the lease. If the lessee fails to exercise the option, the lessee will recognize a loss to the extent of the book value of the right-of-use asset in the period that the option expired.
LO: 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, Measurement Analysis and Interpretation, AICPA PC: None
28.
Initial direct costs are the incremental costs of a lease that would not have been incurred had the lease not been executed. For the lessee, some costs that are included in the right-of-use asset are commissions, legal fees from the execution of the lease, lease documentation preparation costs incurred after the execution of the lease, and consideration paid for a guarantee of residual value by an unrelated third party. For operating leases, the lessor should defer initial direct costs and amortize them as expenses over the term of the lease. In a sales-type lease transaction, the lessor expenses the initial direct costs at lease commencement (in the period in which it recognizes the profit on the sale). An exception is when there is no selling profit or loss on the transaction, in which case the initial direct costs are deferred and recognized over the lease term.
LO: 4, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
29.
A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less. Rather than recording a right-of-use asset and lease liability, lessees may elect to expense lease payments as incurred.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 20 (Continued)
30.
Lessees and lessors must provide additional qualitative and quantitative disclosures to help financial statement users to assess the amount, timing, and uncertainty of future cash flows. Qualitative lease disclosures include the nature of the leases, how variable lease payments are determined, the existence and terms and conditions for options to extend or terminate the lease and for residual value guarantees, and information about significant assumptions and judgments such as discount rates. Quantitative disclosures include total lease cost, finance lease cost segregated between the amortization of the right-of-use assets and interest on the lease liabilities, operating and short-term lease cost, weighted-average remaining lease term and weightedaverage discount rate (segregated between finance and operating leases), and maturity analysis of finance and operating lease liabilities on an annual basis for a minimum of each of the next five years and the sum of the undiscounted cash flows for all years thereafter.
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*31. In a sale-leaseback arrangement, a company (the seller-lessee) transfers an asset to another company (the buyer-lessor) and then leases that asset back from the buyer-lessor. In order to qualify for sale-leaseback treatment, the initial transfer of the asset must be such that the sellerlessee gives up control of the asset to the buyer-lessor. In this way, the transaction is a sale, and gain or loss recognition is appropriate. In addition, the subsequent leaseback must be classified as an operating lease for the seller-lessee. This is because if any of the lease classification tests are met, the seller-lessee never actually gave up control of the asset, and thus a sale is deemed to never have happened. As long as the initial owner of the asset continues to control the asset, it should not record a sale nor recognize a gain or loss. Instead, the transaction is treated as borrowing money from the ‘buyer-lessor’ in a financing arrangement, often labeled a “failed sale.” LO: 5, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*32.
The sale and subsequent lease will receive sale-leaseback accounting treatment. The initial transfer of the asset was a sale, and the seller-lessee gave control of the asset to the buyer-lessor. In addition, the subsequent leaseback is classified as an operating lease, and thus Sanchez never takes control of the asset back from Harper. Had the leaseback been classified as a financing lease, the transaction would have been considered a ‘failed sale’ and would have simply been accounted for as a borrowing arrangement. However, because it qualifies for sale-leaseback treatment, Sanchez should recognize the $4 million gross profit at the commencement of the lease and record a right-of-use asset and lease liability at the present value of the lease payments.
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*33.
Lessors account for a lease as a sales-type lease if the lease transfers control of the underlying asset to the lessee, based on meeting one of the five lease classification tests. If none of the classification tests are met, generally the lease will be classified as an operating lease. However, a direct financing lease is a unique exception to this rule that only occurs in the presence of a third-party residual value guarantee. If the lessor effectively relinquishes control of the asset to the lessee (substantially all risks/rewards of ownership), but there is also a third-party residual value guarantee such that the 90% test is met as a result, the lease is classified as a direct financing lease instead of a sales-type or operating lease.
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*34.
In a sales-type lease, the lessor recognizes the gross profit immediately at the commencement of the lease, and interest revenue each period on the lease receivable. In a direct-financing lease, the lessor defers its gross profit, and recognizes it over the course of the lease term along with interest revenue. In an operating lease, the lessor recognizes lease revenue as periodic rental payments are collected and the performance obligation is satisfied.
LO: 6, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Questions Chapter 20 (Continued) *35.
Under a direct financing lease, the profit on the lease is deferred and recognized over the life of the lease (instead of at the lease commencement as would be the case in a sales-type lease). The deferred gross profit reduces the receivable in the lease, and subsequent accounting for the direct-financing lease is based on a discount rate that will amortize the net lease receivable over the life of the lease to zero. That is, in a direct-financing lease the rate used to amortize the lower net lease receivable (lease receivable less deferred gross profit) will be higher. This results because the rate includes interest revenue on the lease receivable and revenue from amortizing deferred gross profit.
LO: 6, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Solutions to Brief Exercises Brief Exercise 20.1 The lease does not meet the transfer of ownership test, the bargain purchase test, the economic life test [(5 years ÷ 8 years) < 75%], or the specialized asset test. However, it does pass the present value test. The present value of the lease payments [($31,000 x 4.46511*) + ($15,500 x .74726**)] = $150,000) is greater than 90% of the FV of the asset (90% x $150,000 = $135,000). Therefore, Callaway should classify the lease as a finance lease. *Present value of an annuity due of 1 for 5 periods at 6%. **Present value of 1 for 5 periods at 6%. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 20.2 The lease does not meet the transfer of ownership test, the bargain purchase test, or the specialized asset test. While the initial five-year lease term and rental payments would result in the lease failing the economic life test and the present value test, Jelly must also take the renewal option into account when computing the lease term and present value of the lease payments, as the exercise of the renewal option is reasonably certain. When accounting for the bargain renewal option, the lease will meet both the economic life test and the present value test (as shown below). Thus, the lease should be classified as a finance lease for Jelly Co. Economic Life Test 6 years (5 years initial + 1 year for renewal option) ÷ 7 years = 85.7% > 75% Present Value Test PV of initial rental payments (4.54595* x $15,000):
$68,189
PV of bargain renewal option (.78353** x $10,000):
7,835
PV of lease payments: Fair value of the equipment: PV of lease payments as a percent of fair value
$76,024 ÷ $76,024 100%
*Present value of an annuity due of 1 for 5 periods at 5%. **Present value of 1 for 5 periods at 5%. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 20.3
The lease payments in the lease arrangement will include both the annual fixed payments of $800,000 each year, plus the $11,000,000 bargain purchase option at the end of the lease term (as it is reasonably certain to be exercised). Thus, the lease payments for the lease agreement total ($800,000 x 6) + $11,000,000 = $15,800,000. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 20.4 The lease payments for years 1 and 2 will be $1,700 ($2,000 annual rental minus $300 lease incentive). In year 3, Fieger will receive no lease incentive, and will have a full lease payment of $2,000. Thus, in total over the first 3 years, the lease payments will be $5,400 ($1,700 + $1,700 + $2,000). LO: 2, 4 Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 20.5 Variable payments in a lease are not considered in determining the initial value of the lease liability and right-of-use asset. Because the lease payments are based on 4% of net sales, these payments are considered variable, as they are not based on an index or rate, the future level of which is not known at lease commencement. It does not matter that it is highly certain that Sanders will achieve a minimum of $1,000,000 in net sales each year. Thus, these variable lease payments are not included in the initial valuation of the lease liability and right-of-use asset. Since they are the only payments being made in the lease agreement, Sanders would record the right-of-use asset at zero and record lease expense when payments are made. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 20.6 12/31/24 Right-of-Use Asset ($41,933 x 3.57710*) ....................... Lease Liability .........................................................
150,001**
Lease Liability ................................................................ Cash......................................................................... *Present value of an annuity due of 1 for 4 periods at 8%. **Rounded by $2.
150,001 41,933 41,933
Brief Exercise 20.6 (Continued) 12/31/25 Interest Expense [($150,001 – $41,933) x .08] .............. Lease Liability ($41,933 - $8,645) .................................. Cash.........................................................................
8,645 33,288 41,933
Amortization Expense .................................................... Right-of-Use Asset ($150,001 ÷ 4) ....................................................
37,500 37,500
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.7 12/31/25 Interest Expense [($300,000 – $48,337) x .08] .............. Lease Liability ($48,337 - $20,133) ................................ Cash.........................................................................
20,133 28,204
Amortization Expense .................................................... Right-of-Use Asset ($300,000 ÷ 8) ....................................................
48,337 37,500 37,500
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.8 Fair value of leased asset Less: Present value of guaranteed residual value ($5,000 x .50025*) Amount to be recovered through lease payments
$70,000
Amount of equal annual lease payments ($67,499 ÷ 6.74664**)
$10,005
*Present value of 1 for 9 periods at 8%. **Present value of an annuity due of 1 for 9 periods at 8%. LO: 2, 4 Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
2,501 $67,499
Brief Exercise 20.9 Fair value of leased asset Less: Present value of lessor’s expected residual value* ($30,000 x .79209**) Amount to be recovered through lease payments
$47,000
Amount of equal annual lease payments ($23,237 ÷ 3.46511***)
$6,706
23,763 $23,237
*The expectation of the residual value of the lessee would not matter in this case. The lessor uses its own expectation of the residual value in determining the annual lease payments. The lessor probably would not even be aware of the lessee’s expectations. **Present value of 1 for 4 periods at 6%. ***Present value of an ordinary annuity for 4 periods at 6%. LO: 1, 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.10 Lease Receivable (4.99271* x $30,044) ......................... Cost of Goods Sold ........................................................ Sales Revenue ........................................................ Inventory .................................................................
150,001 120,000
Cash ................................................................................ Lease Receivable ....................................................
30,044
150,001 120,000 30,044
*Present value of an annuity due of 1 for 6 periods at 8%. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.11 Cash ................................................................................ Lease Receivable ($30,044 - $9,597) ...................... Lease Revenue [($150,001 – $30,044) x .08] .........
30,044
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
20,447 9,597
Brief Exercise 20.12 Lease Receivable ($40,800 x 4.31213*) ......................... Cost of Goods Sold ........................................................ Sales Revenue ........................................................ Inventory .................................................................
175,935 120,000
Cash ................................................................................ Lease Receivable ....................................................
40,800
175,935 120,000 40,800
*Present value of an annuity due of 1 for 5 periods at 8%. LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.13 Cash ................................................................................ Deposit Liability*.....................................................
40,800 40,800
*When collectibility of lease payments is not probable, the lessor does not derecognize the asset or recognize selling profit on the lease. Instead, Geiberger would recognize any cash receipts as a deposit liability. LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.14 Lease Receivable ........................................................... Interest Revenue .....................................................
57
Inventory ......................................................................... Lease Receivable ....................................................
1,000
57 1,000
Note to Instructor: The above two entries can be combined into one entry at the end of the year, as shown below: Inventory ......................................................................... Interest Revenue ..................................................... Lease Receivable ....................................................
1,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
57 943
Brief Exercise 20.15 1/1/25 Right-of-Use Asset (2.83339* x $23,000) ....................... Lease Liability .........................................................
65,168 65,168
*Present value of an annuity due of 1 for 3 periods at 6%. Lease Liability ................................................................ Cash.........................................................................
23,000 23,000
Schedule A LEBRON JAMES CORPORATION Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Payment $23,000 23,000 23,000
Interest (6%) on Liability $
0 2,530 1,302
Reduction of Lease Liability
Lease Liability
$23,000 20,470 21,698
$65,168 42,168 21,698 0
Schedule B Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(A) (B) Lease Expense Interest (6%) on (Straight-Line) Lease Liability $23,000 23,000 23,000
$2,530 1,302 0
(C) Amortization of ROU Asset (A-B)
Carrying Value of ROU Asset
$20,470 21,698 23,000
$65,168 44,698 23,000 0
12/31/25 Lease Expense ............................................................... Lease Liability (Schedule A) .................................. Right-of-Use Asset (Schedule B) ...........................
23,000 2,530* 20,470
Brief Exercise 20.15 (Continued) *The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in schedule A. Note that this is expensed along with the amortization of the right-of-use asset at the end of 2025. LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.16 1/1/25 Right-of-Use Asset (2.83339* x $35,000) ....................... Lease Liability .........................................................
99,169
Lease Liability ................................................................ Cash.........................................................................
35,000
99,169 35,000
*Present value of an annuity due of 1 for 3 periods at 6%. Schedule A KINGSTON CORPORATION Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27
Interest (6%) Annual Payment on Liability $35,000 35,000 35,000
$
0 3,850 1,981
Reduction of Lease Liability $35,000 31,150 33,019
Lease Liability $99,169 64,169 33,019 0
Brief Exercise 20.16 (Continued) Schedule B Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(A) (B) Lease Expense Interest (6%) on (Straight-Line) Lease Liability $35,000 35,000 35,000
$3,850 1,981 0
(C) Amortization of ROU Asset Carrying Value (A-B) of ROU Asset $31,150 33,019 35,000
12/31/25 Lease Expense ............................................................... Lease Liability (Schedule A) .................................. Right-of-Use Asset (Schedule B) ...........................
$99,169 68,019 35,000 0
35,000 3,850* 31,150
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in schedule A. Note that this is expensed along with the amortization of the right-of-use asset at the end of 2025. LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.17 1/1/25 Cash ................................................................................ Unearned Lease Revenue ......................................
35,000
12/31/25 Unearned Lease Revenue .............................................. Lease Revenue .......................................................
35,000
Depreciation Expense .................................................... Accumulated Depreciation – Leased Equipment ($200,000 ÷ 8) .......................
35,000
35,000 25,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
25,000
Brief Exercise 20.18 1/1/25 Right-of-Use Asset (2.78326* x $12,000) ....................... Lease Liability .........................................................
33,399 33,399
*Present value of an annuity due of 1 for 3 periods at 8%. Lease Liability ................................................................ Cash.........................................................................
12,000 12,000
Schedule A RODGERS CORPORATION Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Payment
Interest (8%) on Liability
$12,000 12,000 12,000
$
Reduction of Lease Liability
0 1,712 889
Lease Liability
$12,000 10,288 11,111
$33,399 21,399 11,111 0
Schedule B Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(A) (B) Lease Expense Interest (8%) on (Straight-Line) Lease Liability $12,000 12,000 12,000
$1,712 889 0
(C) Amortization of ROU Asset (A-B)
Carrying Value of ROU Asset
$10,288 11,111 12,000
$33,399 23,111 12,000 0
Brief Exercise 20.18 (Continued) 12/31/25 Lease Expense ............................................................... Lease Liability (Schedule A) .................................. Right-of-Use Asset (Schedule B) ...........................
12,000 1,712* 10,288
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in schedule A. Note that this is expensed along with the amortization of the right-of-use asset at the end of 2025. LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.19 1/1/25 Cash ................................................................................ Unearned Lease Revenue ......................................
12,000
12/31/25 Unearned Lease Revenue .............................................. Lease Revenue .......................................................
12,000
Depreciation Expense .................................................... Accumulated Depreciation– Leased Equipment [$60,000 ÷ 10] ..........................
12,000
12,000 6,000 6,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.20 $17,000 x 2.83339* = $48,168 *Present value of an annuity due of 1 for 3 periods at 6%. Because the residual value is unguaranteed, Escapee Company does not include it in its computation of the annual lease payments. If the residual value was guaranteed, the lessee may or may not be required to include the residual in the calculation of the lease payments, depending on whether the expected residual value was higher, equal to, or lower than the guaranteed residual value. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.21 (a) The value of the lease liability would remain the same if the only fact changed from BE 20.20 was the guarantee of the expected residual value. Residual values should only be included in the lease liability when the expected residual value is less than the guaranteed residual value (i.e., when the lessee expects to make an additional payment at the end of the lease term to the lessor). (b) Following from the above reasoning, if the expected residual value drops to $5,000 and Escapee guarantees a residual of $9,000, Escapee will need to account for the difference between the expected and guaranteed residual value in calculating the initial lease liability as follows: PV of lease payments ($17,000 x 2.83339*) PV of residual value [($9,000 – $5,000) x 0.83962**] Lease liability
$48,168 3,358 $51,526
*Present value of an annuity due of 1 for 3 periods at 6%. **Present value of 1 for 3 periods at 6%. Note to Instructor: While the measurement of the lease liability/right-ofuse asset only uses the amount probable to be owed under a residual value guarantee, this contrasts with the classification test related to the present value test. That is, the full amount of the guaranteed residual value would be used in performing the present value test for the lessee to determine whether the finance or operating method of accounting for the lease is followed. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.22 12/31/2024 Right-of-Use Asset ......................................................... Lease Liability ......................................................... *PV of rentals ($40,000 x 5.21236*) PV of guaranteed residual value ($20,000 – $10,000***) x 0.70496** Lease liability
215,544* 215,544 $208,494 7,050 $215,544
Brief Exercise 20.22 (Continued) Lease Liability ................................................................ Cash.........................................................................
40,000 40,000
*Present value of an annuity due of 1 for 6 periods at 6%. **Present value of 1 for 6 periods at 6%. ***The lessee need only include in the initial lease liability the amount of the residual value that it expects to pay at the end of the lease term. Thus, in this case, only the residual value in excess of the expected residual value (up to the guaranteed residual) should be discounted to present value and included in the computation of the lease liability. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.23 12/31/24 Lease Receivable ........................................................... Cost of Goods Sold ........................................................ Sales Revenue ........................................................ Inventory .................................................................
222,593* 180,000 222,593 180,000
*([$40,000 x 5.21236] + [$20,000 x .70496]) Cash ................................................................................ Lease Receivable .................................................... 12/31/25 Cash ................................................................................ Lease Receivable ($40,000 - $10,956) .................... Interest Revenue [($222,593 – $40,000) x .06] .......
40,000 40,000 40,000
LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
29,044 10,956
Brief Exercise 20.24 Lease Liability In calculating the lease liability, Forrest must determine which of the executory costs are considered a component of the lease (to be considered in the measurement of the lease liability). • The real estate taxes in this case are variable payments and therefore, are not considered in the measurement of the lease liability and related right-of-use asset. • The fixed $500 insurance payments are included in the measurement of the lease liability because the insurance costs are part of the rental payments. The lease liability is computed as follows: PV of rental payments (4.31213* x $4,638):
$20,000
PV of insurance payments (4.31213* x $500):
2,156
Initial lease liability:
$22,156
*Present value of an annuity due of 1 for 5 periods at 8% Right-of-Use Asset The right-of-use asset is initially measured the same as the lease liability, though it is also adjusted for any initial direct costs, prepaid rent, and lease incentives associated with the lease. The legal fees resulting from the execution of the lease are considered initial direct costs, and must be included in the calculation of the right-of-use asset: Lease liability: Legal fees: Right-of-use asset:
$22,156 1,000 $23,156
Thus, the journal entry to record the initial lease liability and right-of-use asset is as follows: Right-of-Use Asset ......................................................... Cash (Legal Fees) ................................................... Lease Liability .........................................................
23,156*
LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,000 22,156
Brief Exercise 20.25 Answer: $78,998 PV of lease payments: Cash incentive received from Badger (lessor): Lease document preparation costs: Measurement of right-of-use asset at 1/1/25:
$83,498 (5,000) 500 $78,998
Employee salaries are specifically excluded as initial direct costs and would not be included in the calculation of the right-of-use asset. Note to Instructor: The lease liability would not include any adjustments for cash incentive received, or any included initial direct costs. The lease liability would only reflect the present value of future lease payments. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.26 Answer: $46,551 PV of lease payments: Cash incentive received from Highlander (lessor): Commissions for selling agents: Legal fees resulting from the execution of the lease: Measurement of right-of-use asset at 1/1/25:
$44,651 (2,000) 900 3,000 $46,551
Internal engineering costs are specifically excluded as initial direct costs and would not be included in the calculation of the right-of-use asset. Note to Instructor: The lease liability would not include any adjustments for cash incentive received, or any included initial direct costs. The lease liability would only reflect the present value of future lease payments. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.27
1/1/25 Right-of-Use Asset ......................................................... Lease Liability .........................................................
33,974* 33,974
*PV of rentals ($5,300 x 6.20637*) PV bargain purchase option ($2,000 x 0.54027)**
$32,894 1,080 $33,974
*Present value of an annuity due of 1 for 8 periods at 8%. **Present value of 1 for 8 periods at 8%. Lease Liability ................................................................ Cash......................................................................... 12/31/25 Interest Expense [($33,974 – $5,300) x .08] .................. Lease Liability ......................................................... Amortization Expense .................................................... Right-of-Use Asset ($33,974 ÷ 10*) ......................................................
5,300 5,300 2,294 2,294 3,397 3,397
*The right-of-use asset is amortized over the economic life of the asset instead of the lease term because of the bargain-purchase option included in the lease contract, given that the lessee plans to take ownership of the asset. LO: 4, Bloom: AP, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 20.28 Lease Expense ............................................................... Cash.........................................................................
15,000 15,000
*Because the lease term is only 1 year, the lessee treats the lease as a shortterm lease, does not capitalize the asset on its books, and records lease payments as expenses when paid. LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 20.29 The transaction between Irwin and Peete will qualify as a sale-leaseback, as Irwin has transferred control of the asset to Peete. That is, the terms of the leaseback do not meet any of the tests to be classified as a finance lease, and thus do not transfer control back to Irwin. Irwin will recognize a gain on the sale of the asset and record a right-of-use asset and corresponding lease liability for the operating lease entered into with Peete. Subsequent accounting treatment will follow the normal accounting for an operating lease. 1/1/25 Cash ................................................................................ Trucks...................................................................... Gain on Disposal of Plant Assets ($35,000 - $28,000) ... Right-of-Use Asset ......................................................... Lease Liability ($8,696 x 2.67301*).........................
35,000 28,000 7,000 23,245 23,245
*Present value of an ordinary annuity for 3 periods at 6%. IRWIN ANIMATION Lease Amortization Schedule Ordinary-Annuity Basis
Date 1/1/25 1/1/26 1/1/27 1/1/28 *Rounded $1
Annual Payment $8,696 8,696 8,696
Interest (6%) on Liability $1,395 957 491*
Reduction of Lease Liability
Lease Liability
$7,301 7,739 8,205
$23,245 15,944 8,205 0
*Brief Exercise 20.29 (Continued)
Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(A) Lease Expense (Straight-Line) $8,696 8,696 8,696
(B) Interest (6%) on Lease Liability $1,395 957 491
(C) Amortization of Carrying Value ROU Asset (A-B) of ROU Asset $23,245 15,944 8,205 0
$7,301 7,739 8,205
12/31/25 Lease Expense ............................................................... Right-of-Use Asset ................................................. Lease Liability .........................................................
8,696 7,301 1,395
Note to Instructor: The lease payment on 1/1/26 would be as follows: Lease Liability ................................................................ Cash.........................................................................
8,696 8,696
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 20.30 With the change of facts, the leaseback meets the lease term and present value classification tests (5/5 = 100% of asset’s economic life; $8,309 x 4.21236 = $35,000 = 100% of asset’s fair value). As a result, the lease is a finance lease for Irwin. Consequently, Irwin has control of the asset from the lease arrangement and has never given up control of the asset (i.e., a failed sale). Therefore, Irwin will not recognize any gain on the sale of the asset, but instead record a note payable to demonstrate the financing nature of the transaction as shown in the following entry on January 1, 2025. 1/1/25 Cash ................................................................................ Notes Payable [$8,309 x 4.21236*] ......................... * Present value of an ordinary annuity for 5 periods at 6%.
35,000 35,000
*Brief Exercise 20.30 (Continued)
On December 31, 2025, it makes the following entry to record interest on the note payable. 12/31/25 Interest Expense ............................................................ Interest Payable [$35,000 x .06] .............................
2,100 2,100
This sale-leaseback arrangement is a financing transaction and is often referred to as a failed sale. LO: 5, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 20.31 The above lease will be classified as a direct financing lease for Bulls. None of the lease classification criteria are met for a sales-type lease. That is, ownership does not transfer at the end of the lease, there is no bargain purchase option, the asset is not specialized, and the lease term is less than 75% of the useful life of the asset (5 ÷ 8 = 62.5%). In addition, the present value of the lease payments is less than 90% of the fair value of the asset, as shown below: Annual rental payments ................................................. Present value of an ordinary annuity for 5 periods at 4% ..................................................... Present value of lease payments .................................. Fair value of the equipment ........................................... Present value of lease payments as a percentage of fair value .....................................
$4,523 x 4.45182 $20,136 ÷ $30,000 67.12%
The guaranteed residual value is not included in the sales-type lease classification test, as it is not guaranteed by the lessee, but rather an independent 3rd party. However, this 3rd party residual value guarantee is considered when determining whether or not the lease is classified as a direct financing lease. The 90% test will be met when the 3rd party guarantee is considered (as the following calculation shows), and thus the lease is classified as a direct financing lease:
*Brief Exercise 20.31 (Continued)
Annual rental payments ................................................. Present value of an ordinary annuity for 5 periods at 4% ..................................................... Present value of lease payments ..................................
$4,523 x 4.45182 $20,136
3rd party residual value guarantee ................................ Present value of 1 for 5 periods at 4% .......................... Present value of residual value guarantee ...................
$12,000 x .82193 $9,863
Present value of lease payments .................................. Present value of residual value guarantee ................... Present value of lease payments plus 3rd party residual value guarantee............................. Fair value of the equipment ........................................... Present value as a percentage of fair value .................
$20,136 $9,863 $29,999 ÷ $30,000 100%
Because the lease qualifies as a direct financing lease, the gross profit from the lease is deferred and recognized over the course of the lease. The initial entry at the commencement of the lease would be as follows: Lease Receivable ........................................................... Deferred Gross Profit ............................................. Leased Asset ..........................................................
29,999 2,999 27,000
LO: 6, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 20.32 In a normal sale-type lease, Bulls would receive lease payments over the life of the lease which, on a present value basis, equals the lease receivable of $30,000 (using a 4% return). This is demonstrated in the amortization schedule on the next page:
*Brief Exercise 20.32 (Continued)
BULLS, INCORPORATED (Lessor) Lease Amortization Schedule Sales-Type Lease
Date
Annual Lease Payment
1/1/25 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 12/31/29
$4,523 4,523 4,523 4,523 4,523 12,000 $34,615
Interest (4%) on Lease Receivable $1,200 1,067 929 785 634* _____ $4,615
Recovery of Lease Receivable $3,323 3,456 3,594 3,738 3,889 12,000 $30,000
Lease Receivable $30,000 26,677 23,221 19,627 15,889 12,000 -0-
*Rounded $2 In a direct financing arrangement, Bulls will receive the same lease payments, but will recognize lease revenue based on the rate of return that will amortize the net lease receivable to zero (7.11% for Bulls). The following shows the direct financing lease amortization schedule for Bulls: BULLS, INCORPORATED (Lessor) Lease Amortization Schedule Direct Financing Lease
Date
Annual Lease Payment
1/1/25 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 12/31/29 *Rounded by $3.
$4,523 4,523 4,523 4,523 4,523 12,000 34,615
Interest (7.11%) on Receivable $1,920 1,735 1,536 1,324 1,100* _____ $7,615
Reduction of Net Lease Receivable $2,603 2,788 2,987 3,199 3,423 12,000 27,000
Net Lease Receivable $27,000 24,397 21,609 18,622 15,423 12,000 -0-
*Brief Exercise 20.32 (Continued)
The difference between the interest under a sales-type lease ($1,200) and the overall revenue recognized for a direct financing lease ($1,920) is the amount of deferred gross profit that is amortized in the current period ($720). Cash .......................................................................... Deferred Gross Profit** .................................................. Lease Revenue* ...................................................... Lease Receivable ....................................................
4,523 720
*Lease Revenue = Net Lease Receivable x Rate of Return = ($30,000 – $3,000) x .0711 = $1,920 **Deferred Gross Profit = Lease Revenue – Sales-Type Interest = $1,920 – $1,200 = $720 LO: 6, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,920 3,323
Solutions to Exercises Exercise 20.1 (15–20 minutes) Note to Instructor: This is a finance lease, as the lease term is 100% of the asset’s economic life, and the present value of the rental payments are 100% of the asset’s fair value, as shown below: Present value of first payment @ 8% ($5,552.82 x .92593).................................. Present value of second payment @ 8% ($5,830.46 x .85734).................................. Present value of third payment @ 8% ($6,121.98 x .79383)..................................
$ 5,141.52 4,998.69 4,859.81
Present value of the rental payments ....... $15,000.02* *Two cents rounding error. 12/31/24 Right-of-Use Asset ......................................... Lease Liability ......................................
15,000
12/31/25 Interest Expense ($15,000 x 8%) ................... Lease Liability ($5,552.82 - $1,200.00)........... Cash ......................................................
1,200.00 4,352.82
Amortization Expense ($15,000 ÷ 3).............. Right-of-Use Asset ...............................
15,000
5,552.82 5,000.00 5,000.00
12/31/26 Interest Expense [($15,000 - $4,352.82) x 8%] ........................ Lease Liability ($5,830.46 - $851.77) ............. Cash ...................................................... Amortization Expense ($15,000 ÷ 3).............. Right-of-Use Asset ...............................
851.77 4,978.69 5,830.46 5,000.00 5,000.00
Exercise 20.1 (Continued) (b) The initial valuation of the lease liability and related right-of-use asset should not include any unknown increases or decreases in lease payments due to increases or decreases in the CPI. Rather, for the initial measurement of the lease liability, the lessee assumes that all payments will be made as if the CPI level at the commencement date of the lease does not change. Thus, Joe’s Journeys should discount the annual lease payments using the ordinary annuity factor applied to the first lease payment. LO: 1, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.2 (15–20 minutes) (a) This is a finance lease to Burke since the lease term (5 years) is greater than 75% of the economic life (6 years) of the leased asset. The lease term is 831/3% (5 ÷ 6) of the asset’s economic life. (b) Computation of present value of lease payments: $8,668 x 4.54595* = $39,404 *Present value of an annuity due of 1 for 5 periods at 5%. (c) 12/31/24 Right-of-Use Asset .................................................... Lease Liability .....................................................
39,404
Lease Liability .......................................................... Cash .....................................................................
8,668
39,404 8,668
12/31/25 Amortization Expense ............................................... Right-of-Use Asset.............................................. ($39,404 ÷ 5)
7,881
Lease Liability ($8,668 - $1,537) .............................. Interest Expense [($39,404 – $8,668) x .05] .................................... Cash .........................................................
7,131
7,881
1,537
LO: 2, 4 Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.3 (20–25 minutes)
8,668
(a) To Delaney, the lessee, this lease is a finance lease because the terms satisfy the following tests: 1. 2.
The lease term is greater than 75% of the economic life of the leased asset; that is, the lease term is 831/3 % (50/60) of the economic life. The present value of the lease payments for purposes of classifying the lease is greater than 90% of the fair value of the leased asset; that is, the present value of $9,793 (see below) is 98% of the fair value ($10,000) of the leased asset: PV of monthly payment of $200 for 50 months [$200 x 44.36350*] .............................................. PV of residual value of $1,180 [$1,180 x .77929**] .............................................. Present value of lease payments .......................
$8,873 920 $9,793
*Present value of an annuity due of 1 for 50 periods at 0.5% **Present value of 1 for 50 periods at 0.5% Note to the Instructor: The lease payments used in the calculation of the present value for classification purposes for the lessee include the full amount of any guaranteed residual value by the lessee. This contrasts with the calculation of the present value of lease payments to determine the lease liability, as seen in (b). (b) The present value of lease payments, for purposes of determining the lease liability for the lessee, are different than the present value of lease payments in determining the classification of the lease when a residual value is guaranteed by the lessee. That is, to determine the lease liability, the lessee should only include the present value of any guaranteed residual value probable to be owed under the lease agreement (i.e., the amount of guaranteed residual value over the expected residual value). Because the expected residual value is the same as the guaranteed residual value, no amounts are probable to be owed under the lease agreement, and the present value of lease payments to determine the lease liability therefore, is: PV of monthly payment of $200 for 50 months [$200 x 44.36350*] .............................................. *Present value of an annuity due of 1 for 50 periods at 0.5%. Exercise 20.3 (Continued)
$8,873
(c) Right-of-Use Asset .................................................... Lease Liability .....................................................
8,873
(d) Lease Liability ............................................................ Cash .....................................................................
200
(e) Lease Liability ($200 - $43)........................................ Interest Expense (0.5% x [$8,873 – $200])................ Cash .....................................................................
157 43
(f)
177
8,873 200
200
Amortization Expense ............................................... Right-of-Use Asset.............................................. ($8,873 ÷ 50 months)
177
(g) As explained in part (b), the lessee should include the present value of any guaranteed residual value probable to be owed under the lease agreement. Because the expected residual value ($500) is less than the guaranteed residual value ($1,180), Delaney should include the present value of the difference in the initial measurement of the lease liability. Thus, the present value of the lease payments is calculated as follows: PV of monthly payment of $200 for 50 months [$200 x 44.36350*] PV of guaranteed residual value probable to be owed [($1,180 - $500) x .77929**] PV of lease payments
$8,873 530 $9,403
*Present value of an annuity due of 1 for 50 periods at 0.5%. LO: 2, 4 Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.4 (20–30 minutes) (a) The lease will be treated as a finance lease for Kimberly-Clark because the lease meets both the economic life test and the present value test. That is, 1. the present value test in that the present value of the payment is $525,176 [($71,830 x 7.24689*) + ($10,000 x .46319**)] which is equal to the fair value of the storage building. 2. the lease term test in that the lease term is 83% (10/12) which satisfies the 75% test. *Present value of an annuity due of 1 for 10 periods at 8%. **Present value of $1 for 10 periods at 8%. Note that for purposes of calculating the initial lease liability, however, the present value of the lease payments will only include the amount of a residual value guarantee probable to be owed at the end of the lease term. Thus, the initial lease liability and right-of-use asset to be recorded on the books of Kimberly-Clark are calculated as follows: $ 71,830 X 7.24689 $ 520,544
Annual rental payment PV of annuity due of 1 for n = 10, i = 8% PV of periodic rental payments
$
3,000
X $
.46319 1,390
Amount probable to be owed under residual value guarantee ($10,000 - $7,000) PV of 1 for n = 10, i = 8% PV of amount probable to be owed on residual value guarantee
$ + $
520,544 1,390 521,934
PV of periodic rental payments PV of the residual value Lease liability
Exercise 20.4 (Continued) 12/31/24 Right-of-Use Asset................................ Lease Liability ...........................
521,934
Lease Liability ....................................... Cash ...........................................
71,830
521,934 71,830
12/31/25 Amortization Expense .......................... Right-of-Use Asset .................... ($521,934 ÷ 10)
52,193
Lease Liability ....................................... Interest Expense (See Schedule 1) ................................. Cash ...........................................
35,822
52,193
36,008 71,830
12/31/26 Amortization Expense ...................... Right-of-Use Asset .................... ($521,934 ÷ 10)
52,193
Lease Liability ................................... Interest Expense (See Schedule 1) ............................. Cash ...........................................
38,687
52,193
33,143 71,830
Exercise 20.4 (Continued) Schedule 1
KIMBERLY-CLARK CORP. Lease Amortization Schedule (partial) (Lessee)
Annual Lease Interest (8%) on Payment Liability
Date 12/31/24 12/31/24 12/31/25 12/31/26
$71,830 71,830 71,830
$
0 36,008 33,143
Reduction of Lease Liability
Lease Liability
$71,830 35,822 38,687
$521,934 450,104 414,282 375,595
(b) Initial direct costs and lease incentives do not affect the initial measurement of the lease liability. Instead, they only affect the measurement of the right-of-use asset. Initial direct costs incurred by the lessee increase the right-of-use asset, whereas a lease incentive decreases the value of the right-of-use asset. The calculation of the right-of-use asset is as follows: $ + $
521,934 1,000 5,000 525,934
Lease liability Lease incentive Legal fees Right-of-use asset
(c) The annual insurance payments of $5,000 are considered part of the annual payments to the lessor similar to the rental payments, as they do not transfer a separate good or service to the lessee, but rather are part of the payment to use the leased asset and are attributable to the lease component. Therefore, the present value of the $5,000 annual payments should be included in the initial measurement of the lease liability, and thus the right-of-use asset as well. The calculation is as follows: $71,830 Annual rental payment X 7.24689 PV of annuity due of 1 for n = 10, i = 8% $520,544 PV of periodic rental payments $5,000 X 7.24689 $36,234
Annual insurance payment PV of annuity due of 1 for n = 10, i = 8% PV of periodic insurance payments
Exercise 20.4 (Continued) $
3,000
X $
.46319 1,390
$ + + $
520,544 36,234 1,390 558,168
Amount probable to be owed under residual value guarantee ($10,000 - $7,000) PV of 1 for n = 10, i = 8% PV of amount probable to be owed of residual value guarantee PV of periodic rental payments PV of periodic insurance payments PV of the residual value Lease liability
Note how the inclusion of the executory costs leads to an inflated lease liability and related right-of-use asset. Additionally, note that had the insurance payments been variable, they would not have been included at all in the measurement of the lease liability, which would have led to a very different initial measurement of the liability and asset. (d) Because Kimberly-Clark expected the residual value of the asset at the end of the lease to be $7,000, it expected to owe Sheffield an additional $3,000 in addition to returning the asset under the residual value guarantee. Thus, Kimberly-Clark has a lease liability of $3,000 remaining on the books. However, the value of the asset covers the entire guarantee, and thus, no additional cash payment is required by Kimberly-Clark. As a result, they will book a gain, as shown below: Lease Liability ..................................................... Gain on Lease ..............................................
3,000 3,000
LO: 2, 4 Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.5 (15–25 minutes) (a) Fair value of leased asset to lessor Less: Present value of unguaranteed residual value $24,335 x .63017 (Present value of 1 at 8% for 6 periods) Amount to be recovered through lease payments
$245,000
Six periodic lease payments $229,665 ÷ 4.99271*
$46,000**
*Present value of an annuity due of 1 for 6 periods at 8%. **Rounded to the nearest dollar. Exercise 20.5 (Continued)
15,335 $229,665
(b)
MORGAN LEASING COMPANY (Lessor) Lease Amortization Schedule
Date 1/1/25 1/1/25 1/1/26 1/1/27 1/1/28 1/1/29 1/1/30 12/31/30
Annual Lease Payment Plus URV $ 46,000 46,000 46,000 46,000 46,000 46,000 24,335 $300,335
Interest (8%) on Lease Receivable $ –0– 15,920 13,514 10,915 8,108 5,077 1,801* $55,335
Recovery of Lease Receivable $ 46,000 30,080 32,486 35,085 37,892 40,923 22,534 $245,000
Lease Receivable $245,000 199,000 168,920 136,434 101,349 63,457 22,534 0
*Rounded by $2. (c)
1/1/25
Lease Receivable ....................................................... Cost of Goods Sold Sales Revenue ....................................................... Inventory .................................................................
245,000* 229,665** 229,665*** 245,000
*The lease receivable will include both the present value of the rental payments ($46,000 x 4.99271) plus the present value of the residual value ($24,335 x .63017), as the lessor believes it will receive both of these amounts over the life of the lease. **While cost of goods sold normally mirrors the value of the inventory being sold, in this case it is reduced by the present value of the residual value [$245,000 – ($24,335 x .63017)], as the lessor will receive the inventory again at the amount of the residual value. ***Sales revenue represents the present value of the rental payments ($46,000 x 4.99271), but it does not include the present value of the residual value. That is, the lessor will get the residual
Exercise 20.5 (Continued) value back at the end of the lease, and thus has not “sold” that portion of the asset. 1/1/25 Cash ................................................................................ Lease Receivable ....................................................
46,000 46,000
12/31/25 Lease Receivable ........................................................... Interest Revenue .....................................................
15,920 15,920
1/1/26 Cash ................................................................................ Lease Receivable ....................................................
46,000 46,000
12/31/26 Lease Receivable ........................................................... Interest Revenue .....................................................
13,514 13,514
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.6 (20–25 minutes) Computation of annual payments Fair value of leased asset to lessor Less: Present value of residual value ($16,000 x .90703*) Amount to be recovered through lease payments Two periodic lease payments ($145,488 ÷ 1.85941**)
$160,000 14,512 $145,488 $78,244
*Present value of 1 at 5% for 2 periods **Present value of an ordinary annuity of 1 for 2 periods at 5% Castle will classify the lease as a sales-type lease because the agreement meets both the present value test ($145,488/$160,000 = 91% which is greater than 90%) and the lease term test (2/2 = 100%) which is greater than 75%. The $16,000 option to purchase does not count as a bargain purchase, the expected residual value at the end of the lease term is also $16,000.
Exercise 20.6 (Continued) CASTLE LEASING COMPANY (Lessor) Lease Amortization Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/26
Annual Lease Payment $78,244 78,244 16,000
Interest (5%) on Lease Receivable $8,000 4,488 0
Recovery of Lease Receivable
Lease Receivable
$70,244 73,756 16,000
$160,000 89,756 16,000 0
(a) 1/1/25 Lease Receivable ............................................ Cost of Goods Sold ........................................ Sales Revenue ............................................. Inventory ......................................................
160,000* 105,488** 145,488*** 120,000
*($78,244 x 1.85941) + ($16,000 x .90703), rounded **$120,000 – ($16,000 x .90703), rounded ***$160,000 – (16,000 x .90703), rounded 12/31/25 Cash................................................................. Lease Receivable ........................................ Interest Revenue .........................................
78,244 70,244 8,000
12/31/26 Cash................................................................. Lease Receivable ........................................ Interest Revenue .........................................
78,244 73,756 4,488
(b) 12/31/26 Cash................................................................. Lease Receivable ........................................
16,000
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.7 (15–20 minutes)
16,000
(a) The title to the asset passes to the lessee, the lease term is longer than 75% of the economic life of the asset (3/3 = 100%), and the present value of the lease payments is more than 90% of the fair value of the asset ($95,000/$95,000 = 100%). Any of these facts are sufficient to classify this lease as a financing lease to the lessee. Assuming collectibility of the rents is probable, the lease is accounted for as a sales-type lease to the lessor. The lessee should account for the lease as a finance lease and record the right-of-use asset and lease liability at the present value of the lease payments using the incremental borrowing rate if it is impracticable to determine the interest rate implicit in the lease. The lessee’s amortization depends on whether ownership transfers to the lessee or if there is a bargain purchase option. If one of these conditions is fulfilled, amortization would be over the economic life of the asset. Otherwise, it would be amortized over the lease term. Because both the economic life of the asset and the lease term are three years, the leased asset should be depreciated over this period. The lessor should account for the lease as a sales-type lease. The lessor should record a lease receivable and sales revenue equal to the present value of the lease payments of $95,000. In addition, the lessor should remove the asset (inventory) from its books at $70,000, and the related cost of goods sold $70,000. Interest is recognized annually at a constant rate relative to the unrecovered lease receivable (See lease amortization schedule). Fair value of leased asset (Amount to be recovered by lessor through lease payments).............................................................................
$95,000
Three annual lease payments: $95,000 ÷ 2.57710* ...............
$36,863
*Present value of an ordinary annuity of 1 for 3 periods at 8%.
Exercise 20.7 (Continued) (b) Amortization Schedule
1/1/25 12/31/25 12/31/26 12/31/27
Rent Receipt/ Payment
Interest (8%) Revenue/ Expense
Reduction of Principal
Receivable/ Liability
— $36,863 36,863 36,863
— $7,600* 5,259 2,730**
— $29,263 31,604 34,133
$95,000 65,737 34,133 0
*$95,000 x .08 = $7,600 ** Rounded by $1 (c)
1/1/25 Lease Receivable ......................................... Cost of Goods Sold ...................................... Sales Revenue ...................................... Inventory ...............................................
(d)
95,000 70,000
1/1/25 Right-of-Use Asset ....................................... Lease Liability .......................................
(e)
95,000 70,000
95,000 95,000
1/1/25 Right-of-Use Asset ($93,311 + $10,000) ...... Cash ...................................................... Lease Liability ($36,863 x 2.53130*) ............................
103,311 10,000 93,311
*Present value of an ordinary annuity of 1 for 3 periods at 9%. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Measurement, AICPA PC: Communication
Exercise 20.8 (15–20 minutes) (a) $35,004 x 6.58238* = $230,410 *Present value of an annuity due of 1 for 8 periods at 6%. (b) Because the lease term test is met (8/10 = 80% > 75%), the lease is classified as a sales-type lease. 1/1/25 Lease Receivable ......................................................... Cost of Goods Sold ...................................................... Sales Revenue ....................................................... Inventory ................................................................
230,410 160,000
Cash .............................................................................. Lease Receivable ..................................................
35,004
230,410 160,000 35,004
12/31/25 Lease Receivable ......................................................... Interest Revenue ..................................................... [($230,410 – $35,004) x .06]
11,724 11,724
(c) If the collectibility of lease payments is not probable for the lessor, the lessor does not derecognize the asset or recognize selling profit on the lease. Instead, Crosley would recognize any cash receipts as a deposit liability. 1/1/25 Cash ................................................................................ Deposit Liability ......................................................
35,004 35,004
A lessor does not derecognize the asset and recognize selling profit until collectibility becomes probable. (d) Inventory ................................................................. Gain on Lease (Residual Value) ......................
1,000
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,000
Exercise 20.9 (20-25 minutes) (a) Lease Liability = $35,004 x 6.20637* = $217,248 Right-of-Use Asset = $217,248 + $15,000** = $232,248 *Present value of an annuity due of 1 for 8 periods at 8%. **The right-of-use asset is initially valued at the same amount as the lease liability, plus the initial direct costs, minus any lease incentives received. (b) The lease is classified as a finance lease, since the lease term is 80% of the economic life of the asset (8/10), which is more than 75% of the economic life. 1/1/25 Right-of-Use Asset .............................................. Cash.............................................................. Lease Liability .............................................. Lease Liability ..................................................... Cash.............................................................. 12/31/25 Interest Expense .......................................................... Lease Liability ....................................................... [($217,248 – $35,004) x .08] Amortization Expense ($232,248 ÷ 8) ............................................................. Right-of-Use Asset ...............................................
232,248 15,000 217,248 35,004 35,004 14,580 14,580
29,031 29,031
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.10 (20–30 minutes) (a) The lease agreement has a bargain-purchase option and thus, meets the criteria to be classified as a finance lease from the viewpoint of the lessee. Also, the present value of the rental payments plus the bargain purchase option exceeds 90% of the fair value of the assets. (b) The lease agreement has a bargain-purchase option. The collectibility of the lease payments is probable. The lease, therefore, qualifies as a sales-type lease from the viewpoint of the lessor.
Exercise 20.10 (Continued) (c) Computation of lease liability: $20,471.94 Annual rental payment X 4.31213 PV of annuity due of 1 for n = 5, i = 8% $88,277.67 PV of periodic rental payments $ 4,000.00 X .68058 $ 2,722.32
Bargain purchase option PV of 1 for n = 5, i = 8% PV of bargain-purchase option
$88,278.00 + 2,722.00 $91,000.00
PV of periodic rental payments (rounded) PV of bargain-purchase option (rounded) Lease liability RODE COMPANY (Lessee) Lease Amortization Schedule
Date 5/1/25 5/1/25 5/1/26 5/1/27 5/1/28 5/1/29 4/30/30
Annual Lease Payment Plus BPO $ 20,471.94 20,471.94 20,471.94 20,471.94 20,471.94 4,000.00 $106,359.70
Interest (8%) on Liability
$ 5,642.24 4,455.87 3,174.58 1,790.79 296.22* $15,359.70
Reduction of Lease Liability $20,471.94 14,829.70 16,016.07 17,297.36 18,681.15 3,703.78 $91,000.00
Lease Liability $91,000.00 70,528.06 55,698.36 39,682.29 22,384.93 3,703.78 0
*Rounding error is 8 cents. (d)
5/1/25
Right-of-Use Asset ................................................ Lease Liability ..............................................
91,000.00
Lease Liability ....................................................... Cash ..............................................................
20,471.94
91,000.00 20,471.94
12/31/25 Interest Expense ................................................... Lease Liability .............................................. ($5,642.24 x 8/12 = $3,761.49) Exercise 20.10 (Continued)
3,761.49 3,761.49
12/31/25 Amortization Expense ........................................... Right-of-Use Asset ......................................... ($91,000.00 ÷ 10 = ($9,100.00; $9,100.00 X (8/12 = $6,066.67)
6,066.67 6,066.67
1/1/26 Lease Liability ....................................................... Interest Expense .............................................
3,761.49 3,761.49
5/1/26 Interest Expense ................................................... Lease Liability ....................................................... Cash ................................................................
5,642.24 14,829.70 20,471.94
12/31/26 Interest Expense ................................................... Lease Liability................................................. ($4,455.87 x 8/12)
2,970.58 2,970.58
12/31/26 Amortization Expense ........................................... Right-of-Use Asset ......................................... ($91,000.00 ÷ 10 years = ($9,100.00)
9,100.00 9,100.00
(Note to instructor: Because a bargain-purchase option was involved, the leased asset is depreciated over its economic life rather than over the lease term). Also, if reversing entries were not made on 1/1/26, the entry on 5/1/26 is as follows. Interest Expense ($5,642.24 − $3,761.49) ............. Lease Liability ($14,829.70 + $3,761.49) ............... Cash ................................................................
1,880.75 18,591.19
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
20,471.94
Exercise 20.11 (20–30 minutes) Note: The lease agreement has a bargain-purchase option. The collectibility of the lease payments by Mooney is probable. The lease, therefore, qualifies as a sales-type lease from the viewpoint of the lessor. The lease payments associated with this lease are the periodic annual rents plus the bargain purchase option. There is no residual value relevant to the lessor’s accounting in this lease. (a) The lease receivable is computed as follows: $20,471.94 X 4.31213 $88,277.67
Annual rental payment PV of an annuity due of 1 for n = 5, i = 8% PV of periodic rental payments
$ 4,000.00 X .68058 $ 2,722.32
Bargain purchase option PV of 1 for n = 5, i = 8% PV of bargain-purchase option
$88,278.00 + 2,722.00 $91,000.00
PV of periodic rental payments (rounded) PV of bargain-purchase option (rounded) Lease receivable at commencement
(b)
MOONEY LEASING COMPANY (Lessor) Lease Amortization Schedule
Date 5/1/25 5/1/25 5/1/26 5/1/27 5/1/28 5/1/29 4/30/30
Annual Lease Payment Plus BPO
Interest (8%) on Lease Receivable
$ 20,471.94 20,471.94 20,471.94 20,471.94 20,471.94 4,000.00 $106,359.70
*Rounding error is 8 cents.
$ 5,642.24 4,455.87 3,174.58 1,790.79 296.22* $15,359.70
Recovery of Lease Receivable $20,471.94 14,829.70 16,016.07 17,297.36 18,681.15 3,703.78 $91,000.00
Lease Receivable $91,000.00 70,528.06 55,698.36 39,682.29 22,384.93 3,703.78 0
Exercise 20.11 (Continued) (c) 5/1/25 Lease Receivable ................................................ Cost of Goods Sold ............................................. Sales Revenue ............................................. Inventory ......................................................
91,000.00 65,000.00
Cash ..................................................................... Lease Receivable .........................................
20,471.94
91,000.00 65,000.00 20,471.94
12/31/25 Lease Receivable ............................................ Interest Revenue .......................................... ($5,642.24 x 8/12 = $3,761.49)
3,761.49 3,761.49
5/1/26 Cash ..................................................................... Lease Receivable ($20,471.94 - $1,880.75) . Interest Revenue .......................................... ($5,642.24 – $3,761.49)
20,471.94 18,591.19 1,880.75
12/31/26 Lease Receivable ................................................ Interest Revenue .......................................... ($4,455.87 x 8/12 = $2,970.58)
2,970.58 2,970.58
(d) If the collectibility of lease payments is not probable for the lessor, the lessor does not derecognize the asset or recognize selling profit on the lease. Instead, Mooney would recognize any cash receipts as a deposit liability.
Exercise 20.11 (Continued) 5/1/25 Cash ................................................................................ 20,471.94 Deposit Liability ......................................................
20,471.94
A lessor does not derecognize the asset and recognize selling profit until collectibility becomes probable. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.12 (20–25 minutes) (a) This is a finance lease to Flynn since the lease term is 75% (6 ÷ 8) of the asset’s economic life. In addition, although the lease payments are not provided in the problem facts, the lease will also meet the present value test, as shown in part (b). Last, there is a bargain-purchase option in the lease, as Flynn has the option to purchase the asset at the end of the lease term for a price of $4,000 below the expected residual value of the asset, and thus exercisability of the option is reasonably certain. This is a sales-type lease to Bensen since collectibility of the lease payments is probable, the lease term is 75% of the asset’s economic life, the present value test will be met, and there is a bargain purchase option. (b) Computation of annual rental payment (by the lessor): Fair value of leased asset ............................................................... Less: Present value of bargain-purchase option ($1,000 x .74622*) .............................................................. PV of lease payments .....................................................................
$150,000
Six annual lease payments: $149,254 ÷ 5.32948** .......................
$28,005
*Present value of $1 at 5% for 6 periods. **Present value of an annuity due at 5% for 6 periods.
746 $149,254
Exercise 20.12 (Continued) 1/1/25 (c)
Lease Receivable ............................ Cost of Goods Sold......................... Sales Revenue ......................... Inventory ..................................
150,000* 120,000 150,000** 120,000
*($28,005 x 5.32948) + ($1,000 x .74622), rounded **Sales revenue would also include both the present values of the rental payments and the bargain-purchase option. Cash ................................................. Lease Receivable ....................
28,005 28,005
12/31/25 Lease Receivable ............................ Interest Revenue ..................... [($150,000 – $28,005) x .05]
6,100 6,100
(d) If the collectibility of lease payments is not probable for the lessor, the lessor does not derecognize the asset or recognize selling profit on the lease. Instead, Bensen would recognize any cash receipts as a deposit liability. 1/1/25 Cash ................................................................................ Deposit Liability ......................................................
28,005 28,005
A lessor does not derecognize the asset and recognize selling profit until collectibility becomes probable.
Exercise 20.12 (Continued) (e) 1/1/25 Right-of-Use Asset ......................................................... Lease Liability ........................................................... [($28,005 x 5.21236*) + ($1,000 x .70496**)]
146,677
Lease Liability ................................................................ Cash ..........................................................................
28,005
146,677
28,005
*Present value of an annuity due at 6% for 6 periods. **Present value of $1 at 6% for 6 periods.
12/31/25 Amortization Expense .................................................... Right-of-Use Asset ................................................... ($146,677 ÷ 8* years)
18,335 18,335
*The lessee uses the economic life of an asset instead of the lease term for amortization purposes when ownership transfers or there is a bargain purchase option. Interest Expense ............................................................ Lease Liability ........................................................... [($146,677 – $28,005) x .06] (f)
7,120 7,120
The value of the lease liability for the lessee is unaffected by any initial direct costs incurred. However, the initial measurement of the right-ofuse asset must be adjusted for initial direct costs incurred. Thus, the initial right-of-use asset should be measured at $148,677 ($146,677 + $2,000) Right-of-Use Asset................................ Cash ........................................... Lease Liability ...........................
148,677
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
2,000 146,677
Exercise 20.13 (20-25 minutes) (a) The lease will be classified as a sales-type lease for Phelps and a finance lease for Walsh. While ownership does not transfer at the end of the lease, there is no bargain purchase option, the asset is not specialized, and the present value test is not met (see calculation of lease liability for PV of lease payments), the lease term is greater than 75% of the useful life of the asset (5 ÷ 6 = 83%). The calculation of the lease receivable for Phelps is done as follows: Annual rental payments ................................................. Present value of an annuity due for 5 periods at 8% ..................................................... Present value of rental payments (rounded) ................
$4,703 x 4.31213 $20,280*
*This value should be used in performing the present value test. The lease fails the present value test because $20,280 ÷ $23,000 = 88.2%, which is less than 90%. Expected residual value Present value of $1 for 5 periods at 8% Present value of residual value (rounded)
$4,000 x .68058 $2,722
Present value of expected residual value Present value of annual rental payments Lease Receivable
$2,722 20,280 $23,000*
*Rounded by $2. The initial lease liability and right-of-use asset, from Walsh’s (lessee’s) point of view, is the present value of the rental payments ($20,280) and excludes the residual value. This is because Walsh does not guarantee any part of the residual value.
Exercise 20.13 (Continued) (b) Phelps’ Journal Entries 1/1/25 Lease Receivable ................................................ Cost of Goods Sold ............................................ Sales Revenue ............................................... Inventory ........................................................
23,000* 13,280** 20,280*** 16,000
*($4,703 x 4.31213) + ($4,000 x .68058), rounded **$16,000 – ($4,000 x .68058), rounded ***$4,703 x 4.31213, rounded Cash ........................................................................... Lease Receivable................................................. 12/31/25 Lease Receivable ...................................................... Interest Revenue [(23,000 – $4,703) x .08] ....................................
4,703 4,703 1,464 1,464
Walsh’s Journal Entries 1/1/25 Right-of-Use Asset .................................................... Lease Liability ...................................................... Lease Liability ........................................................... Cash ..................................................................... 12/31/25 Interest Expense ....................................................... Lease Liability [($20,280 – $4,703) x .08] ................................... Amortization Expense ............................................... Right-of-Use Asset ($20,280 ÷ 5) ….. .................
20,280 20,280 4,703 4,703 1,246 1,246 4,056 4,056
(c) If the residual value is guaranteed, Walsh must consider this guarantee in determining whether the present value test for classification purposes is met. However, the lease term test was already met, so this will not change the classification of the lease from either party’s perspective.
Exercise 20.13 (Continued) With respect to the initial measurement of the lease receivable, the lessor always includes the residual value in the lease receivable, whether it is guaranteed or not. Therefore, Phelps’ measurement of the lease receivable ($23,000) does not change as a result of the guarantee. For the lessee, only the amount that is probable to be owed under the guaranteed residual value should be included in the initial measurement of the lease liability and right-of-use asset. In this case, because Walsh expects the residual value to be equal to the residual value guarantee, Walsh will not include any amount of the residual value in the calculation of the lease liability and right-of-use asset, and the initial measurements will remain $20,280. In order for the answer to change, the expected residual value would have to be lower than the guarantee. (d) Walsh would need to include the present value of the amount probable to be owed under the residual value guarantee in its initial measurement of the lease liability. Because the expected residual value is less than the guaranteed residual value, Walsh must include the present value of the difference or the amount it expects to pay Phelps at the end of the lease term. Thus, the initial measurement of the lease liability and rightof-use asset would instead be: Present value of rental payments (rounded) ................ Present value of amount probable to be owed [($4,000 – $3,000) x .68058* ...................................... Lease liability..................................................................
$20,280 681 $20,961
*Present value of $1 for 5 periods at 8%. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.14 (20-25 minutes) If the lessee is unaware of the rate implicit in the lease, it should use its incremental borrowing rate to calculate the present value the lease payments and initially measure the lease liability and right-of-use asset. Thus, the calculation of the present value of the lease payments and therefore the lease liability and right-of-use asset would be: Annual rental payments ................................................. Present value of an annuity due for 5 periods at 9% ..................................................... Lease Liability/Right-of-Use Asset................................
$4,703 4.23972 $19,939
Exercise 20.14 (Continued) The lessor is not impacted in any way if the lessee does not know the rate implicit in the lease. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.15 (20–30 minutes) Note: This lease is a finance lease to the lessee because the present value of the minimum lease payments exceeds 90% of the fair value of the asset ($73,094.98 ÷ $80,000 = 91.37%) $25,562.96 X 2.85941 $73,094.98 (a)
Annual rental payment PV of an annuity due of 1 for n = 3, i = 5% PV of minimum lease payments PLOTE COMPANY (Lessee) Lease Amortization Schedule
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Lease Interest (5%) on Payment Liability $25,562.96 25,562.96 25,562.96 $76,688.88
–0– 2,376.60 1,217.30* $3,593.90 $
Reduction of Lease Liability $25,562.96 23,186.36 24,345.66 $73,094.98
Lease Liability $73,094.98 47,532.02 24,345.66 –0–
*Rounding error is 2 cents. (b) 1/1/25 Right-of-Use Asset ................................................ Lease Liability ..................................................
73,094.98 73,094.98
1/1/25 Lease Liability ....................................................... Cash .................................................................
25,562.96 25,562.96
Exercise 20.15 (Continued) 12/31/25 Interest Expense ................................................... Lease Liability ..................................................
2,376.60
Amortization Expense ........................................... Right-of-Use Asset .......................................... ($73,094.98 ÷ 3)
24,364.99
2,376.60 24,364.99
1/1/26 Lease Liability ($23,186.36 + $2,376.60) ............... Cash .................................................................
25,562.96 25,562.96
12/31/26 Interest Expense ................................................... Lease Liability ..................................................
1,217.30
Amortization Expense ........................................... Right-of-Use Asset .......................................... ($73,094.98 ÷ 3)
24,364.99
1,217.30 24,364.99
Note to instructor: The lessor sets the annual rental payment as follows: Fair value of leased asset to lessor Less: Present value of unguaranteed residual value $7,000 x .88900 (Present value of 1 at 4% for 3 periods) Amount to be recovered through lease payments Five periodic lease payments $73,777.00 ÷ 2.88609* *Present value of annuity due of 1 for 3 periods at 4%. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
$80,000.00 6,223.00 $73,777.00 $25,562.96
Exercise 20.16 (20–30 minutes) This lease is an operating lease to the lessee because none of the transfer of control tests are met. The present value of the minimum lease payments is less than 90% of the fair value of the asset ($70,452.63 ÷ $80,000 = 88%). $24,638.87 Annual rental payment X 2.85941 PV of an annuity due of 1 for n = 3, i = 5% $70,452.63 PV of minimum lease payments PLOTE COMPANY Lease Amortization Schedule Annuity-Due Basis
Date
Annual Payment
Interest (5%) on Liability
1/1/25 1/1/25 $24,638.87 $ 0 1/1/26 24,638.87 2,290.69 1/1/27 24,638.87 1,173.29* *Rounding error is 1 cent.
Reduction of Lease Liability
Lease Liability
$24,638.87 22,348.18 23,465.58
$70,452.63 45,813.76 23,465.58 0
Lease Expense Schedule
Date 1/1/25 12/31/25 12//31/26 12/31/27
(A) (C) Lease (B) Amortization of Expense Interest (5%) on ROU Asset Carrying Value (Straight-Line) Lease Liability (A-B) of ROU Asset $24,638.87 24,638.87 24,638.87
$2,290.69 1,173.29 0
$22,348.18 23,465.58 24,638.87
$70,452.63 48,104.45 24,638.87 0
Entries in 2025 are: 1/1/25 Right-of-Use Asset ................................................ Lease Liability ..................................................
70,452.63
Lease Liability ....................................................... Cash ................................................................. Exercise 20.16 (Continued)
24,638.87
70,452.63 24,638.87
12/31/25 Lease Expense ...................................................... Right-of-Use Asset ........................................ Lease Liability ................................................
24,638.87 22,348.18 2,290.69*
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in the first schedule. Note that this is expensed along with amortization of the right-of-use asset at the end of 2025, not in accordance with payment on the first day of 2026. Note to instructor: The lessor sets the annual rental payment as follows: Fair value of leased asset to lessor Less: Present value of unguaranteed residual value $10,000 x .88900 (Present value of 1 at 4% for 3 periods) Amount to be recovered through lease payments Five periodic lease payments $71,110.00 ÷ 2.88609*
$80,000 8,890 $71,110 $24,638.87
*Present value of annuity due of 1 for 3 periods at 4%. LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.17 (10–20 minutes) (a) The lease will be classified as an operating lease for Nelson, as it does not meet any of the classification tests to be a sales-type lease. Entries for Nelson are as follows: 1/1/25 Buildings ................................................................... Cash...................................................................
4,000,000
Cash .......................................................................... Unearned Lease Revenue ................................
275,000
4,000,000 275,000
Exercise 20.17 (Continued) 12/31/25 Unearned Lease Revenue ........................................ Lease Revenue .................................................
275,000
Depreciation Expense .............................................. Accumulated Depreciation— Leased Buildings .......................................... ($4,000,000 ÷ 50)
80,000
275,000
80,000
(b) Entries for Wise are as follows: 1/1/25 Right-of-Use Asset ................................................... Lease Liability ($275,000 x 7.24689*) ......................................
1,992,895
Lease Liability .......................................................... Cash...................................................................
275,000
1,992,895 275,000
*Present value of an annuity due for 10 periods at 8%. WISE INC. Lease Amortization Schedule (partial) Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27 1/1/28
Annual Payment $275,000 275,000 275,000 275,000
Interest (8%) on Liability $ 0 137,432 126,426 114,540
Reduction of Lease Liability
Lease Liability
$275,000 137,568 148,574 160,460
$1,992,895 1,717,895 1,580,327 1,431,753 1,271,293
Exercise 20.17 (Continued) Lease Expense Schedule (partial) (A) Lease (B) Expense Interest (8%) on (Straight-Line) Lease Liability
Date 1/1/25 12/31/25 12/31/26 12/31/27
$275,000 275,000 275,000
$137,432 126,426 114,540
(C) Amortization of ROU Asset (A-B)
Carrying Value of ROU Asset
$137,568 148,574 160,460
$1,992,895 1,855,327 1,706,753 1,546,293
12/31/25 Lease Expense ................................................. Lease Liability ............................................ Right-of-Use Asset.....................................
275,000 137,432* 137,568
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in the first schedule. Note that this is expensed along with amortization of the right-of-use asset at the end of 2025. (c) The real estate broker’s fee should be capitalized as part of the right-ofuse asset and amortized over the 10-year period. As a result, the initial measurement of the right-of-use asset would be $2,022,895 ($1,992,895 + $30,000). LO: 3, 4, Bloom: AP, Difficulty: Simple, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.18 (15–20 minutes) (a) Overall from the leased asset, Young Co. will report $38,455 ($150,955 – $112,500 [$900,000/8]) for 2025 when netting the lease revenue with depreciation expense. Lessor Entries for 2025: 1/1/25 Machine ...................................................... Cash ................................................ Cash ............................................................ Unearned Revenue ........................
900,000 900,000 150,955 150,955
Exercise 20.18 (Continued) 12/31/25 Unearned Revenue ................................................... Lease Revenue .................................................
150,955 150,955
Depreciation Expense .............................................. Accumulated Depreciation – Leased Asset ($900,000 ÷ 8)........................
112,500 112,500
(b) Lessee Entries for 2025: 1/1/25 Right-of-Use Asset ................................................... Lease Liability ...................................................
427,714* 427,714
Lease Liability .......................................................... Cash...................................................................
150,955 150,955
*$150,955 x 2.83339PVF-AD(3,6%) ST. LEGER INC. Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Payment
Interest (6%) on Liability
$150,955 150,955 150,955
$
0 16,606 8,545
Reduction of Lease Liability
Lease Liability
150,955 134,349 142,410
$427,714 276,759 142,410 0
Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(A) Lease Expense (Straight-Line) $150,955 150,955 150,955
(B) Interest (6%) on Lease Liability 16,606 8,545 0
(C) Amortization of ROU Asset (A-B)
Carrying Value of ROU Asset
134,349 142,410 150,955
$427,714 293,365 150,955 0
Exercise 20.18 (Continued) 12/31/25 Lease Expense ......................................................... Lease Liability ................................................... Right-of-Use Asset ...........................................
150,955 16,606* 134,349
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in the first schedule. Note that this is expensed along with the lease expense at the end of 2025. (c) Under the short-term lease election, St. Leger will not need to record the right-of-use asset or lease liability on its books. Instead, the company can expense lease payments as incurred. 1/1/25 Lease Expense ......................................................... Cash...................................................................
150,955 150,955
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.19 (20-25 minutes) (a) The lease is an operating lease to both Moeller and Kaluzniak, as none of the classification tests are met. The lease term is only 43% (3 ÷ 7) of the economic life of the asset, there is no bargain purchase, ownership does not transfer, and the asset is not specialized. The calculation for the 90% test shows the present value of lease payments is below 90% ($3,222 ÷ $7,000 = approximately 46%) and ($3,165 ÷ $7,000 = approximately 45%): Kaluzniak Corporation $1,137 Annual rental payment x 2.83339 PV of annuity due of 1 for n = 3, i = 6% $3,222 PV of periodic rental payments Moeller, Inc. $1,137 x 2.78326 $3,165
Annual rental payment PV of annuity due of 1 for n = 3, i = 8% PV of periodic rental payments
Exercise 20.19 (Continued) (b) 1/1/25 Right-of-Use Asset .............................................. Lease Liability ..............................................
3,165 3,165
Lease Liability ..................................................... Cash..............................................................
1,137 1,137
MOELLER COMPANY Lease Amortization Schedule Annuity-Due Basis
Annual Payment
Date 1/1/25 1/1/25 1/1/26 1/1/27
$1,137 1,137 1,137
Interest (8%) on Liability $
0 162 84
Reduction of Lease Liability
Lease Liability
$1,137 975 1,053
$3,165 2,028 1,053 0
Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(C) (A) (B) Amortization of Carrying Lease Expense Interest (8%) on ROU Asset Value of ROU (Straight-Line) Lease Liability (A-B) Asset $1,137 1,137 1,137
$ 162 84 0
12/31/25 Lease Expense .................................................... Lease Liability* ............................................ Right-of-Use Asset ......................................
$975 1,053 1,137
$3,165 2,190 1,137 0
1,137 162 975
*The lease liability is accrued for the interest that is incurred to date at the end of the year. The interest, as well as a portion of the original lease liability ($975) will be paid on the first day of 2026.
Exercise 20.19 (Continued) (c) As always, the first step will be determining the initial value of the lease liability. In this case, initial direct costs and prepayments do not affect the value of the lease liability (though they will affect the value of the right-of-use asset). With respect to executory costs, only those considered to be part of fixed payments to the lessor should be included in the initial measurement of the lease liability. As a result, only the insurance costs should be included in the present value test. The following calculation shows the calculation of the lease liability for Moeller: $3,165 557 $3,722
PV of annual rental payment (see calculation in part a) PV of insurance payments ($200 x 2.78326*) Lease liability
*Present value of an annuity due of 1 for 3 periods at 8%. The initial measurement of the right-of-use asset will be increased for any initial direct costs (i.e., commissions) and any prepayments. As a result, the calculation of the right-of-use asset is as follows: $3,722 500 750 $4,972
Initial measurement of lease liability (calculated above) Commissions paid Prepaid rent Right-of-use asset
(d) This lease qualifies for the short-term lease election for Moeller, as it is one year or less. Assuming that Moeller elects to use the short-term lease option, the company records lease expense when payments are made to the lessor. Thus, Moeller accounts for the lease as follows: 1/1/25 Lease Expense .................................................... Cash..............................................................
1,137
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
1,137
Exercise 20.20 (20-25 minutes) (a)
Fair value of leased asset to lessor Less: Present value of unguaranteed residual value $4,500 x .83962 (present value of 1 at 6% for 3 periods) Amount to be recovered through lease payments Three periodic lease payments $3,222 ÷ 2.83339*
$7,000 3,778 $3,222 $1,137
*Present value of annuity due of 1 for 3 periods at 6%. (b) Because this is an operating lease to Kaluzniak, the asset is not derecognized, but rather kept on the books and depreciated as normal. Lease payments are simply recognized as revenue when they are paid and earned. Thus, Kaluzniak will make the following journal entries: 1/1/25 Cash ..................................................................... Unearned Lease Revenue ...........................
1,137
12/31/25 Unearned Lease Revenue ................................... Lease Revenue ............................................
1,137
Depreciation Expense ......................................... Accumulated Depreciation – Equipment ($5,000 ÷ 7) ............................
1,137
1,137 714 714
(c) For a lessor, initial direct costs (in this case, legal fees) incurred in accordance with an operating lease should be amortized and expensed over the term of the lease. However, internal costs in this case, (advertising) occur whether a lease was executed or not, and as a result should be expensed as incurred. Thus, for 2025, the following entries are made: 1/1/25 Prepaid Legal Fees.............................................. Cash.............................................................. (Over the course of the year) Advertising Expense ........................................... Cash ............................................................. Exercise 20.20 (Continued)
700 700 500 500
12/31/25 Legal Expense .................................................... Prepaid Legal Fees ($700 ÷ 3) .....................
233 233
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.21 (20-25 minutes) (a) The lease is an operating lease for both Rauch and Donahue, as none of the classification tests are met. The lease term is only 67% (4 ÷ 6) of the economic life of the asset, there is no bargain purchase, ownership does not transfer, and the asset is not specialized. The calculation for the 90% test shows the present value of lease payments is below 90% ($18,214 ÷ $25,000 = 73%): $4,892 x 3.72325 $18,214
Annual rental payment PV of annuity due of 1 for n = 4, i = 5% PV of periodic rental payments
(b) DONAHUE CORPORATION Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27 1/1/28
Annual Payment $4,892 4,892 4,892 4,892
Interest (5%) on Liability $
0 666 455 233
Reduction of Lease Liability $4,892 4,226 4,437 4,659
Lease Liability $18,214 13,322 9,096 4,659 -0-
Exercise 20.21 (Continued) Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28 (c)
(A) (C) Lease (B) Amortization of Expense Interest (5%) on ROU Asset Carrying Value (Straight-Line) Lease Liability (A-B) of ROU Asset $4,892 4,892 4,892 4,892
$ 666 455 233 -0-
$4,226 4,437 4,659 4,892
$18,214 13,988 9,551 4,892 -0-
1/1/25
Right-of-Use Asset .............................................. Lease Liability ..............................................
18,214
Lease Liability ..................................................... Cash..............................................................
4,892
12/31/25 Lease Expense .................................................... Lease Liability .............................................. Right-of-Use Asset ......................................
18,214 4,892 4,892 666* 4,226
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in the first schedule. Note that this is expensed along with amortization of the right-of-use asset at the end of 2025. 1/1/26 Lease Liability ..................................................... Cash ....................................................... 12/31/26 Lease Expense .................................................... Lease Liability ....................................... Right-of-Use Asset................................
4,892 4,892 4,892 455 4,437
Exercise 20.21 (Continued) (d) Initial direct costs do not affect the value of the lease liability, but they do change the value of the right-of-use asset. The initial measurement of the right-of-use asset will be increased for any initial direct costs. As a result, the calculation of the right-of-use asset is as follows: $18,214 +
750 $18,964
Initial measurement of lease liability (Calculated in part a) Initial direct costs Right-of-use asset
To demonstrate how this impacts the amortization of the right-of-use asset, below are the tables associated with the lease in this situation: DONAHUE CORPORATION Lease Amortization Schedule Annuity-Due Basis Reduction Annual Interest (5%) on of Lease Payment Liability Liability
Date 1/1/25 1/1/25 1/1/26 1/1/27 1/1/28
$4,892 4,892 4,892 4,892
$
0 666 455 233
$4,892 4,226 4,437 4,659
Lease Liability $18,214 13,322 9,096 4,659 -0-
Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28
(C) (A) (B) Amortization of Carrying Lease Expense Interest (5%) on ROU Asset Value of ROU (Straight-Line) Lease Liability (A-B) Asset $5,080* 5,080 5,080 5,078
$ 666 455 233 -0-
$4,414 4,625 4,847 5,078
$18,964 14,550 9,925 5,078 -0-
*Total payments divided by the lease term, or $20,318 [($4,892 x 4) + $750] divided by 4 years (rounded).
Exercise 20.21 (Continued) 1/1/25 Right-of-Use Asset................................ Cash ........................................... Lease Liability ...........................
18,964
Lease Liability ....................................... Cash ...........................................
4,892
12/31/25 Lease Expense ...................................... Lease Liability ........................... Right-of-Use Asset ....................
750 18,214 4,892 5,080 666 4,414
(e) A fully guaranteed residual value by Donahue would lead to a finance lease for the company, and thus, the subsequent treatment of the rightof-use asset and lease liability would be different. Instead of reporting a single lease expense, Donahue recognizes both amortization expense on the right-of-use asset (which would be calculated the same way as depreciation on similar assets) and interest expense (same amounts as operating lease). Note, however, that the initial measurement of the right-of-use asset and lease liability would not change, as the company expects the residual value to be equal to the guaranteed residual value. Therefore, no amount is probable to be owed under the guarantee, and no amount needs to be accounted for in the initial lease liability by Donahue. (f)
A bargain renewal option would cause Donahue to take the additional year (and payment) into account when determining how to classify the lease and the initial measurement of the lease liability and right-of-use asset. However, for purposes of the classification, Donahue need not know the value of the bargain renewal option, as the additional year of lease term causes the lease term to be 5 years, which is greater than 75% of the useful life of the asset. (5 ÷ 6 = 83%). Thus, Donahue classifies the lease as a finance lease and accounts for it in the same way as described in part (e). The only difference is the present value of the bargain renewal option must be included in the initial measurement of the lease liability, as it is probable that it will be paid.
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Exercise 20.22 (25-30 minutes) (a)
Fair value of leased asset to lessor Less: Present value of unguaranteed residual value $8,250 x .82270 (Present value of 1 at 5% for 4 periods) Amount to be recovered through lease payments Four periodic lease payments $18,213 ÷ 3.72325*
$25,000 6,787 $18,213 $4,892
*Present value of annuity due of 1 for 4 periods at 5%. (b)
1/1/25 Cash ....................................................... Unearned Lease Revenue ........
4,892
12/31/25 Unearned Lease Revenue .................... Lease Revenue ..........................
4,892
Depreciation Expense .......................... Accumulated Depreciation – Equipment ($20,000 ÷ 6) .......
4,892
4,892 3,333 3,333
(c) Even though the expected residual value declined, the fact that Donahue has guaranteed a residual value of $8,250 leads Rauch to calculate rental payments based on the same amount as if a residual value of $8,250 were unguaranteed. That is, Rauch will look to recover through the lease payments, whatever portion of the fair value of the asset it does not recover through the receipt of a residual value at the end of the lease term. Thus, all else being equal, Rauch would demand the same amount in lease payments from Donahue as Rauch would under the original facts of the question. Note to Instructor: The explanation above assumes all else being equal. However, because Donahue guarantees the residual value, it is possible that Rauch would compensate this reduction in risk with a lower interest rate used in computing the payments, and the payments would therefore be lower in value. In addition, the guarantee of the entire residual value of the asset would make the lease a finance lease for Donahue and a sales-type lease for Rauch.
Exercise 20.22 (Continued) (d) A fully guaranteed residual value by Donahue would cause the lease to be classified as a sales-type lease by Rauch. As a result, Rauch would recognize sales revenue and a lease receivable at the commencement of the lease for the entire fair value of the asset, as well as derecognize the asset and recognize cost of goods sold. Rauch would then recognize lease revenue for any interest accrued on the lease receivable over the lease term and amortize the lease receivable over the term as well. Upon receipt of the asset again at the end of the lease term, Rauch would write off the remaining lease receivable, and record the asset as inventory at its fair value, along with any cash payment required to be collected if the fair value is less than the guaranteed residual value. (e) A bargain renewal option also would cause the lease to be classified as a sales-type lease by Rauch, as it would cause the lease term to be 83% (5 ÷ 6 = 83%) of the economic life of the asset. Thus, the accounting for the lease by Rauch would be essentially the same as explained in part (d). However, as sales revenue, Rauch would only recognize the present value of the lease payments and bargain renewal option. That is, Rauch would need to find the amount of residual value expected at the end of the lease term and reduce both sales revenue and cost of goods sold by the present value of the residual value. In addition, at the end of the lease term, Rauch could potentially recognize a gain or loss on the lease, as the value of the residual value it receives could potentially be higher or lower than the lease receivable it needs to remove upon the return of the asset. LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Exercise 20.23 (20–30 minutes) Elmer’s Restaurants (Seller-Lessee)* 1/1/25 Cash ....................................................................... Equipment ...................................................... Gain on Sale of Equipment ($680,000 - $600,000)..
680,000
Right-of-Use Asset ................................................ Lease Liability ................................................ ($115,970 x 2.78326)**
322,775
Lease Liability ....................................................... Cash................................................................
115,970
600,000 80,000 322,775
115,970
Exercise 20.23 (Continued) ELMER’S RESTAURANTS Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Payment
Interest (8%) on Liability
$115,970 115,970 115,970
Reduction of Lease Liability
Lease Liability
115,970 99,426 107,379
$322,775 206,805 107,379 0
$0 16,544 8,591*
*Rounded by $1. Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(A) Lease Expense (Straight-Line) $115,970 115,970 115,970
(B) Interest (8%) on Lease Liability
(C) Amortization of ROU Asset (A-B)
Carrying Value of ROU Asset
99,426 107,379 115,970
$322,775 223,349 115,970 0
$16,544 8,591 0 12/31/25
Lease Expense ...................................................... Lease Liability ................................................ Right-of-Use Asset ........................................
115,970 16,544 99,426
*Lease should be treated as an operating lease because none of the finance lease classification tests are met. **Present value of an annuity due for 3 periods at 8%.
Exercise 20.23 (Continued) Liquidity Finance Co. (Buyer-Lessor)* 1/1/25 Equipment........................................................... Cash ............................................................. Cash .................................................................... Unearned Lease Revenue .......................... 12/31/25 Unearned Lease Revenue .................................. Lease Revenue ........................................... Depreciation Expense ......................................... Accumulated Depreciation – Equipment ($680,000 ÷ 10) ......................
680,000 680,000 115,970 115,970 115,970 115,970 68,000 68,000
*Lease should be treated as an operating lease because the lease does not meet any of the sales-type classification tests. LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Exercise 20.24 (20–30 minutes) (a)
The situation described is a simple sale of equipment. Only one entry for the sale of the equipment is required: 1/1/25 Cash ...................................................... 520,000 Equipment ................................. 400,000 Gain on Disposal of Equipment 120,000
(b)
The situation described is known as a failed sale. That is, the terms of the lease meet the criteria to be classified as a finance lease to the lessee (lease term > 75% of economic life, present value of lease payments > 90% of fair value of the asset). Under a finance lease, the lessee is deemed to have taken control of the asset. However, since the sale and the lease occur on the same day, the seller/lessee is deemed to never have given up control in the first place, and the lease is viewed simply as a financing arrangement. The present value of the lease payments is $520,000 [$67,342.42 x 7.72173*], which is 100% of the fair value of the asset. *Present value of an ordinary annuity for 10 years at 5%.
*Exercise 20.24 (Continued) 1/1/25 Cash .................................................................... Note Payable ............................................
520,000
12/31/25 Interest Expense ($520,000 x 5%) ..................... Note Payable ($67,342.42 - $26,000.00) ..... Cash.............................................................
26,000.00 41,342.42
520,000
67,342.42
(c) The situation described is considered a sale-leaseback agreement for financial reporting purposes. That is, the terms of the lease meet the criteria to be classified as an operating lease to the lessee (lease term < 75% of economic life, present value of lease payments < 90% of fair value of the asset). Under an operating lease, the lessee is not deemed to take control of the asset. However, upon the sale of the asset, the seller-lessee does relinquish control of the asset, and thus can recognize any gain on the sale. The lease is accounted for as a normal operating lease. 1/1/25 Cash .................................................................... Equipment ................................................... Gain on Disposal of Equipment ................. ($520,000 - $400,000) Right-of-Use Asset ............................................. Lease Liability ($67,342.42 x 2.85941*) .............................
520,000 400,000 120,000 192,559.59 192,559.59
*Present value of an annuity due for 3 periods at 5%. Lease Liability .................................................... Cash.............................................................
67,342.42 67,342.42
*Exercise 20.24 (Continued) ZARLE INC. Lease Amortization Schedule Annuity-Due Basis
Annual Payment
Date 1/1/25 1/1/25 1/1/26 1/1/27
Interest (5%) on Liability
$67,342.42 67,342.42 67,342.42
Reduction of Lease Liability
$0 6,260.86 3,206.81*
Lease Liability
67,342.42 61,081.56 64,135.61
$192,559.59 125,217.17 64,135.61 0
*Rounded $.03 Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(C) (A) (B) Amortization of Carrying Lease Expense Interest (5%) on ROU Asset Value of ROU (Straight-Line) Lease Liability (A-B) Asset $67,342.42 67,342.42 67,342.42
$6,260.86 3,206.81 0
12/31/25 Lease Expense ................................................... Lease Liability ............................................. Right-of-Use Asset .....................................
61,081.56 64,135.61 67,342.42
$192,559.59 131,478.03 67,342.42 0
67,342.42
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
6,260.86 61,081.56
*Exercise 20.25 (20-25 minutes) (a) The lease will be classified as an operating lease for Jabari but will meet the classification tests of a direct financing lease for Giannis. None of the lease classification tests are met for a finance/sales-type lease. That is, ownership does not transfer at the end of the lease, there is no bargain purchase option, the asset is not specialized, and the lease term is less than 75% of the useful life of the asset (10 ÷ 15 = 67%). In addition, the present value of the lease payments is less than 90% of the fair value of the asset, as shown below: Annual rental payments ................................................. Present value of an ordinary annuity for 10 periods at 5% ................................................... Present value of lease payments (rounded) ................. Fair value of the building ............................................... Present value of lease payments as a percentage of fair value .....................................
$3,449 x 7.72173 $26,632 ÷ 34,000 78.33%
The guaranteed residual value is not included in the finance/sales-type lease classification test, as it is not guaranteed by the lessee, but rather an independent 3rd party. Therefore, Jabari classifies the lease as an operating lease. However, the 3rd party residual value guarantee is considered when determining whether or not the lease is classified as a direct financing lease for the lessor. The 90% test will be met when the 3rd party guarantee is considered (as the following calculation shows), and thus the lease is classified as a direct financing lease for Giannis: Annual rental payments ................................................. Present value of an ordinary annuity for 10 periods at 5% ................................................... Present value of lease payments (rounded) .................
$3,449 7.72173 $26,632
3rd party residual value guarantee ................................ Present value of 1 for 10 periods at 5% ........................ Present value of residual value guarantee ...................
$12,000 x .61391 $7,367
Present value of lease payments .................................. Present value of residual value guarantee ................... Present value of lease payments plus 3rd party residual value guarantee (rounded) ........... Fair value of the equipment ........................................... Present value as a percentage of fair value .................
$26,632 $7,367 $34,000 ÷ 34,000 100%
*Exercise 20.25 (Continued) Because the lease qualifies as a direct financing lease, the gross profit from the lease is deferred and recognized over the course of the lease. (b) GIANNIS CORPORATION (Lessor) Lease Amortization Schedule Sales-Type Lease
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 12/31/30 12/31/31 12/31/32 12/31/33 12/31/34 12/31/35
*Rounded $2
Annual Lease Payment $3,449 3,449 3,449 3,449 3,449 3,449 3,449 3,449 3,449 3,449 12,000 $46,490
Interest (5%) on Lease Receivable $1,700 1,613 1,521 1,424 1,323 1,217 1,105 988 865 734* _______ $12,490
Recovery of Lease Receivable $1,749 1,836 1,928 2,025 2,126 2,232 2,344 2,461 2,584 2,715 12,000 $34,000
Lease Receivable $34,000 32,251 30,415 28,487 26,462 24,336 22,104 19,760 17,299 14,715 12,000 -0-
*Exercise 20.25 (Continued) GIANNIS CORPORATION (Lessor) Lease Amortization Schedule Direct Financing Lease
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 12/31/30 12/31/31 12/31/32 12/31/33 12/31/34 12/31/34
Annual Lease Payment $3,449 3,449 3,449 3,449 3,449 3,449 3,449 3,449 3,449 3,449 12,000 $46,490
Interest (13.24%) on Receivable $2,913 2,842 2,761 2,670 2,567 2,450 2,318 2,168 1,999 1,802* _______ $24,490
Reduction of Net Lease Receivable $536 607 688 779 882 999 1,131 1,281 1,450 1,647 12,000 $22,000
Net Lease Receivable $22,000 21,464 20,857 20,169 19,390 18,508 17,509 16,378 15,097 13,647 12,000 -0-
*Rounded $5 The difference between the interest under a sales-type lease (ex. in first year, $1,700) and the overall revenue recognized for a direct financing lease ($2,913) is the amount of deferred gross profit that is amortized in the current period ($1,213).
*Exercise 20.25 (Continued) (c) 1/1/25 Lease Receivable ........................................................... Deferred Gross Profit ............................................. Leased Asset ..........................................................
34,000 12,000 22,000
12/31/25 Cash ................................................................................ Deferred Gross Profit** .................................................. Lease Revenue* ...................................................... Lease Receivable ....................................................
3,449 1,213 2,913 1,749
*Interest Revenue = Net Lease Receivable x Rate of Return = ($34,000 – $12,000) x .1324 = $2,913 (rounded) **Deferred Gross Profit = Interest Revenue – Sales-Type Interest = $2,913 – $1,700 = $1,213 12/31/26 Cash ................................................................................ Deferred Gross Profit** .................................................. Lease Revenue* ...................................................... Lease Receivable ....................................................
3,449 1,229 2,842 1,836
*Interest Revenue = Net Lease Receivable x Rate of Return = ($34,000 – $12,000 + $1,213 – $1,749) x .1324 = ($34,000 – $12,000 – $536) x .1324 = $2,842 (rounded) **Deferred Gross Profit = Interest Revenue – Sales-Type Interest = $2,842 – $1,613 = $1,229 (d) 1/1/27 Right-of-Use Asset .............................................. Lease Liability ($3,449 x 7.72173*) ....................................
26,632
*Present value of an ordinary annuity for 10 periods at 5%.
26,632
*Exercise 20.25 (Continued) JABARI, INC. Lease Amortization Schedule (partial) Annuity-Due Basis
Annual Payment
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28
$3,449 3,449 3,449 3,449
Interest (5%) on Liability $1,332 1,226 1,115 998
Reduction of Lease Liability $2,117 2,223 2,334 2,451
Lease Liability $26,632 24,515 22,292 19,958 17,507
Lease Expense Schedule (partial) (C) (A) (B) Amortization of Carrying Lease Expense Interest (5%) on ROU Asset Value of ROU (Straight-Line) Lease Liability (A-B) Asset
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28
$3,449 3,449 3,449 3,449
$1,332 1,226 1,115 998
12/31/25 Lease Expense ...................................... Lease Liability ....................................... Right-of-Use Asset .................... Cash ........................................... 12/31/26 Lease Expense ...................................... Lease Liability ....................................... Right-of-Use Asset .................... Cash ...........................................
$2,117 2,223 2,334 2,451
$26,632 24,515 22,292 19,958 17,507
3,449 2,117 2,117 3,449 3,449 2,223 2,223 3,449
*Exercise 20.25 (Continued) (e) The rate of return required to amortize the net lease receivable to zero would increase greatly. Recall the rate’s purpose is to create a rate to multiply by the net lease receivable in order to amortize a portion of the deferred gross profit in addition to recognizing interest revenue for the period. Given the way the facts changed, the deferred gross profit total does not change. That is, the fair value of the building minus the book value ($34,000 – $22,000 = $12,000) does not change. However, it will be amortized over a shorter period of time than when considering the original facts. Therefore, a greater portion of the deferred gross profit (and thus revenue in general) will need to be recognized each period of the lease, as there are fewer total periods. To do this, a higher rate must be used to recognize revenue each period, as the lease term was cut in half while the deferred gross profit remained the same. (f)
Had Jabari guaranteed the residual value of the building itself, the company would be required to classify the lease as a finance lease. This is because it would then include the present value of the residual value guarantee in the calculation of the present value of the lease payments when determining the present value test. As shown in part (a), the present value of the lease payments is 100% of the fair value of the building, and thus the lease meets the 90% test. Under a finance lease instead of an operating lease, Jabari would recognize amortization expense and interest expense separately on the income statement, as opposed to reporting a single straight-line lease expense.
The present value classification test is the same for meeting the sales-type lease tests for a lessor. Thus, the test is satisfied, and Giannis would classify the lease as a sales-type lease. With respect to revenue recognition, Giannis would book sales revenue (along with the related cost of goods sold) immediately upon the commencement of the lease, and simply recognize subsequent interest on the lease receivable as lease revenue as it is earned. This contrasts with its revenue recognition under a direct finance lease from part (a), in that the gross profit from the lease agreement is deferred over the lease term under a direct finance lease. Thus, by having Jabari guarantee the residual value instead of a 3rd party, Giannis would be able to book all gross profit upfront instead of amortizing it over the lease term. LO: 6, Bloom: AP, Difficulty: Moderate, Time: 10-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Time and Purpose of Problems Problem 20.1 (Time 25–35 minutes) Purpose—to provide an understanding of the journal entries to be recorded for a finance lease by the lessee given a guaranteed residual value. Journal entries for two periods are required. Problem 20.2 (Time 20–30 minutes) Purpose—to develop an understanding of the accounting by the lessee for a finance lease. The student is required to explain the relationship between the capitalized amount of leased equipment and the leasing arrangement. The student is asked to prepare the lessee’s journal entries at the date of commencement, for amortization of the leased asset, and for the first lease payment, as well as to indicate the amounts that should be reported on the lessee’s balance sheet. Problem 20.3 (Time 25–30 minutes) Purpose—to develop an understanding of the accounting for a finance lease by the lessee in an annuity due arrangement. The student is required to prepare the lease amortization schedule for the entire term of the lease and all the necessary journal entries for the lease through the first two lease payments. The student is also asked to indicate the amounts that would be reported on the lessee’s balance sheet. Problem 20.4 (Time 20–30 minutes) Purpose—to develop an understanding of the accounting for a finance lease by a lessee in an annuitydue arrangement. The student is required to prepare all the journal entries, with supportive computations, which the lessee would have made to record the lease for the first period of the lease. Problem 20.5 (Time 20–25 minutes) Purpose—to develop an understanding of the accounting principles used in a finance lease with a bargain purchase option for the lessee. The student is required to discuss the nature of the lease and make journal entries for the lessee. Problem 20.6 (Time 20–25 minutes) Purpose—to develop an understanding of the accounting principles used in a sales-type lease for both the lessee and the lessor. The student is required to discuss the nature of the lease and make journal entries for both the lessee and the lessor. Problem 20.7 (Time 30–40 minutes) Purpose—to develop an understanding of a sales-type lease with a guaranteed residual value. The student discusses the classification of the lease and computes the lease receivable at commencement of lease, sales price, and cost of goods sold. The student prepares a 10-year amortization schedule and all of the lessor’s journal entries for the first year. Problem 20.8 (Time 30–40 minutes) Purpose—to develop an understanding of a finance lease with a guaranteed residual value. The student explains why it is a finance lease and computes the amount of the initial liability and right-of-use asset (with initial direct costs). The student prepares a 10-year amortization schedule and all of the lessee’s journal entries for the first year.
Problem 20.9 (Time 30–40 minutes) Purpose—to develop an understanding of the accounting treatment accorded a sales-type lease involving an unguaranteed residual value. The student is required to discuss the nature of the lease with regard to the lessor and to compute the lease receivable, the sales price, and the cost of goods sold. The student is also required to construct a 10-year lease amortization schedule for the leasing arrangement, and to prepare the lessor’s journal entries for the first year of the lease contract. Problem 20.10 (Time 30–40 minutes) Purpose—to develop an understanding of lessee accounting for a finance lease with an unguaranteed residual value. The student explains why it is a finance lease and computes the amount of the initial liability. The student prepares a 10-year amortization schedule and all of the lessee’s journal entries for the first year. Problem 20.11 (Time 30–40 minutes) Purpose—to develop an understanding of how residual values affect the accounting for the lessee and the lessor. The student must understand both the accounting for a guaranteed and unguaranteed residual value and possible classification by the lessor as a direct financing lease. Problem 20.12 (Time 35–45 minutes) Purpose—to develop an understanding of the accounting procedures involved in a finance/sales-type leasing arrangement. The student is required to discuss the nature of this lease transaction from the viewpoint of both the lessee and lessor. The student is also requested to prepare the journal entries to record the lease for both the lessee (including initial direct costs) and lessor plus illustrate the items and amounts that would be reported on the balance sheet at the end of the first year for the lessee and the lessor. Problem 20.13 (Time 30–40 minutes) Purpose—to provide an understanding of how lease information is reported on the balance sheet and income statement for three different years in regard to the lessee. In addition, the year-end month is changed in order to help provide an understanding of the complications involved with partial periods. Problem 20.14 (Time 40–50 minutes) Purpose—to provide an understanding of how lease information is reported on the balance sheet and income statement for three different years in regard to the lessor. In addition, the year-end month is changed in order to help provide an understanding of the complications involved with partial periods. Problem 20.15 (Time 30–40 minutes) Purpose—to develop an understanding of the accounting treatment for operating leases. The student is required to identify the type of lease involved, explain the respective reasons for their classification, and discuss the accounting treatment that should be applied for both the lessee and lessor. The student is also asked to prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor and consider the effect of an unguaranteed residual value for the lessor. Problem 20.16 (Time 30–40 minutes) Purpose—to develop an understanding of the accounting treatment for an operating lease. The student is required to identify the type of lease involved, explain the respective reasons for their classification, and discuss the accounting treatment that should be applied for both the lessee and lessor. The student is also asked to prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor.
Problem 20.17 (Time 20–30 minutes) Purpose—to develop an understanding of the accounting treatment for operating leases. The student is required to identify the type of lease involved, explain the respective reasons for their classification, and discuss the accounting treatment that should be applied for both the lessee and lessor. The student is also asked to prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor and to discuss the disclosures required of the lessee and lessor.
Solutions to Problems Problem 20.1
Note: This lease Is a Finance Lease To The Lessee Because The Lease Term (Six Years) Exceeds 75% Of The Remaining Economic Life Of The Asset (Six Years). Also, The Present Value of The Lease Payments Exceeds 90% Of The Fair Value Of The Asset. $ 113,864 x 4.99271 $ 568,490
Annual Rental Payment PV Of an Annuity-Due Of 1 For N = 6, I = 8% PV Of Periodic Rental Payments
$ x $
50,000 .63017 31,509
Guaranteed Residual Value PV Of 1 For n = 6, i = 8% PV Of Guaranteed Residual Value
$ 568,490 + 31,509 $ 599,999
PV Of Periodic Rental Payments PV Of Guaranteed Residual Value PV Of Lease Payments
However, for Purposes Of Measuring The Initial Lease Liability, Only Amounts Expected To Be Owed Under The Residual Value Guarantee Should Be Included. That is, Only The Present Value Of The Difference Between The Residual Value Guarantee And The Expected Residual Value At The End Of The Lease Term Should Be Included. $ 113,864 x 4.99271 $ 568,490
Annual Rental Payment PV Of An Annuity-Due Of 1 For n = 6, i = 8% PV Of Periodic Rental Payments
$
5,000
x $
.63017 3,151
Amount Expected To Be Owed Under Residual Value Guarantee ($50,000 – $45,000) PV Of 1 For n = 6, i = 8% PV Of Guaranteed Residual Value
$ 568,490 + 3,151 $ 571,641
PV Of Periodic Rental Payments PV Of Guaranteed Residual Value PV Of Lease Payments
Problem 20.1 (Continued) (a)
VANCE COMPANY (Lessee) Lease Amortization Schedule
Date
Annual Lease Payment Plus GRV
Interest (8%) on Liability
Reduction of Lease Liability
1/1/25
Lease Liability $571,641
–0–
$113,864
457,777
113,864
36,622
77,242
380,535
1/1/27
113,864
30,443
83,421
297,114
1/1/28
113,864
23,769
90,095
207,019
1/1/29
113,864
16,562
97,302
109,717
1/1/30
113,864
8,777
105,087
4,630
12/31/30
5,000
370
4,630
0
$688,184
$116,543
$571,641
1/1/25
$113,864
1/1/26
$
(b) January 1, 2025 Right-of-Use Asset ......................................................... Lease Liability ......................................................... Lease Liability ................................................................ Cash......................................................................... December 31, 2025 Interest Expense ............................................................ Lease Liability ......................................................... Amortization Expense .................................................... Right-of-Use Asset ($571,641 ÷ 6) ......................... January 1, 2026 Lease Liability ($36,622 + $77,242) ............................... Cash.........................................................................
571,641 571,641 113,864 113,864 36,622 36,622 95,274 95,274 113,864 113,864
Problem 20.1 (Continued) December 31, 2026 Interest Expense ............................................................ Lease Liability ......................................................... Amortization Expense .................................................... Right-of-Use Asset ($571,641 ÷ 6) .........................
30,443 30,443 95,274 95,274
Note to instructor: The guaranteed residual value is not subtracted from the right-of-use asset for purposes of determining the amortizable base. This reflects the intangible nature of the right-of-use asset. The lessee records as a right-of-use asset only the amount of the fair value of the asset it intends to use up throughout the course of the lease term. The return of the asset to the lessor is not considered a benefit to the lessee, and thus should not be included in the right-of-use asset. The right-of-use asset should be amortized to zero, as all of its benefit is realized through the asset’s use. (c) A lease incentive does not impact the measurement of the lease liability. However, a reduction in the right-of-use asset must be made. Thus, the right-of-use asset would be measured at $566,641 ($571,641 – $5,000). The prepayment of rent by the lessee should be recorded as an asset in the form of an increased right-of-use asset. Therefore, the right-of-use asset would initially be measured at $576,641 ($571,641 + $5,000). LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.2
(a) The $550,000 is the present value of the five annual lease payments of $120,987 to be made at the beginning of each year discounted at 5% since the lessee knows the implicit rate. (b) Right-of-Use Asset ................................................. Lease Liability .................................................. ($120,987 x Present value of annuity due factor for 5 years at 5%: $120,987 x 4.54595 = $550,000*)
550,000 550,000
*Rounded. Lease Liability ......................................................... Cash ..................................................................
120,987
(c) Amortization Expense ............................................ Right-of-Use Asset........................................... ($550,000 x 40% = $220,000)
220,000
Interest Expense ..................................................... Lease Liability .................................................. (See amortization schedule)
21,451
(d) Lease Liability ......................................................... Cash ..................................................................
120,987
120,987 220,000
21,451
120,987
CAGE COMPANY (Lessee) Lease Amortization Schedule (partial)
Date
Annual Lease Payment
Interest (5%) on Liability
Reduction of Lease Liability
1/1/25
Lease Liability $550,000
–0–
$120,987
429,013
120,987
21,451
99,536
329,477
120,987
16,474
104,513
224,964
1/1/25
$120,987
1/1/26 1/1/27
$
Problem 20.2 (Continued) (e)
CAGE COMPANY Balance Sheet (Partial) December 31, 2025 Assets
Non-current assets: Right-of-use Asset
Liabilities $330,000
Current: Lease liability
$120,987*
Noncurrent: Lease liability
$329,477**
*The current portion of the lease liability will contain a component for the accrued interest expense to be paid on the lease liability ($429,013 x 5% = $21,451) plus a component for the reduction of the original lease liability ($120,987 – $21,451 = $99,536). **See amortization schedule from part (d).
(f)
Insurance payments are an executory cost. Assuming a gross lease, the insurance payments must be included in the present value of the lease payments when initially valuing the lease liability. Therefore, the initial liability would be measured as follows: Present value of rental payments (see part b) ...... Present value of insurance payments ($2,000 x 4.54595*) ............................................... Lease Liability .........................................................
$550,000 9,092 $559,092
* PV of an annuity due of $1 for 5 periods at 5%. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.3
(a) December 31, 2025 Right-of-Use Asset ......................................................... Lease Liability ......................................................... (To record leased asset and related liability at the present value of 5 future annual payments of $40,000 plus a bargain-purchase option of $5,000 discounted at 8%)
175,888 175,888*
*($40,000 x 4.31213**) + ($5,000 x .68058***) = $175,888 **Present value of an annuity due of 1 for 5 periods at 8%. ***Present value of 1 for 5 periods at 8%. December 31, 2025 Lease Liability ......................................................... Cash .................................................................. (To record the first rental payment) (b)
40,000 40,000
LUDWICK STEEL COMPANY (Lessee) Lease Amortization Schedule (Annuity Due Basis)
Date
Annual Lease Payment
Interest (8%) on Liability
Reduction of Lease Liability
Lease Liability
12/31/25
—
—
—
$175,888
12/31/25
$40,000
0
$40,000
135,888
12/31/26
40,000
10,871
29,129
106,759
12/31/27
40,000
8,541
31,459
75,300
12/31/28
40,000
6,024
33,976
41,324
12/31/29
40,000
3,306
36,694
4,630
12/31/30
5,000
370
4,630
0
$
Problem 20.3 (Continued) December 31, 2026 Amortization Expense ............................................ Right-of-Use Asset........................................... (To record amortization of the right-of-use asset based on a cost to Ludwick of $175,888 and a life of 7 years) December 31, 2026 Interest Expense ..................................................... Lease Liability ......................................................... Cash .................................................................. (To record annual payment on lease liability of which $10,871 represents interest at 8% on the unpaid principal of $135,888) (c)
December 31, 2027 Amortization Expense ............................................... Right-of-Use Asset.............................................. (To record annual amortization on leased assets) Interest Expense ........................................................ Lease Liability ............................................................ Cash ..................................................................... (To record annual payment on lease liability of which $8,541 represents interest at 8% on the unpaid principal of $106,759)
25,127 25,127
10,871 29,129 40,000
25,127 25,127
8,541 31,459 40,000
Note: Because a bargain purchase option is used, the right-of-the-asset should be amortized over seven years.
Problem 20.3 (Continued) (d)
LUDWICK STEEL COMPANY Balance Sheet (Partial) December 31, 2027 Non-current assets: Right-of-Use asset
Current liabilities: $125,634* Lease liability Long-term liabilities: Lease liability
$33,976** $41,324***
*$175,888 – ($25,127 x 2) **Reduction of lease liability in 2028 (see schedule in part (b)). ***Lease liability as of 12/31/27 less the reduction of lease liability in 2028 ($75,300 – $33,976) LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.4
Entries on August 1, 2025: (1) Right-of-Use Asset ............................................ Lease Liability .............................................
4,119,480 4,119,480
Explanation and computation: This is a finance lease because the lease term exceeds 75% of the asset’s useful life. That is, the lease term is 80% (12 ÷ 15) of the asset’s useful life. The leased computer and the related liability are recorded at the present value of the lease payments as follows: $40,000 x 102.987 = $4,119,480. (2) Lease Liability ................................................... Cash ............................................................
40,000 40,000
Explanation: This entry is to record the August 1, 2025, first payment under the lease agreement. No interest is recognized on August 1 because the agreement began on that date, and no time has elapsed. Entries on August 31, 2025: (1) Interest Expense ............................................... Lease Liability ............................................
20,397 20,397
Explanation and computation: Interest accrued on the unpaid balance of the lease liability from August 1 to August 31, 2025, is computed as follows: ($4,119,480 – $40,000) x .005 = $20,397. (2) Amortization Expense ...................................... Right-of-Use Asset.....................................
28,608 28,608
Explanation and computation: Amortization is recorded for one month of the use of computer using the lease term: ($4,119,480 ÷ 12) x 1/12 = $28,608. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.5 (a)
GRISHELL TRUCKING COMPANY Schedule to Compute the Discounted Present Value of Terminal Facilities and the Related Obligation January 1, 2025 Present value of first 10 payments: Immediate payment ...................................... $ 800,000 Present value of an ordinary annuity for 9 years at 6% ($800,000 x 6.801692) ........ 5,441,354 $6,241,354* Present value of last 10 payments: First payment of $320,000 ............................ Present value of an ordinary annuity for 9 years at 6% ($320,000 x 6.801692) ........ Present value of last 10 payments at January 1, 2033 ......................................... Discount to January 1, 2025 ($2,496,541 x .558395) ..............................
320,000 2,176,541 2,496,541 1,394,056
Discounted present value of terminal facilities and related obligation ...............
$7,635,410
(Note to instructor: The student can compute the $6,241,354 by using the present value of an annuity due for 10 periods at 6%. *The calculation could also be done as a pure annuity due of 1 for 10 periods as follows ($2 rounding difference): First 10 annual payments ............................ Present value of an annuity due of 1 for 10 years at 6% ...........................................
$800,000 x 7.80169 $6,241,352
For the last ten periods, the present value of an annuity due for 20 periods less the present value of an annuity due for 10 periods can be used as follows: (12.15812 – 7.80169) x $320,000 = $1,394,058 ($2 difference due to rounding). The $1 bargain purchase option is not included in this computation because it is immaterial.
Problem 20.5 (Continued) (b)
GRISHELL TRUCKING COMPANY Journal Entries 1/1/27
(1)
Lease Liability ($386,732 + $413,268) ................ Cash ..............................................................
800,000 800,000
Partial Amortization Schedule (Annuity-Due Basis)
Date 1/1/25 1/1/25 1/1/26 1/1/27 1/1/28 (2)
Lease Payment $800,000 800,000 800,000 800,000
Interest (6%) on Lease Liability
$ 0 410,125 386,732 361,936
Reduction of Lease Liability
Lease Liability
$800,000 389,875 413,268 438,064
$7,635,410 6,835,410 6,445,535 6,032,267 5,594,203
12/31/27
Amortization Expense ............................................ Right-of-Use Asset........................................... (To record annual amortization expense on leased assets) ($7,635,410 ÷ 40)
190,885 190,885
Note: The leased asset is depreciated over its economic life because a bargain-purchase option is available at the end of the lease term. (3)
12/31/27
Interest Expense ..................................................... Lease Liability .................................................. (To record interest accrual at 6% on outstanding lease liability of $6,032,267)
361,936
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
361,936
Problem 20.6 (a) This is a finance lease for Jensen since the lease term is greater than 75% of the economic life of the leased asset. The lease term is 78% (7 ÷ 9) of the asset’s economic life. In addition, the present value of the lease payments is greater than 90% of the asset’s fair value, as shown in part (c). This is a sales-type lease for Glaus (lessor), for the same reasons as for the lessee. (b) Calculation of annual rental payment $700,000 – ($50,000 x .71068*) = $109,365 6.07569** *Present value of $1 at 5% for 7 periods. **Present value of an annuity due at 5% for 7 periods. (c) Computation of lease liability, or present value of lease payments: PV of annual payments:
$109,365 x 5.91732* = $647,148
*Present value of an annuity due at 6% for 7 periods. Because the guaranteed residual value is equal to the expected residual value, the lessee would not include any amount of the guaranteed residual value in its calculation of the initial lease liability. Note that Jensen used its incremental borrowing rate because Jensen does not know the implicit rate. Note to the Instructor: The lease liability only includes the amount expected to be owed under a residual value guarantee. This contrasts with the classification test, which includes the full value of a guaranteed residual. The classification test would be performed as done below: PV of annual payments: PV of guaranteed residual value:
$109,365 x 5.91732* = $647,148 $50,000 x .66506** = 33,253 $680,401 *Present value of an annuity due at 6% for 7 periods. **Present value of $1 at 6% for 7 periods. $680,401 ÷ $700,000 = 97%, which is greater than 90%, and thus, the lease is a finance lease to the lessee.
Problem 20.6 (Continued) 1/1/25 (d) Right-of-Use Asset ......................................................... Lease Liability .........................................................
647,148
Lease Liability ................................................................ Cash.........................................................................
109,365
647,148 109,365
12/31/25 Amortization Expense .................................................... Right-of-Use Asset ($647,148 ÷ 7) ......................................................
92,450
Interest Expense ............................................................ Lease Liability ($647,148 – $109,365) x .06.................................
32,267
92,450
32,267
1/1/26 Lease Liability ................................................................ Cash.........................................................................
109,365* 109,365
*The reduction in the liability is composed of two components. One component is the payment of the accrued interest expense from the prior period ($32,267) and the other component is the reduction of the initial lease liability recorded ($77,098). 12/31/26 Amortization Expense .................................................... Right-of-Use Asset ................................................. ($647,148 ÷ 7)
92,450
Interest Expense ............................................................ Lease Liability ......................................................... [$647,148 – $109,365 – ($109,365 - $32,267) x .06]
27,641
92,450
27,641
Problem 20.6 (Continued) 1/1/25 (e) Lease Receivable ........................................................... Cost of Goods Sold ........................................................ Sales Revenue ........................................................ Inventory .................................................................
700,000 525,000
Cash ................................................................................ Lease Receivable ....................................................
109,365
700,000 525,000 109,365
12/31/25 Lease Receivable ........................................................... Interest Revenue [($700,000 – $109,365) x .05] ..............................
29,532 29,532
1/1/26 Cash ................................................................................ Lease Receivable ....................................................
109,365 109,365
12/31/26 Lease Receivable ........................................................... Interest Revenue [$700,000 – $109,365 – ($109,365 - $29,532) x .05] ........................................ (f)
25,540
PV of annual payments ($109,365 x 5.91732*) PV of amount probable to be owed [($50,000 – $40,000) x .66506**] Lease Liability
25,540 $647,148 $6,651 $653,799
*Present value of an annuity due for 7 periods at 6%. **Present value of $1 for 7 periods at 6%. In this case, the guaranteed residual value is greater than the expected residual value. Therefore, the lessee must include the present value of the amount probable to be owed under the guaranteed residual value in its calculation of the initial lease liability. LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.7 (a) The noncancelable lease is a sales-type lease because: (1) the lease term is for 83% (10 ÷ 12) of the economic life of the leased asset, and (2) the present value of the lease payments exceeds 90% of the fair value of the leased property (see calculation below). 1.
2. 3.
Lease Receivable: Present value of annual payments of $60,000 made at the beginning of each period for 10 years, $60,000 x 8.10782 (PV of an annuity due at 5%) ..........
$486,469
Present value of guaranteed residual value, $15,000 x .61391 (PV of $1 at 5% for 10 years)............. Present value of lease payments ..............................
9,209 $495,678
Sales price is the same as the present value of lease payments ..............................................................
$495,678
Cost of sales is the cost of manufacturing the x-ray machine .................................................................
$300,000
Problem 20.7 (Continued) (b)
AMIRANTE INC. (Lessor) Lease Amortization Schedule (Annuity due basis, guaranteed residual value) Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10 End of 10 (a) (b) (c) (d)
Annual Lease Payment Plus Residual Value (a) — $ 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 15,000 $615,000
Interest (5%) on Lease Receivable (b) — — $ 21,784 19,873 17,867 15,760 13,548 11,226 8,787 6,226 3,537 714 $119,322
Recovery of Lease Lease Receivable Receivable (c) (d) — $495,678 $ 60,000 435,678 38,216 397,462 40,127 357,335 42,133 315,202 44,240 270,962 46,452 224,510 48,774 175,736 51,213 124,523 53,774 70,749 56,463 14,286 14,286 0 $495,678
Annual lease payments and guaranteed residual value. Preceding balance of (d) x 5%, except beginning of first year of lease term. (a) minus (b). Preceding balance minus (c).
(c) Lessor’s journal entries: Beginning of the Year Lease Receivable .................................................... Cost of Goods Sold ................................................ Sales Revenue ................................................. Inventory .......................................................... (To record lease receivable and sale) Selling Expenses .................................................... Accounts Payable/Cash .................................. (To record the incurrence of initial direct costs relating to the lease)
495,678 300,000 495,678 300,000 14,000 14,000
Problem 20.7 (Continued) Cash............................................................................ Lease Receivable ................................................ (To record receipt of the first lease payment) End of the Year Lease Receivable ....................................................... Interest Revenue ................................................. (To record interest during the first year of the lease)
60,000 60,000
21,784
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
21,784
Problem 20.8
(a) The noncancelable lease is a finance lease because: (1) the lease term is for 83% (10 ÷ 12) of the economic life of the leased asset and (2) the present value of the lease payments exceeds 90% of the fair value of the leased asset, as shown below: PV of Lease Payments: PV of rental payments, $60,000 x 8.10782 ....................... PV of guaranteed residual value, $15,000 x .61391 ........ PV of lease payments ....................................................... Fair value of the asset ...................................................... Percentage of fair value of the leased asset ...................
$486,469 9,209 $495,678 ÷ 495,678 100%
However, for purposes of measuring the initial lease liability, only probable amounts expected to be owed under the residual value guarantee should be included. That is, only the present value of the difference between the residual value guarantee and the expected residual value at the end of the lease term should be included. The calculation of the initial value of the lease liability is as follows: PV of Lease Liability: PV of rental payments, $60,000 x 8.10782 ....................... PV of guaranteed residual expected to be owed [($15,000 – $10,000) x .61391]....................................... Initial lease liability ...........................................................
$486,469 3,070 $489,539
Problem 20.8 (Continued) (b)
CHAMBERS MEDICAL (Lessee) Lease Amortization Schedule (Annuity-Due Basis, Guaranteed Residues Value) Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10 End of 10
Annual Lease Payment Plus GRV (a) $ 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 5,000 $605,000
Interest (5%) on Unpaid Liability (b)
Reduction of Lease Liability (c)
$
$ 60,000 38,523 40,449 42,472 44,595 46,825 49,166 51,625 54,206 56,916 4,762 $489,539
0 21,477 19,551 17,528 15,405 13,175 10,834 8,375 5,794 3,084 238 $115,461
Lease Liability (d) $489,539 429,539 391,016 350,567 308,095 263,500 216,675 167,509 115,884 61,678 4,762 0
(a) Annual lease payments and amount expected to be owed under residual value guarantee. (b) Preceding balance of (d) x 5%, except beginning of first year of lease term. (c) (a) minus (b). (d) Preceding balance minus (c).
(c) Lessee’s journal entries: Beginning of the Year Right-of-Use Asset ................................................. Lease Liability .................................................. (To record the lease of x-ray equipment using finance lease method) Lease Liability ......................................................... Cash .................................................................. (To record payment of annual lease obligation) Problem 20.8 (Continued)
489,539 489,539
60,000 60,000
End of the Year Interest Expense ..................................................... Lease Liability .................................................. (To record accrual of annual interest on lease obligation) Amortization Expense ............................................ Right-of-Use Asset........................................... (To record amortization expense for year 1 using straight-line method [$489,539 ÷ 10 years])
21,477 21,477
48,954 48,954
Note to instructor: The guaranteed residual value is not subtracted from the right-of-use asset for purposes of determining the amortizable base. This reflects the intangible nature of the right-of-use asset. The lessee records as a right-of-use asset only the amount of the fair value of the asset it intends to use up throughout the course of the lease term. The return of the asset to the lessor is not considered a benefit to the lessee, and thus should not be included in the right-of-use asset. The right-of-use asset should be amortized to zero, as all of its benefits are realized through the asset’s use. (d) The document preparation costs are considered initial direct costs. As such, they will impact the initial measurement of the right-of-use asset but will not affect the lease liability. The right-of-use asset must be increased as a result of any initial direct costs incurred. Therefore, under the new circumstances, the initial measurement of the right-ofuse asset would be $496,539 ($489,539 + $7,000). LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.9
(a) The lease is a sales-type lease because: (1) the lease term exceeds 75% of the asset’s estimated economic life (10/12 = 83%), and (2) the present value of the lease payments is greater than 90% of the fair value of the asset, as calculated below: $ 40,000 x 7.24689 $ 289,876
Annual rental payment PV of an annuity-due of 1 for n = 10, i = 8% PV of periodic rental payments
$ 289,876 ÷ 299,140 96.90%
PV of periodic rental payments Fair value of check-in kiosk Rental payments percentage of fair value
1.
Present value of an annuity due of $1 for 10 periods discounted at 8% ...................................... Annual lease payment .................................................... Present value of the 10 rental payments ....................... Add: Present value of estimated residual value of $20,000 in 10 years at 8% ($20,000 x .46319) .................................................. Lease receivable at commencement .............................
7.24689 x $ 40,000 $289,876 9,264 $299,140
2.
Sales revenue is $289,876 (the present value of the 10 annual lease payments) or the lease receivable of $299,140 minus the PV of the unguaranteed residual value of $9,264.
3.
Cost of goods sold is $170,736 (the $180,000 cost of the asset less the present value of the unguaranteed residual value of $9,264). The $4,000 in sales commissions are not included in the cost of goods sold, though they would be expensed separately by the lessor.
Problem 20.9 (Continued) (b)
GEORGE COMPANY (Lessor) Lease Amortization Schedule Annuity Due Basis, Unguaranteed Residual Value Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10 End of 10
Annual Lease Payment Plus Residual Value (a)
Interest (8%) on Lease Receivable (b)
Lease Receivable Recovery (c)
$ 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 20,000 $420,000
$ 0 20,731 19,190 17,525 15,727 13,785 11,688 9,423 6,977 4,335 1,479* $120,860
$ 40,000 19,269 20,810 22,475 24,273 26,215 28,312 30,577 33,023 35,665 18,521 $299,140
Lease Receivable (d) $299,140 259,140 239,871 219,061 196,586 172,313 146,098 117,786 87,209 54,186 18,521 0
*Rounding error is $3. (a) lease). (b) (c) (d)
Annual lease payment (and return of expected residual value at end of the Preceding balance of (d) x 8%, except beginning of first year of lease term. (a) minus (b). Preceding balance minus (c).
(c) Beginning of the Year Lease Receivable ........................................................... Cost of Goods Sold ........................................................ Sales Revenue ........................................................ Inventory ................................................................. (To record the sale and the cost of goods sold in the lease transaction) Selling Expenses ............................................................ Cash......................................................................... (To record payment of the initial direct costs relating to the lease)
299,140 170,736 289,876 180,000
4,000 4,000
Problem 20.9 (Continued) Cash ................................................................................... Lease Receivable ....................................................... (To record receipt of the first lease payment) End of the Year Lease Receivable .............................................................. Interest Revenue ........................................................ (To record interest during the first year of the lease)
40,000 40,000
20,731
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
20,731
Problem 20.10
(a) The lease is a finance lease because: (1) the lease term exceeds 75% of the asset’s economic life (10/12 = 83%) and (2) the present value of the lease payments exceeds 90% of the fair value of the leased asset. Initial Lease Liability: Lease payments ($40,000) x PV of an annuity due for 10 periods at 8% (7.24689) .................. (b)
$289,876
NATIONAL AIRLINES (Lessee) Lease Amortization Schedule (Annuity-due basis and URV) Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10
Annual Lease Payment (a) — $ 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 $400,000
Interest (8%) on Lease Liability (b) — — $ 19,990 18,389 16,660 14,793 12,777 10,599 8,247 5,706 2,963 $110,124
Reduction of Lease Liability (c) — $ 40,000 20,010 21,611 23,340 25,207 27,223 29,401 31,753 34,294 37,037 $289,876
Lease Liability (d) $289,876 249,876 229,866 208,255 184,915 159,708 132,485 103,084 71,331 37,037 0
(a) Annual lease payment required by lease contract. (b) Preceding balance of (d) x 8%, except beginning of first year of lease term. (c) (a) minus (b). (d) Preceding balance minus (c).
Problem 20.10 (Continued) (c) Lessee’s journal entries: Beginning of the Year Right-of-Use Asset ......................................................... Lease Liability ......................................................... (To record the lease of computer equipment using finance lease method) Lease Liability ................................................................ Cash......................................................................... (To record the first rental payment) End of the Year Interest Expense ............................................................ Lease Liability ......................................................... (To record accrual of annual interest on lease liability) Amortization Expense .................................................... Right-of-Use Asset ................................................. (To record amortization expense for first year [$289,876 ÷ 10])
289,876 289,876
40,000 40,000
19,990 19,990
28,988
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
28,988
Problem 20.11
(a) The lease agreement satisfies the 90% of fair value requirement (calculation below). PV of Lease Payments: PV of rental payments, $30,300 x 7.24689* ..................... $219,581 PV of guaranteed residual value, $50,000 x .46319**...... 23,160 PV of Lease Payments ...................................................... $242,741 Fair value of the asset ...................................................... ÷ $242,741 Percentage of fair value of the leased asset ................... 100% For the lessee, it is a finance lease, and for the lessor, it is a sales-type lease. Note to Instructor: While the present value classification test includes the full amount of the residual value guarantee, for purposes of measuring the initial lease liability, only amounts expected to be owed under the residual value guarantee should be included. That is, only the present value of the difference between the residual value guarantee and the expected residual value at the end of the lease term should be included. The calculation of the initial value of the lease liability is as follows: PV of Lease Liability: PV of rental payments, $30,300 x 7.24689* ..................... PV of guaranteed residual expected to be owed [($50,000 – $45,000) x .46319**] .................................... Initial lease liability ........................................................... *Present value of an annuity due of 1 for 10 periods at 8%. **Present value of 1 for 10 periods at 8%.
$219,581 2,316 $221,897
Problem 20.11 (Continued) (b)
January 1, 2025 Lessee: Right-of-Use Asset ................................................. Lease Liability .................................................. (see calculation in part a) Lease Liability ......................................................... Cash ..................................................................
221,897 221,897 30,300 30,300
January 1, 2025 Lessor: Lease Receivable .................................................... Cost of Goods Sold ................................................ Sales Revenue ................................................. Inventory .......................................................... Cash......................................................................... Lease Receivable .............................................
242,741 180,000 242,741 180,000 30,300 30,300
December 31, 2025 Lessee: Interest Expense ..................................................... Lease Liability [($221,897– $30,300) x .08] .......................... Amortization Expense ............................................ Right-of-Use Asset ($221,897 ÷ 10)..............................................
15,328 15,328 22,190 22,190
December 31, 2025 Lessor: Lease Receivable ....................................................... Lease Revenue [($242,741 – $30,300) x .08] .............................
16,995 16,995
Problem 20.11 (Continued) (c) In both (1) and (2), the lessee is no longer obligated or expected to make any payment at the end of the lease. As a result, there should be no amount of the residual value included in the lessee’s initial measurement of the lease liability or right-of-use asset. Thus, in both (1) and (2), the amount of the initial lease liability is $219,581, or the present value of the annual rental payments (see part (a) for calculation). (d) (1) When a residual value is guaranteed by a 3rd party, it creates a unique situation for a lessor. In this case, King expects to receive 100% of the fair value of the asset through the rental payments of the lessee and the payment of the residual value guarantee (either the return of equipment by the lessee and/or cash from the 3rd party). While King relinquishes control of the equipment to Goring, Goring does not take control of the asset, as the present value of the lease payments for Goring is less than 90% of the fair value of the asset, and no other classification test is met. As a result, the existence of a 3rd party guarantee leads the asset to be classified as a direct financing lease to the lessor, as the present value of the rental payments plus any guaranteed residual (whether guaranteed by the lessee or an unrelated 3rd party) exceeds 90% of the fair value of the equipment, and collectibility of the payments is probable. While the classification of the lease changes, the initial measurement of the lease receivable for the lessor does not; that is, the lease receivable is still equal to the present value of the rental payments plus the residual value, or $242,741 [(see calculation in part (a)]. Note to Instructor: while the lease receivable does not change, the net investment in the lease does. Net investment in the lease is defined as the lease receivable plus any unguaranteed residual value minus deferred gross profit. Thus, as a result of the profit of the transaction being deferred instead of recognized upfront, the net investment would be $242,741 – [$242,741 – $180,000] = $180,000.
Problem 20.11 (Continued) (2) While the lessor still includes even an unguaranteed residual value in the calculation of a lease receivable under a sales-type or directfinance lease, the lack of a residual value guarantee in this case could lead the lease to be classified as an operating lease, as present value of the lease payments may be less than 90% of the fair value of the asset. As a result, the lessor might not remove the asset from its books at all, but rather continue to depreciate the asset as normal and book lease revenue as it receives and earns rental payments. In this situation ($219,581 ÷ $242,741 = 90.5%) the present value test is still met and the lease is classified as a sales-type lease. LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.12 (a) The lease should be treated as a finance lease by Winston Industries requiring the lessee to capitalize the leased asset. The lease qualifies for finance lease accounting by the lessee because: (1) title to the engine’s transfers to the lessee, (2) the lease term is equal to the estimated life of the asset, and (3) the present value of the minimum lease payments exceeds 90% of the fair value of the leased engines. In addition, the engines are specially built. For Ewing Inc., the transaction is a sales-type lease because the same classification tests are met as were met for Winston. This lease arrangement also represents the manufacturer’s financing the transaction over a period of 10 years. Present Value of Lease Payments $384,532 x 7.80169* ..................................................
$3,000,000
*Present value of an annuity due at 6% for 10 years, rounded by $1. Dealer Profit Sales (present value of lease payments) .................... Less: Cost of engines ................................................... Profit on sale ................................................................. (b) Right-of-Use Asset ........................................... Lease Liability ............................................
3,000,000
(c) Lease Receivable .............................................. Cost of Goods Sold .......................................... Sales Revenue ........................................... Inventory ....................................................
3,000,000 2,600,000
$3,000,000 2,600,000 $ 400,000 3,000,000
3,000,000 2,600,000
(d) Lessee (January 1, 2025) Lease Liability ................................................... Cash ............................................................
384,532
Lessor (January 1, 2025) Cash................................................................... Lease Receivable .......................................
384,532
384,532
384,532
Problem 20.12 (Continued) (e)
WINSTON INDUSTRIES/EWING INCORPORATED Lease Amortization Schedule
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Lease Receipt/ Payment
Interest on Receivable/ Liability at 6%
Reduction in Receivable/ Liability
$384,532 384,532 384,532
$ –0– 156,928 143,272
$384,532 227,604 241,260
Lessee December 31, 2025 Interest Expense ............................................... Lease Liability ............................................ Amortization Expense ...................................... Right-of-Use Asset (3,000,000 ÷ 10) .......... Lessor December 31, 2025 Lease Receivable .............................................. Interest Revenue ........................................ (f)
Lease Receivable/ Liability $3,000,000 2,615,468 2,387,864 2,146,604
156,928 156,928 300,000 300,000 156,928 156,928
WINSTON INDUSTRIES Balance Sheet (Partial) December 31, 2025 Non-current assets: Right-of-Use $2,700,000* asset
Current liabilities: Lease liability
$384,532**
Long-term liabilities: Lease liability (See amortization schedule in part (e))
$2,387,864***
*$3,000,000 – ($3,000,000 ÷ 10) **Lease payments in 2026 (on January 1) will be the following: Lease Liability ................................................... Cash ............................................................ Problem 20.12 (Continued)
384,532 384,532
Part of the reduction in the lease liability will be attributable to the previously accrued interest expense, and part will be a reduction of the initial lease liability recorded. Nonetheless, the full payment will be a reduction in lease liability in the following year and should be classified as current. ***$3,000,000 – $384,532 + $156,928 – $384,532 EWING INC. Balance Sheet (Partial) December 31, 2025 Assets Current assets: Lease receivable ........................................................
$ 384,532*
Noncurrent assets: Lease receivable ........................................................
$2,387,864**
Note: The title Net Investment in leases is sometimes shown instead of Lease receivable. *Lease receivable is composed of accrued interest revenue ($156,928) as well as the planned reduction of the initial lease receivable ($227,604). **$2,615,468 – $227,604 (g) Legal fees incurred in connection with a lease are considered initial direct costs of the lease and should be capitalized as part of the rightof-use asset. In contrast, lease incentives reduce the initial value of the right-of-use asset. However, neither initial direct costs nor lease incentives affect the value of the lease liability. Thus, the entry to initially record the lease is as follows: Right-of-Use Asset ................................................... Cash ($50,000 – $30,000) .................................. Lease Liability ...................................................
2,980,000 20,000
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
3,000,000
Problem 20.13 (a) 1.
$ 20,027 $ 52,174
Interest expense (See amortization schedule) Amortization expense ($313,043 ÷ 6 = $52,174)
$ 62,700
Current liabilities: Lease liability
$207,670
Long-term liabilities: Lease liability
$260,869
Non-current assets: Right-of-Use asset ($313,043 – $52,174)
$ 16,614 $ 52,174
Interest expense (See amortization schedule) Amortization expense ($313,043 ÷ 6 = $52,174)
$ 62,700
Current liabilities: Lease liability
$161,584
Long-term liabilities: Lease liability
$208,695
Non-current Assets: Right-of-Use Asset
2.
3. 4.
(b) 1.
$ 5,007 $ 13,044
Interest expense ($20,027 x 3/12 = $5,007) Amortization expense ($313,043 ÷ 6 = $52,174; ($52,174 x 3/12 = $13,044)
Problem 20.13 (Continued) 2.
3.
$ 47,680
Current liabilities: Lease liability ($42,673 + $5,007)
$207,670
Long-term liabilities: Lease liability ($250,343 + $5,007 – $47,680)
$299,999
Non-current Assets: Right-of-Use Asset ($313,043 – $13,044)
$ 19,174 $ 52,174
4. $ 50,240
Interest expense [($20,027 – $5,007) + ($16,614 x 3/12) = [$15,020 + $4,154 = $19,174] Amortization expense ($313,043 ÷ 6 = $52,174) Current liabilities: Lease liability ($46,086 + [$16,614 x 3/12] = [$46,086 + $4,154 = $50,240)
$161,584
Long-term liabilities: Lease liability ($207,670 + $4,154 – $50,240)
$247,825
Property, plant, and equipment: Right-of-Use Asset ($313,043 – $13,044 – $52,174)
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.14 (a) 1.
$313,043 $280,000 $ 20,027
Sales revenue Cost of goods sold Lease revenue
$ 62,700
Current assets: Lease receivable ($42,673 + $20,027)
$207,670
Noncurrent assets: Lease receivable (net investment)
$ 16,614
Lease revenue
$ 62,700
Current assets: Lease receivable ($46,086 + $16,614)
$161,584
Noncurrent assets: Lease receivable (net investment)
$313,043 $280,000 $ 5,007
Sales revenue Cost of goods sold Lease revenue ($20,027 x 3/12 = $5,007)
$ 47,680
Current assets: Lease receivable ($42,673 + $5,007)
$207,670
Noncurrent assets: Lease receivable
2.
3. 4.
(b) 1.
2.
3.
$ 19,174
4.
Lease revenue [($20,027 – $5,007) + ($16,614 x 3/12) = [$15,020 + $4,154 = $19,174]
$ 50,240
Current assets: Lease receivable ($46,086 + $4,154)
$161,584
Noncurrent assets: Lease receivable
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Problem 20.15 (a) The lease agreement satisfies the 90% of fair value requirement (calculation below). PV of Lease Payments: PV of rental payments, $12,471 x 3.72325* ..................... PV of guaranteed residual value, $17,500 x .82270**...... PV of lease payments ....................................................... Fair value of the asset ...................................................... Percentage of fair value of the leased asset ...................
$46,433 14,397 $60,830 ÷$67,000 90.79%
*Present value of an annuity due of 1 for 4 periods at 5%. **Present value of 1 for 4 periods at 5%. For the lessee, it is a finance lease, and for the lessor, it is a sales-type lease. Note to Instructor: While the present value classification test includes the full amount of the residual value guarantee, for purposes of measuring the initial lease liability, only amounts expected to be owed under the residual value guarantee should be included. That is, only the present value of the difference between the residual value guarantee and the expected residual value at the end of the lease term should be included. The calculation of the initial value of the lease liability is as follows: PV of Lease Liability: PV of rental payments, $12,471 x 3.72325* ..................... PV of guaranteed residual expected to be owed ............ Initial lease liability ........................................................... (b) January 1, 2025 Right-of-Use Asset ......................................................... Lease Liability ......................................................... (see calculation in part a)
$46,433 -0$46,433
46,433 46,433
Problem 20.15 (Continued) Lease Liability ................................................................ Cash......................................................................... December 31, 2025 Interest Expense ............................................................ Lease Liability [($46,433 – $12,471) x .05] .................................. Amortization Expense .................................................... Right-of-Use Asset ($46,433 ÷ 4) ........................................................
12,471 12,471 1,698 1,698 11,608 11,608
(c) January 1, 2025 Lease Receivable ........................................................... Cost of Goods Sold ($50,000 – $14,397) ....................... Sales Revenue ($67,000 – $14,397) ....................... Inventory ................................................................. Cash ................................................................................ Lease Receivable .................................................... December 31, 2025 Lease Receivable .............................................................. Lease Revenue [($67,000 – $12,471) x .05] ......................................
67,000 35,603 52,603 50,000 12,471 12,471
2,726 2,726
(d) Without the residual value guarantee, the lease agreement fails to satisfy the 90% of fair value requirement (calculation below). PV of Lease Payments: PV of rental payments, $12,471 x 3.72325* ..................... Fair value of the asset ...................................................... Percentage of fair value of the leased asset ...................
$46,433 ÷ $67,000 69.30%
*Present value of an annuity due of 1 for 4 periods at 5%. For both the lessee and the lessor, it is classified as an operating lease.
Problem 20.15 (Continued) Irving Company (Lessee) Entries January 1, 2025 Right-of-Use Asset ......................................................... Lease Liability ......................................................... (see calculation in part a) Lease Liability ................................................................ Cash.........................................................................
46,433 46,433 12,471 12,471
IRVING COMPANY Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27 1/1/28
Annual Payment $12,471 12,471 12,471 12,471
Interest (5%) on Liability $
0 1,698 1,159 594
Reduction of Lease Liability
Lease Liability
$12,471 10,773 11,312 11,877
$46,433 33,962 23,189 11,877 0
Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27 12/31/28
(A) (B) Lease Expense Interest (5%) on (Straight-Line) Lease Liability $12,471 12,471 12,471 12,471
$1,698 1,159 594 0
(C) Amortization of ROU Asset Carrying Value (A-B) of ROU Asset $10,773 11,312 11,877 12,471
$46,433 35,660 24,348 12,471 0
Problem 20.15 (Continued) December 31, 2025 Lease Expense ............................................................... Lease Liability ......................................................... Right-of-Use Asset .................................................
12,471 1,698* 10,773
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in the first schedule. Note that this is expensed along with amortization of the right-of-use asset at the end of 2025. Anthony Incorporated (Lessor) Entries January 1, 2025 Cash ................................................................................ Unearned Lease Revenue ...................................... December 31, 2025 Unearned Lease Revenue ................................................. Lease Revenue .......................................................... Depreciation Expense ....................................................... Accumulated Depreciation – Leased Machinery ($50,000 ÷ 10) ..........................
12,471 12,471 12,471 12,471 5,000
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
5,000
Problem 20.16 (a) The lease will be classified as an operating lease for both the lessee and the lessor. The lease does not transfer ownership at the end of the lease term, does not have a bargain purchase option, and the asset is not specialized. In addition, neither the 75% test (3 ÷ 8 = 37.5%) nor the 90% test (calculation below) are met. PV of Lease Payments: PV of rental payments, $10,521 x 2.83339* ..................... Fair value of the asset ...................................................... Percentage of fair value of the leased asset ...................
$29,810 ÷ $55,000 54.20%
*Present value of an annuity due of 1 for 3 periods at 6%. (b) DAWKINS COMPANY Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Payment $10,521 10,521 10,521
Interest (6%) on Liability $ 0 1,157 596
Reduction of Lease Liability
Lease Liability
$10,521 9,364 9,925
$29,810 19,289 9,925 0
Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/26 12/31/27
(A) (B) Lease Expense Interest (6%) on (Straight-Line) Lease Liability $10,521 10,521 10,521
$1,157 596 0
(C) Amortization of ROU Asset (A-B)
Carrying Value of ROU Asset
$9,364 9,925 10,521
$29,810 20,446 10,521 0
Problem 20.16 (Continued) (c) January 1, 2025 Right-of-Use Asset ......................................................... Lease Liability ......................................................... (see calculation in part a) Lease Liability ................................................................ Cash......................................................................... December 31, 2025 Lease Expense ............................................................... Lease Liability ......................................................... Right-of-Use Asset .................................................
29,810 29,810 10,521 10,521
10,521 1,157* 9,364
*The accrual of the lease liability is a result of the accrual of interest related to the lease liability, as shown in the lease amortization schedule. Note that this is expensed along with the amortization of the right-of-use asset at the end of 2025. (d) January 1, 2025 Cash ................................................................................ Unearned Lease Revenue ......................................
10,521
December 31, 2025 Unearned Lease Revenue ................................................. Lease Revenue ..........................................................
10,521
Depreciation Expense ....................................................... Accumulated Depreciation – Leased Machinery ($40,000 ÷ 8)............................
10,521
10,521 5,000 5,000
Problem 20.16 (Continued) (e) When a lessee elects to use the short-term lease option, the company need not recognize a lease liability or right-of-use asset on its books. Instead, the lessee expenses payments as they are made. As a result, if the lease were only 1 year, Dawkins’ only entry for the lease would be the following: January 1, 2025 Lease Expense ............................................................... Cash.........................................................................
10,521
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
10,521
Problem 20.17 (a) The lease is an operating lease to the lessee and lessor because: 1.
it does not transfer ownership,
2.
it does not contain a bargain purchase option,
3.
it does not cover at least 75% of the estimated economic life (5/7 = 71%) of the crane, and
4.
the present value of the lease payments is not at least 90% of the fair value of the leased crane.
$48,555 annual lease payments x PV of an annuity-due at 8% for 5 years $48,555 x 4.31213 = $209,375, which is less than $216,000 (90% x $240,000). 5.
it does not meet the specialized asset test.
At least one of the five tests would have had to be satisfied for the lease to be classified as other than an operating lease. (b) Lessee’s Entries 1/1/25 Right-of-Use Asset ............................................................ Lease Liability ............................................................ Lease Liability ................................................................... Cash............................................................................
209,375 209,375 48,555 48,555
Problem 20.17 (Continued) ABRIENDO CONSTRUCTION Lease Amortization Schedule (partial) Annuity-Due Basis
Annual Payment
Date 1/1/25 1/1/25 12/31/25 12/31/26 12/31/27
Date 1/1/25 12/31/25 12/31/26 12/31/27
$48,555 48,555 48,555 48,555
Interest (8%) on Liability $
0 12,866 10,010 6,927
Reduction of Lease Liability
Lease Liability
48,555 35,689 38,545 41,628
$209,375 160,820 125,131 86,586 44,958
Lease Expense Schedule (partial) (C) (A) (B) Amortization Lease Expense Interest (8%) on of ROU Asset (Straight-Line) Lease Liability (A-B) $48,555 48,555 48,555
$12,866 10,010 6,927
$35,689 38,545 41,628
12/31/25 Lease Expense .................................................................. Right-of-Use Asset ................................................... Lease Liability ............................................................
Carrying Value of ROU Asset $209,375 173,686 135,141 93,513
48,555 35,689 12,866
Lessor’s Entries 1/1/25 Cash ................................................................................... Unearned Lease Revenue .........................................
48,555 48,555
Problem 20.17 (Continued) 12/31/25 Depreciation Expense ....................................................... Accumulated Depreciation—Leased Equipment [($240,000 – $15,000) ÷ 7] ..................................... Unearned Lease Revenue ................................................. Lease Revenue ..........................................................
32,143 32,143 48,555 48,555
(c) Abriendo, as lessee, must record both a lease liability, as well as a rightof-use asset. The first cash payment is a total reduction of the lease liability (as no time has passed, and thus, no interest has accrued). At the end of the year, Abriendo must make an accrual for the annual lease expense. In this case, since the payment does not occur until the first day of the following year, Abriendo must accrue a lease liability equal to the amount of interest for 2025. In addition, Abriendo amortizes the asset whatever amount gives the company a straight-line lease expense. In the balance sheet, Abriendo will present a right-of-use asset of $173,686 ($209,375 – $35,689) and a lease liability of $173,686 ($209,375 – $48,555 + $12,866). In the income statement, Abriendo will show a single lease expense for $48,555. Cleveland, as lessor, must disclose in the balance sheet or in the notes the cost of the leased crane ($240,000) and the accumulated depreciation of $32,143 separately from assets not leased. Additionally, Cleveland must disclose in the notes the minimum future rentals as a total of $194,220, and for each of the succeeding four years: 2026—$48,555; 2027— $48,555; 2028—$48,555; 2029—$48,555. The income statement for the lessor reports lease revenue of $48,555. While this amount was initially unearned, Cleveland earned that revenue through the passing of time that the crane was leased. As a result, at the end of the year, Cleveland makes an adjusting entry to recognize that revenue. LO: 3, Bloom: AP, Difficulty: Simple, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
UYJ 20.1 Financial Reporting Problem (a) In Note 12 P&G’s only operating leases are disclosed. (b) P&G reported (note 12) P&G has a significant amount of operating leases totaling $891 million. P&G indicates that operating lease payments of $239 million are due in 1 year. (c) P&G in note 12 disclosed future minimum rental commitments under noncancelable operating leases in excess of one year as of June 30, 2019, of: 2020—$263 million 2021—$209 million 2022—$165 million 2023—$141 million 2024—$121 million After 2024—$244 million Total lease payments = $1,143 million. Note: The notes to the financial statements and MD&A are not included in Appendix B. It can be accessed at P&G’s corporate site. LO: 2, 4, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ20.2 Comparative Analysis Case (a) Southwest and Delta use both finance leases and operating leases. Southwest primarily leases aircraft and some terminal space. Delta leases aircraft, airport facilities and other ground property and equipment. (b) Southwest has some long-term leases that don’t expire until after 2025 and in many cases the leases can be renewed. Most aircraft leases have purchase options at or near the end of the lease term at fair market value, generally limited to a stated percentage of the lessor’s defined cost of the aircraft. (c) Maturities of lease liabilities were as follows: (in millions):
2021 2022 2023 2024 2025 Thereafter Total lease payments Less imputed interest Total lease obligations Less current obligations Long-term lease obligations
Operating leases
Finance leases
$ 371 253 219 193 156 1,156 $2,348 (480) 1,868 (306) $ 1,562
$ 102 98 94 90 74 156 $ 614 (72) 542 (83) $ 459
(d) At year-end 2020, the present value of minimum lease payments under finance leases was $459 million. Imputed interest deducted from the future minimum annual rental commitments was $83 million. (e) The details of lease cost are set forth below (in $millions):
(f)
2020
2019
$1,701
$1,794
The main difference between Southwest and Delta is that Delta is leasing more types of assets compared to Southwest. In addition to aircraft and terminal space, Delta is leasing airport terminals maintenance facilities, ticket offices, and other property and equipment.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
UYJ 20.3 Financial Statement Analysis Case ($ millions) (a) The total obligations under finance leases at 1/31/2020 for WalMart Company is $4,818 [Current: $511 + Noncurrent: $4,307] (the present value of the future lease payments). (b) The total rental expense for WalMart in fiscal 2020 (ending 1/31/2020) was $4,237 ($2,670 operating + $1,477 finances). (c) The present value of minimum lease payments related to operating leases is $17.964 million. LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: None
UYJ 20.4 Accounting, Analysis, and Principles Accounting (a) There are five lease capitalization tests. They are (1) transfer of ownership, (2) bargain-purchase option, (3) the lease term is 75% or more of the economic life of the leased asset, (4) the present value of the lease payments is 90% or more of the leased asset’s fair value, and (5) alternative use test. This lease does not transfer ownership. The option to purchase at the end of the lease is clearly not a bargain. The lessor has an alternative use for the computers at the end of the lease. The lease term is (3 ÷ 5) = 0.6 or 60% of the economic life, so the economic life test is not met. The recovery of investment test is as follows: Present value of lease payments = $3,057.25 x (PVF-AD3,12%) = ($3,057.25 x 2.69005) = $8,224.16. Present value of lease payments as % of fair value = $8,224.16 ÷ $10,000 = 0.8224 or 82.24%. Therefore, the present value test is not met either. Consequently, this lease is accounted for as an operating lease. Therefore, Salaur makes the following journal entries at the commencement date. 1/1/25 Right-of-Use Asset ...................... Lease Liability......................
8,224.16
Lease Liability ............................. Cash .....................................
3,057.25
8,224.16 3,057.25
Accounting, Analysis, and Principles (Continued) SALAUR COMPANY Lease Amortization Schedule Annuity-Due Basis
Date 1/1/25 1/1/25 1/1/26 1/1/27
Annual Payment $3,057.25 3,057.25 3,057.25
Interest (12%) on Liability $
0 620.03 327.56
Reduction of Lease Liability
Lease Liability
$3,057.25 2,437.22 2,729.69
$8,224.16 5,166.91 2,729.69 0
Lease Expense Schedule
Date 1/1/25 12/31/25 12/31/25 12/31/26
(A) Straight-Line Expense $3,057.25 3,057.25 3,057.25
(B) Interest (12%) on Lease Liability $ 620.03 327.56 0
(C) Amortization of Carrying Value ROU Asset of ROU Asset (A-B) $2,437.22 2,729.69 3,057.25
$8,224.16 5,786.94 3,057.25 0
The entry to record lease expense in 2025 is as follows. 12/31/25 Lease Expense ............................ Right-of-Use Asset .............. Lease Liability......................
3,057.25 2,437.22 620.03
Accounting, Analysis, and Principles (Continued) (b)
With the bargain purchase option, the lease is now classified as a finance lease. Salaur computes the lease liability and right-of-use asset, as follows. Present value of lease payments = $3,057.25 x (PVF-AD3,12) = ($3,057.25 x 2.69005) = $8,224.16 Present value of bargain purchase option = $100 x (PV3,12) = ($100 x .7118)
= 71.18 $8,295.34
Salaur makes the following entries at lease commencement. 1/1/25 Right-of-Use Asset ................................................ Lease Liability ................................................
8,295.34
Lease Liability ....................................................... Cash................................................................
3,057.25
8,295.34 3,057.25
SALAUR COMPANY Lease Amortization Schedule
Date 1/1/25 1/1/25 1/1/26 1/1/27 1/1//28
Annual Lease Payment Plus BPO $ 3,057.25 3,057.25 3,057.25 100.00 $9,271.75
Interest (12%) on Liability
Reduction of Lease Liability
$
$ 3,057.25 2,428.68 2,720.12 89.29 $8,295.34
0 628.57 337.13 10.71 $976.41
Lease Liability $8,295.34 5,238.09 2,809.41 89.29 0
Accounting, Analysis, and Principles (Continued) 12/31/25 Interest Expense ................................................... Lease Liability ................................................
628.57
Amortization Expense ........................................... Right-of-Use Asset ($8,295.34 ÷ 5) ............................................
1,659.07
628.57
1,659.07
Note that the right-of-use asset is amortized over the economic life (5 years) of the asset, as Salaur is expected to purchase the computers at the end of the lease. Analysis While all leases with terms longer than one year are capitalized (recorded on the balance sheet), the amounts differ depending on whether the lease is classified as a finance or operating lease. As indicated in the entries above, the right-of-use asset increases and the denominator of the return on assets ratio (ROA = Net income ÷ Average assets) will increase, but by different amounts (generally by more with a finance lease, and by higher amounts in the early years of a finance lease). The classification tests are designed such that leases that represent an in-substance purchase will increase the denominator more, which is more representative of the transaction. Similarly, the debt to assets ratio (Total debt ÷ Total assets) will reflect the obligations, according to the non-cancellable payments required in the lease. This reporting is in contrast to prior GAAP, under which many operating leases were not capitalized, which gave the impression that companies with operating leases looked more profitable and more solvent than is really the case. If companies capitalize differing percentages of their leases, it will be difficult to compare the companies based on ROAs and debt to total asset ratios.
Accounting, Analysis, and Principles (Continued) Principles The fundamental quality is faithful representation. The lease criteria are designed to report leases according to their economic substance. Thus, if through a lease arrangement a company has control of the leased asset (whether classified as finance or operating), it meets the definition of an asset and should be recognized on the balance sheet. Similarly, the associated liability should be recognized if it represents an unavoidable obligation and thereby meets the definition of a liability. That is, the financial statements faithfully represent (completeness) if they report all assets and liabilities of the company. Note to instructor: Under prior GAAP, companies could structure a lease to avoid capitalization, which detracts from faithful representational reporting of the lease arrangement, which may not be neutral. LO: 2, 4, Bloom: SYN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Time and Purpose of Critical Thinking CT 20.1 (Time 15–25 minutes) Purpose—to provide the student with an understanding of the theoretical reasons for requiring certain leases to be capitalized by the lessee and how a finance lease is recorded at its commencement and how the amount to be recorded is determined. The student explains how to determine the lessee’s expenses during the first year and how the lessee will report the lease on the balance sheet at the end of the year. CT 20.2 (Time 25–35 minutes) Purpose—to provide an understanding of the factors underlying the accounting for a leasing arrangement from the point of view of both the lessee and lessor. The student is required to determine the classification of this leasing arrangement, the appropriate accounting treatment which should be accorded this lease, and the financial statement disclosure requirements for both the lessee and lessor. CT 20.3 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the classification of three leases. The student determines how the lessee should classify each lease, what amount should be recorded as a liability at the commencement of each lease, and how the lessee should record each lease payment for each lease. CT 20.4 (Time 15–25 minutes) Purpose—to provide the student with an assignment to describe: (a) the accounting for a finance lease both at commencement and during the first year and (b) the accounting for an operating lease. The student is also required to compare and contrast a sales-type lease with a direct-financing lease. CT 20.5 (Time 30–40 minutes) Purpose—to develop a memo to your audit supervisor to discuss: (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for the lease. As part of the discussion, you are required to make the journal entry necessary to record the lease property. CT 20.6 (Time 20–25 minutes) Purpose—to provide the student with a lease arrangement with a bargain-purchase option in order to examine the ethical issues of lease accounting. *CT 20.7 (Time 15–25 minutes) Purpose— The student is required to discuss the accounting issues related to a sale-leaseback.
CT 20.1 (a)
The FASB believes that the reporting of an asset and liability for a lease arrangement is consistent with the conceptual framework definition of assets and liabilities. That is, assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. It follows that if the lease transfers control of the underlying asset to a lessee, then the lease is classified as a finance lease; all other leases are classified as operating leases. In an operating lease, a lessee obtains the right to use the underlying asset, but not ownership of the asset itself. Operating leases are capitalized since the right-to-use is an asset and a liability is incurred.
(b)
Evans should account for this lease at its commencement as an asset and an obligation at an amount equal to the present value at the beginning of the lease term of lease payments during the lease term. From the information provided, this lease is a finance lease as control of the asset belongs to Evans.
(c)
Evans will incur interest expense equal to the interest rate used to capitalize the lease at its commencement multiplied by the appropriate net carrying value of the lease liability at the beginning of the period. In addition, Evans will incur an expense relating to amortization of the cost of the right-ofuse asset. This amortization should be based on the lease term and amortized in a manner consistent with Evans’ normal depreciation policy for owned assets.
(d)
The right-of-use asset recorded under the finance lease should be classified on Evans’ December 31, 2025, balance sheet as noncurrent and should be separately identified by Evans in its balance sheet or footnotes thereto. The related obligation recorded under the finance lease should be reported on Evans’ December 31, 2025, balance sheet appropriately classified into current and noncurrent liabilities categories and should be separately identified by Evans in its balance sheet.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
CT 20.2 (a)
(1)
Because the present value of the lease payments is greater than 90 percent of the fair value of the asset at commencement of the lease, Sylvan should record this as a finance lease.
(2) Since the given facts state that Sylvan (lessee) does not have access to information that would enable determination of Breton Leasing Corporation’s (lessor) implicit rate for this lease, Sylvan should determine the present value of the lease payments using the incremental borrowing rate (10 percent). This is the rate that Sylvan would have to pay for a like amount of debt obtained through normal third-party sources (bank or other direct financing). (3) The amount recorded as an asset on Sylvan’s books should be shown in the noncurrent asset section of the balance sheet as “Right-of-Use Asset or another similar title. At the same time as the asset is recorded, a corresponding liability (“Lease Liability” or similar title) is recognized in the same amount. This liability is classified as both current and noncurrent, with the current portion being that amount that will be paid on the principal amount during the next year. The cost of the lease is matched with revenue through amortization taken on the machine over the life of the lease. Since ownership of the machine is not expressly conveyed to Sylvan in the terms of the lease at its commencement, the term of the lease is the appropriate life for amortization purposes. The lease payments represent a payment of principal and interest at each payment date. Interest expense is computed at the rate at which the lease payments were discounted and represents a fixed interest rate applied to the declining balance of the debt. Executory costs (such as insurance, maintenance, or taxes) paid by Sylvan are charged to an appropriate expense, accrual, or deferral account as incurred or paid. (4) The lessee should make the following qualitative disclosures: • Nature of its leases, including general description of those leases. • How variable lease payments are determined. • Existence and terms and conditions for options to extend or terminate the lease and for residual value guarantees. • Information about significant assumptions and judgments (e.g., discount rates).
CT 20.2 (Continued) In addition, the quantitative information that should be disclosed for the lessee is follows: • Total lease cost • Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities • Operating and short-term lease cost. • Weighted-average remaining lease term and weighted-average discount rate (segregated between finance and operating leases). • Maturity analysis of finance and operating lease liabilities, on an annual basis for a minimum of each of the next five years, the sum of the undiscounted cash flows for all years thereafter. (b)
(1) Based on the given facts, Breton has entered into a sales-type lease. The discounted present value of the lease payments is in excess of 90 percent of the fair value of the asset at commencement of the lease arrangement and collectibility of lease payments is probable. (2) Breton should record a Lease Receivable for the present value of the lease payments and the present value of the residual value. It might be noted that since the residual value is unguaranteed that Breton may choose to record the residual value in a separate account and not include the residual value in the lease receivable amount. It should also remove the machine from the books by a credit to the applicable asset account. (3) During the life of the lease, Breton will record payments received as a reduction in the receivable. Interest is recognized as interest revenue by applying the implicit interest rate to the declining balance of the lease receivable. The implicit rate is the rate of interest that will discount the sum of the payments and unguaranteed residual value to the fair value of the machine at the date of the lease agreement. This method of income recognition is termed the effective interest method of amortization. In this case, Breton will use the 9% implicit rate. (4) Breton must make the following disclosures with respect to this lease: ▪ ▪ ▪ o o
Lease-related income, including profit and loss recognized at lease commencement for sales-type, and Interest income. Income from variable lease payments not included in the lease receivable. The components of the net investment in sales-type, including the carrying amount of the lease receivable, the unguaranteed residual asset. A maturity analysis for operating lease payments and a separate maturity analysis for the lease receivable (sales-type). Management approaches for risk associated with residual value of leased assets (e.g., buyback agreements or third-party insurance).
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
CT 20.3 (a)
A lease should be classified as a finance lease when it transfers substantially all of the benefits and risks inherent to the ownership of property by meeting any one of the five tests for classifying a lease as a finance lease. Lease L should be classified as a finance lease because the lease term is equal to 80 percent of the estimated economic life of the equipment, which exceeds the 75 percent test or more. Lease M should be classified as a finance lease because the lease contains a bargain purchase option. Lease N should be classified as an operating lease because it does not meet any of the five tests for classifying a lease as a finance lease.
(b)
For Lease L, Santiago Company should record as a liability at the commencement of the lease an amount equal to the present value of the lease payments during the lease term. For Lease M, Santiago Company should record as a liability at the commencement of the lease an amount determined in the same manner as for Lease L plus the bargain purchase option should be included in the lease payments at its present value. For Lease N, Santiago Company should record as a liability at the commencement of the lease the present value of the lease payments.
(c)
For Lease L, Santiago Company should allocate each lease payment between a reduction of the liability and interest expense so as to produce a constant periodic rate of interest on the remaining balance of the liability. Thus, the interest expense and amortization of the right-of-use asset will not equal the lease payment. For Lease M, Santiago Company should allocate each lease payment in the same manner as for Lease L. For Lease N, if the lease does not meet any of the lease classification tests for a finance lease, a lessee should classify such a lease as an operating lease. For leases classified as operating, the lessee records a right-of-use asset and lease liability at commencement of the lease, similar to the finance lease approach. However, unlike the finance lease, the lessee records the same amount for lease expense each period over the lease term (often referred to as the straight-line method for expense measurement). To accomplish the goal of achieving a single operating cost that is constant from period to period, companies continue to use the effective interest method for amortizing the lease liability. However, instead of reporting interest expense, a lessee reports interest on the lease liability as Lease Expense. In addition, the lessee no longer reports amortization expense related to the right-of-use asset. Instead, it “plugs” in an amount that increases the lease expense amount so that it is the same amount from period to period. This plugged amount then reduces the right-of-use asset, such that both the right-of-use asset and the lease liability are amortized to zero at the end of the lease.
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Measurement Analysis and Interpretation, Reporting, AICPA PC: None
CT 20.4
Part 1 (a)
A lessee would account for a finance (and an operating lease) as an asset and a liability at the commencement of the lease. For a finance lease, rental payments during the year are allocated between a reduction in the liability and interest expense. The asset is amortized in a manner consistent with the lessee’s normal depreciation policy for owned assets, except that in most circumstances, the period of amortization would be the lease term.
(b)
If the lease does not meet any of the lease classification tests for a finance lease, a lessee should classify such a lease as an operating lease. For leases classified as operating, the lessee records a right-of-use asset and lease liability at commencement of the lease, similar to the finance lease approach. However, unlike the finance lease, the lessee records the same amount for lease expense each period over the lease term (often referred to as the straight-line method for expense measurement). To accomplish the goal of achieving a single operating cost that is constant from period to period, companies continue to use the effective interest method for amortizing the lease liability. However, instead of reporting interest expense, a lessee reports interest on the lease liability as Lease Expense. In addition, the lessee no longer reports amortization expense related to the right-of-use asset. Instead, it “plugs” in an amount that increases the lease expense amount so that it is the same amount from period to period. This plugged amount then reduces the right-of-use asset, such that both the rightof-use asset and the lease liability are amortized to zero at the end of the lease.
Part 2 (a)
A lease receivable is recorded in as sales-type lease by the lessor. The lease receivable is the present value of the lease payments plus the present value of the unguaranteed residual value accruing to the benefit of the lessor. Under the operating method, the lessor continues to recognize the asset on its balance sheet and recognizes equal amounts of lease revenue (straight-line basis) in each period. In most cases, it also depreciates the leased asset on a straight-line basis.
(b)
For a sales-type lease, interest revenue is recognized over the lease term by use of the effective interest method to produce a constant periodic rate of return on the lease receivable. In an operating lease, the lessor recognizes lease revenue for the rent payments and depreciates the leased asset over its economic life.
(c)
In a sales-type lease, the excess of the sales price over the carrying amount of the leased equipment is considered gross profit and would be included in income in the period when the sales transaction is recorded. Subsequently, it also recognizes interest revenue over the life of the lease. In an operating lease, there is no gross profit. The revenue on the lease transaction is composed of the rental payments.
LO: 2, 3, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*CT 20.5 Memorandum Prepared by: (Your Initials) Date: HOCKNEY, INC. December 31, 2025 Reclassification of Leased Auto as a Finance Lease While performing a routine inspection of the client’s garage, I found a used automobile which was not listed among the company’s assets in the equipment subsidiary ledger. I asked Stacy Reeder, plant manager, about the vehicle, and she indicated that because it was only being leased, it was not listed along with other company assets. Having elected to account for this agreement as a short-term lease, Hockney, Inc. had charged $3,240 to 2025 rent expense. Examining the noncancelable lease agreement entered into with Crown New and Used Cars on January 1, 2025, I determined that the automobile should be capitalized as a finance lease because its lease term (2 years) is greater than 75% of its useful life (2.5 years). In addition, Hockney guaranteed the estimated residual value at the end of the lease term, meaning the present value of the lease payments are 100% of the fair value of the automobile. I advised the client to capitalize this lease at the present value of its rental payments: $5,778 (the present value of the monthly payments). After inquiring of management about the residual value expected at the end of the lease agreement, and ensuring management’s significant judgments and assumptions were reasonable, I determined that the expected residual value of the lease equals the guaranteed residual, and thus none of the residual value guarantee should be included in the initial measurement of the lease liability or right-of-use asset (as no amount is expected to be owed under the residual value guarantee). The following journal entry to record the initial lease liability and related right-of-use asset was suggested to management: Right-of-Use Asset ........................................................................... Lease Liability ..........................................................................
5,778 5,778
To account for the first year’s payments as well as to reverse the original entries, I advised the client to make the following entry: Lease Liability .................................................................................. Interest Expense (8% x $5,778) ....................................................... Rent Expense ..........................................................................
2,778 462 3,240
*CT 20.5 (Continued) Finally, this vehicle must be amortized over its lease term, using the straight-line method. I computed annual amortization of $2,889 (the initial right-of-use asset, $5,778, divided by the 2year lease term). The client was advised to make the following entry to record 2025 amortization: Amortization Expense ...................................................................... Right-of-Use Asset ...................................................................
2,889 2,889
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Professional Behavior
CT 20.6 (a)
(b)
(c)
The ethical issues are fairness and integrity of financial reporting versus profits and possibly misleading financial statements. On one hand, if Buchanan can substantiate her position, it is possible that the agreement should be considered an operating lease. On the other hand, if Buchanan cannot or will not provide substantiation, she would appear to be trying to manipulate the financial statements to reduce the recorded lease liability, to increase net income in the earlier years of the lease term, and/or get straight-line lease expense reporting. If Buchanan has no particular expertise in copier technology, she has no rational case for her suggestion. If she has expertise, then her suggestion may be rational and would not be merely a means to manipulate the balance sheet to avoid recording a higher liability. Suffolk must decide whether the situation presents a legitimate difference of opinion where professional judgment could take the answer either way or an attempt by Buchanan to mislead. Suffolk must decide whether he wishes to argue with Buchanan or simply accept Buchanan’s position. Suffolk should assess the consequences of both alternatives. Suffolk might conduct further research regarding copier technology before reaching a decision.
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Professional Behavior
*CT 20.7 (a)
The major accounting issue is whether the transaction is a sale or a financing. To determine whether it is a sale, the revenue recognition guidelines are used. That is, if control has passed from seller to buyer, then a sale has occurred. Conversely, if control has not passed from seller to buyer the transaction is recorded as a financing (often referred to as a failed sale).
(b)
(1) This transaction should be reported as a financing as control of the leased asset has not passed from the seller to the buyer. In essence, Perriman is borrowing money from the purchaser-lessor (often referred to as a financing or a failed sale). (2) In a financing (failed sale), Perriman: • does not reduce the carrying value of the building; • continues to depreciate the building as if it was the legal owner; and • increases cash and records a note payable.
LO: 5, Bloom: AN, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Codification Exercises CE20.1 Master Glossary (a)
Commencement date of the lease (commencement date) is the date on which a lessor makes an underlying asset available for use by a lessee.
(b)
The incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.
(c)
Unguaranteed residual asset is amount that a lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.
(d)
Variable lease payments are payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.
LO: 2, 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE20.2 According to FASB ASC 842-10-30-5 to 6: Initial Measurement of the Lease Payments At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term: • • • • • •
Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31). Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option (assessed considering the factors in paragraph 842-10-55-26). Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d). For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55- 36).
Lease payments do not include any of the following: • • •
Variable lease payments other than those in paragraph 842-10-30-5(b) Any guarantee by the lessee of the lessor’s debt Amounts allocated to non-lease components in accordance with paragraphs 842-10-15- 33 through 15-42.
LO: 2, 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Exercises (Continued) CE20.3 According to 842-20-50-3 (Disclosure): A lessee shall disclose all of the following: a. Information about the nature of its leases, including: 1. A general description of those leases. 2. The basis and terms and conditions on which variable lease payments are determined. 3. The existence and terms and conditions of options to extend or terminate the lease. A lessee should provide narrative disclosure about the options that are recognized as part of its right-ofuse assets and lease liabilities and those that are not. 4. The existence and terms and conditions of residual value guarantees provided by the lessee. 5. The restrictions or covenants imposed by leases, for example, those relating to dividends or incurring additional financial obligations. A lessee should identify the information relating to subleases included in the disclosures provided in (1) through (5), as applicable. b. Information about leases that have not yet commenced but that create significant rights and obligations for the lessee, including the nature of any involvement with the construction or design of the underlying asset. c. Information about significant assumptions and judgments made in applying the requirements of this Topic, which may include the following: 1. The determination of whether a contract contains a lease (as described in paragraphs 84210-15-2 through 15-27) 2. The allocation of the consideration in a contract between lease and non-lease components (as described in paragraphs 842-10-15-28 through 15-32). 3. The determination of the discount rate for the lease. 842-20-50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions: a. Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities. b. Operating lease cost determined in accordance with paragraphs 842-20-25-6(a) and 842-20-257. c. Short-term lease cost, excluding expenses relating to leases with a lease term of one month or less, determined in accordance with paragraph 842-20-25-2. d. Variable lease cost determined in accordance with paragraphs 842-20-25-5(b) and 842-2025-6(b). e. Sublease income, disclosed on a gross basis, separate from the finance or operating lease expense. f. Net gain or loss recognized from sale and leaseback transactions in accordance with paragraph 842-40-25-4. g. Amounts segregated between those for finance and operating leases for the following items: 1. Cash paid for amounts included in the measurement of lease liabilities, segregated between operating and financing cash flows 2. Supplemental noncash information on lease liabilities arising from obtaining right-ofuse assets 3. Weighted-average remaining lease term 4. Weighted-average discount rate. LO: 2, 4, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE20.4 According to FASB ASC 842-30-35-1 > Sales-Type and Direct Financing Leases After the commencement date, a lessor shall measure the net investment in the lease by doing both of the following: a. Increasing the carrying amount to reflect the interest income on the net investment in the lease. A lessor shall determine the interest income on the net investment in the lease in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease. b. Reducing the carrying amount to reflect the lease payments collected during the period. 842-30-35-2 After the commencement date, a lessor shall not remeasure the net investment in the lease unless the lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. LO: 3, 4, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a)
According to FASB ASC 842-20-30-1 (Initial Measurement – General): 1. At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement (as described in paragraphs 842-20-30-2 through 30-4). 2. According to 842-20-30-5 (Initial Measurement of the Right-of-Use Asset), at the commencement date, the cost of the right-of-use asset shall consist of all of the following: a. The amount of the initial measurement of the lease liability b. Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received c. Any initial direct costs incurred by the lessee (as described in paragraphs 842-10-30-9 through 30-10).
(b) According to the FASB ASC 842-10-30-1 to 3 (Lease Term and Purchase Options), an entity shall determine the lease term as the noncancellable period of the lease, together with all of the following: a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option b. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option c. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. 842-10-30-2 At the commencement date, an entity shall include the periods described in paragraph 842-10-30-1 in the lease term having considered all relevant factors that create an economic incentive for the lessee (that is, contract-based, asset-based, entity-based, and market-based factors). Those factors shall be considered together, and the existence of any one factor does not necessarily signify that a lessee is reasonably certain to exercise or not to exercise an option. 842-10-30-3 At the commencement date, an entity shall assess an option to purchase the underlying asset on the same basis as an option to extend or not to terminate a lease, as described in paragraph 842-10-30-2.
Codification Research Case (Continued) (c) According to FASB ASC 842-10-25-8 (Lease Modifications), An entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present: a. The modification grants the lessee an additional right-of-use not included in the original lease (for example, the right to use an additional asset). b. The lease payments increase commensurate with the standalone price for the additional right-of-use, adjusted for the circumstances of the particular contract. For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee. LO: 1, 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CHAPTER 21 Accounting Changes and Error Analysis Assignment Classification Table (By Topic) Brief Questions Exercises Exercises Problems
Topics 1.
Differences between change in principle, change in estimate, change in entity, errors.
2.
Accounting changes:
3.
*4.
Critical Thinking
2, 4, 6, 7, 8, 9, 12, 13, 15, 21
8, 10
3, 5
1, 2, 3, 4
10
3, 6
1, 2, 4, 5
a.
Comprehensive.
1, 3
b.
Changes in estimate, changes in depreciation methods.
2, 3, 8, 18
4, 5, 9
8, 9, 11, 12, 13, 14
2, 4, 6, 7
1, 2, 3, 4, 5, 6
c.
Changes in accounting for long-term construction contracts.
2, 10
1, 2, 10
1, 6
4
1, 2
d.
Change from FIFO to average cost.
e.
Change from FIFO to LIFO. 2, 11
10
f.
Change from LIFO.
8
3
g.
Miscellaneous.
1, 3, 4, 5, 6, 7, 8, 10
8, 9, 10
4, 7
3 1, 2
2, 3, 5, 7 1, 3 1, 5
Correction of an error. a.
Comprehensive.
8, 14, 15, 17, 19
8, 9, 10
10, 15, 16, 18, 19, 20, 21
3, 4, 6, 7, 2, 3, 4 8, 9, 10
b.
Depreciation.
2, 18, 21
6, 7
11, 15, 17, 18
2, 6, 8
c.
Inventory.
9, 16, 20
10
9, 17, 18 8, 10
11, 12
22, 23
Changes between fair value and equity methods.
*This material is dealt with in an Appendix to the chapter.
11, 12
1, 2
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Critical Thinking
1. Discuss the types of accounting changes and understand the accounting for changes in accounting principles.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 9, 10
1, 2, 3, 4, 5, 6, 7, 10
1, 2, 3, 4, 5, 6
1, 2, 3, 4, 5
2. Describe the accounting for changes in estimates and changes in the reporting entity.
12, 13
4, 5, 9
8, 9, 10, 11, 12, 13, 14
2, 3, 4, 5
1, 2, 3, 4, 5, 6
3. Describe the accounting for correction of errors.
15, 16, 17, 18, 19, 20, 21
6, 7, 8, 10
9, 10, 11, 2, 3, 4, 6, 15, 16, 17, 7, 8, 9, 10 18, 19, 20, 21
4. Analyze the effect of errors.
14
*5. Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.
11, 12
18, 19, 20, 21
3, 6, 7, 8, 9, 10
22, 23
11, 12
1, 2, 3, 4
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E21.1 E21.2 E21.3 E21.4 E21.5 E21.6 E21.7 E21.8 E21.9 E21.10 E21.11 E21.12 E21.13 E21.14 E21.15 E21.16 E21.17 E21.18 E21.19 E21.20 E21.21 *E21.22 *E21.23
Change in principle—long-term contracts. Change in principle—inventory methods. Accounting change. Accounting change. Accounting change. Change in principle—long-term contracts. Various changes in principle—inventory methods. Accounting changes—depreciation. Change in estimate and error; financial statements. Accounting for accounting changes and errors. Error and change in estimate—depreciation. Depreciation changes. Change in estimate—depreciation. Change in estimate—depreciation. Error correction entries. Error analysis and correcting entry. Error analysis and correcting entry. Error analysis. Error analysis; correcting entries. Error analysis. Error analysis. Change from fair value to equity. Change from equity to fair value.
Moderate Moderate Complex Complex Complex Simple Moderate Complex Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Complex Complex Moderate Moderate Complex Complex Complex
10–15 10–15 25–30 25–30 30–35 10–15 20–25 30–35 25–30 5–10 15–20 20–25 10–15 20–25 15–20 10–15 10–15 25–30 20–25 20–25 10–15 25–30 15–20
P21.1 P21.2 P21.3 P21.4 P21.5 P21.6 P21.7 P21.8 P21.9 P21.10 *P21.11 *P21.12
Change in principle—inventory—periodic. Change in estimate and error correction. Comprehensive accounting change and error analysis problem. Error corrections and accounting changes. Accounting changes. Accounting change and error analysis. Error corrections. Comprehensive error analysis. Error analysis. Error analysis and correcting entries. Fair value to equity method with goodwill. Change from fair value to equity method.
Complex Moderate Complex Complex Moderate Complex Moderate Complex Moderate Complex Moderate Complex
30–35 30–35 30–40 30–40 40–50 25–30 25–30 30–35 20–25 50–60 20–25 20–25
CT21.1 CT21.2 CT21.3 CT21.4 CT21.5 CT21.6
Analysis of various accounting changes and errors. Analysis of various accounting changes and errors. Analysis of three accounting changes and errors. Analysis of various accounting changes and errors. Change in principle, estimate. Change in estimate.
Moderate Moderate Complex Moderate Moderate Moderate
25–35 20–30 30–35 20–30 20–30 10–15
Answers to Questions 1.
The major reasons why companies change accounting methods are: (a) Desire to show better profit picture. (b) Desire to increase cash flows through reduction in income taxes. (c) Requirement by Financial Accounting Standards Board to change accounting methods. (d) Desire to follow industry practices. (e) Desire to show a better measure of the company’s income.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
2.
(a) Change in accounting principle; retrospective application is generally not made because it is impracticable to determine the effect of the change on prior years. The FIFO inventory amount is therefore generally the beginning inventory in the current period. (b) Correction of an error and therefore prior period adjustment; adjust the beginning balance of retained earnings. (c) Increase income for litigation settlement, assuming it was not accrued. (d) Change in accounting estimate; currently and prospectively. Part of operating section of income statement. (e) Reduction of accounts receivable and the allowance for doubtful accounts. (f) Change in accounting principle; retrospective application to prior period financial statements.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
3.
The three approaches suggested for reporting changes in accounting principles are: (a) Currently—the cumulative effect of the change is reported in the current year’s income as a special item. (b) Retrospectively—the cumulative effect of the change is reported as an adjustment to retained earnings. The prior year’s statements are changed on a basis consistent with the newly adopted principle. (c) Prospectively—no adjustment is made for the cumulative effect of the change. Previously reported results remain unchanged. The change shall be accounted for in the period of the change and in subsequent periods if the change affects future periods.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
4.
The FASB believes that the retrospective approach provides financial statement users the most useful information. Under this approach, the prior statements are changed on a basis consistent with the newly adopted standard; any cumulative effect of the change for prior periods is recorded as an adjustment to the beginning balance of retained earnings of the earliest period reported.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
5.
The indirect effect of a change in accounting principle reflects any changes in current or future cash flows resulting from a change in accounting principle that is applied retrospectively. An example is the change in payments to a profit-sharing plan that is based on reported net income. Indirect effects are not included in the retrospective application, but instead are reported in the period in which the accounting change occurs (current period).
LO: 1, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
6.
A change in an estimate is simply a change in the way an individual perceives the realizability of an asset or liability. Examples of changes in estimate are: (1) change in the realizability of trade receivables, (2) revisions of estimated lives, (3) changes in estimates of warranty costs, and (4) change in estimate of deferred charges or credits. A change in accounting estimate affected by a change in accounting principle occurs when a change in accounting estimate is inseparable from the effect of a related change in accounting principle. An example would be switching from capitalizing advertising expenditures to expensing them if the future benefit of the expenditures can no longer be estimated with reasonable certainty.
LO: 1, Bloom: K, C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 21 (Continued) 7.
This is an example of a situation in which it is difficult to differentiate between a change in accounting principle and a change in estimate. In such a situation, the change should be considered a change in estimate, and accordingly, should be handled currently and prospectively. Thus, all costs presently capitalized and viewed as providing doubtful future values should be expensed immediately, and costs currently incurred should also be expensed immediately.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
8.
(a) Charge to expense—possibly separately disclosed. (b) Change in estimate that is affected by a change in accounting principle—currently and prospectively. (c) Charge to expense—possibly separately disclosed. (d) Correction of an error and reported as a prior period adjustment—adjust the beginning balance of retained earnings. (e) Change in accounting principle—retrospective application to all affected prior-period financial statements. (f) Change in accounting estimate—currently and prospectively.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
9.
This change is to be handled as a correction of an error. As such, the portion of the change attributable to prior periods ($23,000 = $52,000 − $29,000) should be reported as an adjustment to the beginning balance of retained earnings in the 2025 financial statements. If statements for previous years are presented for comparative purposes, these statements should be restated to correct for the error. The remainder of the inventory value ($29,000) should be reported in the 2025 income statement as a reduction of materials cost.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
10.
Preferability is a difficult concept to apply. The problem is that there are no basic objectives to indicate which is the most preferable method, assuming a selection between two generally accepted accounting practices is possible, such as LIFO and FIFO. If a FASB standard creates a new principle or expresses preference for or rejects a specific accounting principle, a change is considered clearly acceptable. A more appropriate matching of revenues and expenses is often given as the justification for a change in accounting principle.
LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
11.
When a company changes to the LIFO method, the base-year inventory for all subsequent LIFO calculations is the beginning inventory in the year the method is adopted. This assumes that prior years’ income is not changed because it would be too impractical to do so. The only adjustment necessary may be to adjust the beginning inventory from a lower-of-cost-or-net realizable value approach to a cost basis. This establishes the beginning LIFO layer.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
12.
Where individual company statements were reported in prior years and consolidated financial statements are to be prepared this year, the following reporting and disclosure practices should be implemented: (1) The financial statements of all prior periods presented should be restated to show the financial information for the new reporting entity for all periods. (2) The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it. (3) The effect of the change on income from continuing operations, net income, and earnings per share amounts should be disclosed for all periods presented.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 21 (Continued) 13.
This change represents a change in reporting entity. This type of change should be reported by restating the financial statements of all prior periods presented to show the financial information for the new reporting entity for all periods. The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it. The effect of the change on income from continuing operations, net income, and earnings per share amounts should be disclosed for all periods presented.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
14.
Counterbalancing errors are errors that will be offset or corrected over two periods. Noncounterbalancing errors are errors that are not offset in the next accounting period. An example of a counterbalancing error is the failure to record accrued wages or prepaid expenses. Failure to capitalize equipment and record depreciation is an example of a noncounterbalancing error.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
15.
A correction of an error in previously issued financial statements should be handled as a priorperiod adjustment. Thus, such an error should be reported in the year that it is discovered as an adjustment to the beginning balance of retained earnings. In addition, if comparative statements are presented, the prior periods affected by the error should be restated. The disclosures need not be repeated in the financial statements of subsequent periods. As an illustration, assume that credit sales of $40,000 were inadvertently overlooked at the end of 2024. When the error was discovered in a 2025, the appropriate entry to record the correction of the error would have been (ignoring income tax effects): Accounts Receivable ................................................................................. Retained Earnings .............................................................................
40,000 40,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
16.
This change represents a change from an accounting principle that is not generally accepted to an accounting principle that is acceptable. As such, this change should be handled as a correction of an error. Thus, in the 2025 statements, the cumulative effect of the change should be reported as an adjustment to the beginning balance of retained earnings. If 2024 statements are presented for comparative purposes, these statements should be restated to correct for the accounting error.
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
17.
Retained earnings is correctly stated at December 31, 2027. Failure to accrue salaries in earlier years is a counterbalancing error that has no effect on 2027 ending retained earnings.
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
18.
December 31, 2026 Equipment ................................................................................................. Accumulated Depreciation—Equipment ($6,000 ÷ 10) ....................... Retained Earnings ............................................................................. (To correct for the error of expensing installation costs on machinery acquired in January, 2025) Depreciation Expense [($36,000* – $3,600**) ÷ 20] ................................... Accumulated Depreciation—Equipment ............................................. (To record depreciation on machinery for 2026 based on a 20-year useful life) *$30,000 + $6,000. **$36,000 ÷ 10.
LO: 3, Bloom: AP, Difficulty: Complex, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
6,000 600 5,400
1,620 1,620
Questions Chapter 21 (Continued) 19.
The amortization error decreases net income by $2,700 in 2025. Interest expense related to the discount should have been charged for $300 [($3,000 ÷ 20) x 2] but was charged for $3,000. There was only one amortization to be recorded in 2025 on July 1. The entry to correct for this error is as follows: Discount on Bonds Payable [($3,000 – ($3,000 / 20)] ................................ Interest Expense ................................................................................
2,700 2,700
Note: The entry to record accrued interest on the $100,000 of principal at 11% for 6 months is: Interest Expense ....................................................................................... Discount on Bonds Payable ............................................................... Interest Payable ($100,000 x 0.11 x 6 / 12) ........................................
5,650 150 5,500
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
20.
This error has no effect on net income because both purchases and inventory were understated. The entry to correct for this error, assuming a periodic inventory system (we are using the Purchases account), is: Purchases ................................................................................................. Accounts Payable ..............................................................................
13,000 13,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
21.
This error overstates net income by $2,400 in 2025. Depreciation should have been charged to net income. The entry to correct for this error is as follows: Depreciation Expense ($24,000 ÷ 10)........................................................ Accumulated Depreciation—Equipment .............................................
2,400
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
2,400
Solutions to Brief Exercises Brief Exercise 21.1 Construction in Process ($120,000 – $80,000) ......... Deferred Tax Liability [($120,000 – $80,000) × .20] ............................. Retained Earnings ..............................................
40,000 8,000 32,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 21.2 Difference in profit-sharing expense—prior years: Pre-tax income—percentage-of-completion ............. Pre-tax income—cost recovery .................................
$120,000 80,000 $ 40,000 × .01 $ 400
Indirect effect ..............................................................
The indirect effect from prior years will be reported as a profit-sharing expense for year 2025. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 21.3 Inventory ..................................................................... Deferred Tax Liability ($1,200,000 × .20) ........... Retained Earnings ..............................................
1,200,000
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
240,000 960,000
Brief Exercise 21.4 This is a change in estimate effected by a change in accounting principle. Cost of depreciable assets ......................................... Accumulated depreciation.......................................... Carrying value at January 1, 2025 .............................. Salvage value .............................................................. Depreciable base .........................................................
$250,000 (90,000) 160,000 (40,000) $120,000
Depreciation in 2025 = $120,000 ÷ 8 = $15,000. Depreciation Expense ................................................. Accumulated Depreciation ..................................
15,000 15,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 21.5 Depreciation Expense ....................................................... Accumulated Depreciation—Equipment ..................
*Book value before change Cost .................................................... Less: Accumulated depreciation ......
24,000 24,000
$74,000 16,000** $58,000
**[($74,000 – $18,000) ÷ 7] × 2 LO: 2, Bloom: AP, Difficulty: Complex, 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 21.6 Equipment.......................................................................... 50,000 Accumulated Depreciation—Equipment .................. Retained Earnings ..................................................... Deferred Tax Liability ................................................ (*$20,000 = $50,000 × 2/5); [**$9,000 = ($50,000-$20,000) × .30] LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
20,000* 21,000 9,000**
Brief Exercise 21.7 BEIDLER COMPANY Retained Earnings Statement For the Year Ended December 31, 2025 Retained earnings, January 1, as previously reported ....... Less: Correction of depreciation error, net of tax ......... Retained earnings, January 1, as adjusted ..................... Add: Net income ............................................................. Less: Dividends ................................................................ Retained earnings, December 31 .....................................
$2,000,000 320,000* 1,680,000 900,000 250,000 $2,330,000
*$400,000 × (1 – 0.2) LO: 3, Bloom: AN, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 21.8 a. b. c. d. e.
2025 Overstated Overstated Understated Overstated No effect
2026 Overstated Understated Overstated Understated Overstated
LO: 3, Bloom: AN, Difficulty: Complex, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 21.9 1.
The change to a three-year remaining life for the purpose of computing depreciation on production equipment is a change in estimate due to a change in conditions.
2.
This is an expense classification change arising from a change in the use of the building for a different purpose. Thus, it is not a change in principle, a change in estimate, or an error.
3.
The change to expensing preproduction costs (writing the costs off in one year as opposed to several years) is a change in estimate due to a change in conditions.
LO: 1, 2, Bloom: AN, Difficulty: Moderate, Time: 5-7, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 21.10
1.
Both FIFO and LIFO are generally accepted accounting principles; thus, this item is a change in accounting principle.
2.
This oversight is a mistake that should be corrected. Such a correction is considered a change due to error.
3.
Both the cost-recovery method and the percentage-of-completion method are generally accepted accounting principles; thus, this item is a change in accounting principle.
LO: 1, 3, Bloom: AN, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 21.11 Cash ($95,000 × .10) ....................................................... Equity Investments ................................................. Dividend Revenue ($80,000 × .10)..........................
9,500 1,500 8,000
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
*Brief Exercise 21.12 January 1, 2026 Equity Investments (Conrad Corporation) .................. Cash.........................................................................
475,000
Equity Investments (Conrad Corporation) ................... Equity Investments .................................................
185,000
Retained Earnings .......................................................... Fair Value Adjustment ............................................
34,000
475,000 185,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
34,000
Solutions to Exercises Exercise 21.1 (10–15 minutes) (a) The net income to be reported in 2026, using the retrospective approach, would be computed as follows: Income before income tax $700,000 Income tax (.20 × $700,000) 140,000 Net income $560,000 (b) Construction in Process....................................... Deferred Tax Liability ($190,000 × .20) ........... Retained Earnings .........................................
190,000 38,000 152,000*
*($190,000 × .80 = $152,000) LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.2 (10–15 minutes) (a) Inventory ................................................................... Retained Earnings .............................................
14,000* 14,000
*($19,000 + $23,000 + $25,000) – ($15,000 + $18,000 + $20,000) (b) Net Income (FIFO)
2023 2024 2025
$19,000 23,000 25,000
(c) Inventory ................................................................... Retained Earnings .............................................
24,000*
*($19,000 + $23,000 + $25,000) – ($12,000 + $14,000 + $17,000) LO: 1, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
24,000
Exercise 21.3 (25–30 minutes) (a)
TAVERAS CO. Income Statement For the Year Ended December 31 LIFO 2023 Sales ........................................................ $3,000 Cost of goods sold .................................. 800 Operating expenses ................................ 1,000 Net income ........................................$1,200b
2024 $3,000 1,000 1,000 $1,000
2025 $3,000 1,130 1,000 $ 870
Income Statement For the Year Ended December 31 FIFO 2023 Sales ........................................................ $3,000 Cost of goods sold .................................. 820 Operating expenses ................................ 1,000 Net income ........................................ $1,180a
(b)
2024 $3,000 940 1,000 $1,060
2025 $3,000 1,100 1,000 $ 900
TAVERAS CO. Income Statement For the Year Ended December 31 2025 Sales ........................................................ $3,000 Cost of goods sold .................................. 1,100 Operating expenses ................................ 1,000 Net income ........................................ $ 900
2024 As adjusted (Note A) $3,000 940 1,000 $1,060
Exercise 21.3 (Continued) (c) Note A: Change in Method of Accounting for Inventory Valuation On January 1, 2025, Taveras elected to change its method of valuing its inventory to the FIFO method, whereas in all prior years inventory was valued using the LIFO method. The new method of accounting for inventory was adopted because it better reflects the current cost of the inventory on the balance sheet and comparative financial statements of prior years have been adjusted to apply the new method retrospectively. The following financial statement line items for fiscal years 2025 and 2024 were affected by the change in accounting principle.
Balance Sheet Inventory Retained Earnings
2025 2024 LIFO FIFO Difference LIFO FIFO Difference $ 320 $ 390 $70 $ 200 $ 240 $40 3,070 3,140 70 2,200 2,240 40
Income Statement Cost of Goods Sold Net Income
$1,130 $1,100 870 900
$30 30
$1,000 1,000
$940 1,060
$60 60
Statement of Cash Flows (no effect)
(d) Retained earnings statements after retrospective application. 2025 Retained earnings, January 1, as reported Less: Adjustment for cumulative effect of applying new accounting method (FIFO) Retained earnings, January 1, as adjusted Net income Retained earnings, December 31 ($1,180a - $1,200b)
$2,240 900 $3,140
2024 $1,200 20* 1,180 1,060 $2,240
LO: 1, Bloom: AP, Difficulty: Difficult, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 21.4 (25–30 minutes) (a) Retained earnings, January 1, as reported ................. Cumulative effect of change in accounting principle to average cost .......................................... Retained earnings, January 1, as adjusted .................
2022 $160,000 (15,000)^ $145,000
^[$10,000 (2020) + $5,000 (2021)] (b) Retained earnings, January 1, as reported ................. Cumulative effect of change in accounting principle to average cost .......................................... Retained earnings, January 1, as adjusted .................
2025 $590,000 (25,000)* $565,000
*[$10,000 (2020) + $5,000 (2021) + $10,000 (2022) – $10,000 (2023) + $10,000 (2024)] (c) Retained earnings, January 1, as reported ................. Cumulative effect of change in accounting principle to average cost .......................................... Retained earnings, January 1, as adjusted .................
2026 $780,000 (20,000)** $760,000
**($25,000* at 12/31/2024 – $5,000) (d) Net income .............................
2023 $130,000
2024 $290,000
2025 $310,000
LO: 1, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 21.5 (30–35 minutes) (a)
KENSETH COMPANY Income Statement For the Year Ended Sales revenue .................................................. Cost of goods sold .......................................... Operating expenses Income before profit sharing ................... Profit sharing expense .................................... Net income ................................................
2025 $3,000 1,100 1,000 $ 900 96 $ 804
2024 $3,000 940 1,000 $1,060 100 $ 960
Under GAAP, Kenseth Company should report $100 as the profitsharing expense in 2024, even though the profit-sharing expense would be $106 if FIFO had been used in 2024. (b) The profit-sharing expense reflects an indirect effect of the change in accounting principle. Under GAAP, indirect effects from periods before the change are recorded in the year of the change. In this case, profit sharing expense recorded in 2025 is composed of: $900 × .10 = $90 (2025 under FIFO) $ 60 × .10 = 6 (difference in profit sharing for 2024) $96 (profit sharing expense for FIFO in 2025) (c)
Retained Earnings Statement Retained earnings, January 1, as reported ................. Cumulative effect of change to FIFO ($960 – $900) ...... Retained earnings, January 1, as adjusted ................. Add: Net income ........................................................... Deduct: Dividends ........................................................ Retained earnings, December 31 .................................
LO: 1, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
2025 $ 900 60 960 804 500 $1,264
Exercise 21.6 (10–15 minutes) (a) The net income to be reported in 2026, using the retrospective approach, would be computed as follows: Income before income tax $900,000 Income tax (.20 × $900,000) 180,000 Net income $720,000 (b) Construction in Process (2025 difference) ......... Deferred Tax Liability (.20 × $290,000) ......... Retained Earnings .........................................
290,000 58,000 232,000*
*($290,000 × .80 = $232,000) LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.7 (20–25 minutes) (a) Retained Earnings ..................................................... Inventory ............................................................. *2023 *2024 *2025
$2,000 5,000 1,000 $8,000
8,000 8,000*
($26,000 – $24,000) ($30,000 – $25,000) ($28,000 – $27,000) 2026
2025
2024
2023
($30,000
$27,000
$25,000
$24,000
(b) Inventory .................................................................... Retained Earnings ..............................................
19,000
Net income
**2023 *2024 *2025
Net income
$ 6,000 9,000 4,000 $19,000
19,000**
($26,000 – $20,000) ($30,000 – $21,000) ($28,000 – $24,000) 2026
2025
2024
2023
($34,000
$28,000
$30,000
$26,000
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.8 (30–35 minutes) (a) Depreciation to date on equipment Sum-of-the-years’-digits depreciation 2023 (5/15 × $510,000*) 2024 (4/15 × $510,000) 2025 (3/15 × $510,000)
$170,000 136,000 102,000 $408,000
*$525,000 − $15,000 Cost of equipment Less: Depreciation to date Book value (December 31, 2025)
$525,000 408,000 $117,000
Book value – Salvage value = Depreciable cost $117,000 – $15,000 = $102,000 Depreciation for 2026: $102,000 / 2 = $51,000 Depreciation Expense ........................................... Accumulated Depreciation—Equipment ......
51,000 51,000
(b) Depreciation to date on building $693,000 / 30 years = $23,100 per year $23,100 × 3 = $69,300 depreciation to date Cost of building Less: Depreciation to date Book value (December 31, 2025)
$693,000 69,300 $623,700
Depreciation for 2026: $623,700 / (40 – 3) = $16,857 Depreciation Expense ........................................... Accumulated Depreciation—Buildings.........
16,857
LO: 2, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
16,857
Exercise 21.9 (25–30 minutes) Change from sum-of-the-years digit to straight-line Cost of depreciable assets ................................. Less: Depreciation in 2025 ($100,000 × 4/10)..... Book value at December 31, 2025 ......................
$100,000 40,000 $ 60,000
Depreciation for 2026 using straight-line depreciation Book value at December 31, 2025 ...................... Estimated useful life ............................................ Depreciation for 2026 ($60,000 ÷ 3) ....................
$60,000 3 years $20,000
DENISE HABBE INC. Retained Earnings Statement For the Year Ended 2026 Retained earnings, January 1, unadjusted ........... $125,000 Less: Correction of error for inventory overstatement .................................................. 24,000 Retained earnings, January 1, adjusted ............... 101,000 Add: Net income 86,000 Less: Dividends...................................................... 30,000 Retained earnings, December 31 .......................... $157,000
2025
$ 72,000 54,000 25,000 $101,000
Note to instructor: 1.
2025 cost of sales increased $24,000; 2026 cost of sales decreased $24,000. As a result, net income for 2025 is overstated $24,000 and net income for 2026 is understated $24,000 as a result of the inventory error.
2.
2025 expenses remained unchanged.
3.
2026 expenses decreased $10,000 ($30,000 – $20,000). Net income in 2026 is therefore $86,000 ($52,000 + $24,000 + $10,000).
4.
Additional disclosures would be required as indicated in the chapter.
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.10 (5–10 minutes) 1. 2. 3. 4. 5.
a. b. a. b. b.
6. 7. 8. 9. 10.
a. b. a. b. b.
LO: 1, 2, 3, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.11 (15–20 minutes) December 31, 2026 Retained Earnings ($550,000 × 9/55*)........................... Accumulated Depreciation—Equipment .............. (To correct for the omission of depreciation expense in 2024) Cost of Machine Less: Depreciation prior to 2026 2023 ($550,000 × 10/55*) 2024 ($550,000 × 9/55) 2025 ($550,000 × 8/55) Book value at January 1, 2026
90,000 90,000
$550,000 $100,000 90,000 80,000
270,000 $280,000
* [10 × (10 + 1)] / 2 Depreciation for 2026: $280,000 ÷ 7 = $40,000 Depreciation Expense ................................................... Accumulated Depreciation—Equipment .............. (To record depreciation expense for 2026)
40,000
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
40,000
Exercise 21.12 (20–25 minutes) (a) Computation of depreciation for 2026: Cost of building $800,000 Less: Depreciation prior to 2026 2022 ($800,000 – $0) × .05* $40,000 2023 ($800,000 – $40,000) × .05 38,000 2024 ($800,000 – $78,000) × .05 36,100 2025 ($800,000 – $114,100) × .05 34,295 148,395 Book value, January 1, 2026 $651,605 **(1 ÷ 40) × 2 Depreciation expense for 2026: $16,711 [($651,605 – $50,000) ÷ 36] Depreciation Expense ............................................ Accumulated Depreciation—Buildings .........
16,711 16,711
(b) Computation of 2026 depreciation expense on the equipment: Cost of equipment Less: Accumulated depreciation [($100,000 – $10,000) ÷ 12] × 4 years Book value, 1/1/26 2026 Depreciation expense:
$100,000 30,000 $ 70,000
$70,000 – $5,000 $65,000 = $13,000 = (9 – 4) 5
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.13 (10–15 minutes) (a) No entry necessary. Changes in estimates are treated prospectively. (b) Depreciation Expense ............................................... Accumulated Depreciation—Equipment .......... *Original cost Accumulated depreciation [($510,000 – $10,000) ÷ 10] × 7 Book value (1/1/26) Estimated salvage value Remaining depreciable basis Remaining useful life (15 years – 7 years) Depreciation expense—2026
19,375*
$510,000 (350,000) 160,000 (5,000) 155,000 ÷ 8 $ 19,375
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
19,375
Exercise 21.14 (20–25 minutes) (a) Cost of equipment $1,600,000 Less: Depreciation prior to 2026 2023 ($1,600,000 × 0.25*) $400,000 2024 ($1,200,000 [$1,600,000 − $400,000] × 0.25) 300,000 2025 ($ 900,000 [$1,200,000 − $300,000] × 0.25) 225,000 925,000 Book value at January 1, 2026 $675,000 *1/8 x 2 = .25 2026 Depreciation: ($675,000 – $100,000) ÷ 5 = $115,000 Depreciation Expense ........................................... Accumulated Depreciation—Equipment ......
(b) Income before depreciation expense Depreciation expense Net income
115,000 115,000 2026 $300,000 115,000 $185,000
2025 $270,000 225,000 $ 45,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.15 (15–20 minutes) 1.
Accumulated Depreciation—Equipment ................. Depreciation Expense ....................................... Retained Earnings .............................................
Depreciation taken Less: Depreciation (correct)
25,500. 8,500 17,000
2024–2025
2026
$170,000* * 153,000** *$ 17,000
$85,000 76,500 $ 8,500
*$510,000 × 1/6 × 2 **($510,000 − $51,000) ÷ 1/6 × 2 2. 3.
Retained Earnings .................................................... Salaries and Wages Expense ........................... No entry necessary.
45,000 45,000
Exercise 21.15 (Continued) 4.
5.
Amortization Expense ............................................ Retained Earnings .................................................. Copyrights ....................................................... ($45,000 ÷ 20 = $2,250; ($2,250 × 2 = $4,500)
2,250 4,500
Loss (Write off of Inventory) .................................. Retained Earnings ...........................................
87,000
6,750
87,000
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.16 (10–15 minutes) 1. 2. 3. 4.
Salaries and Wages Expense ................................ Salaries and Wages Payable ..........................
3,400
Salaries and Wages Expense ................................ Salaries and Wages Payable ..........................
31,100
Prepaid Insurance ($2,640 × 10/12)........................ Insurance Expense .........................................
2,200
Sales Revenue ........................................................ [$2,120,000 ÷ (1.00 + 0.06)] × .06 Sales Taxes Payable .......................................
120,000
Sales Taxes Payable............................................... Sales Tax Expense ..........................................
103,400
3,400 31,100 2,200
120,000 103,400
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.17 (10–15 minutes) Retained Earnings .......................................................... Inventory ................................................................. Accumulated Depreciation—Equipment ............... ($38,500 – $17,000)
37,700 16,200 21,500
Computations: Effect on retained earnings over (under) statement Overstatement of 2026 ending inventory Overstatement of 2025 depreciation Understatement of 2026 depreciation Total effect of errors on retained earnings
($16,200 ( (17,000) ( 38,500 ($37,700
Note: The understatement of inventory in 2025 was a self-correcting error at the end of 2026. LO: 3, Bloom: AP, Difficulty: Complex, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.18 (25–30 minutes) (a) Effect of errors on 2026 net income: $24,700 overstatement Computations: Effect on 2026 net income over (under) statement Understatement of 2025 ending inventory Overstatement of 2026 ending inventory Expensing of insurance premium in 2025 ($66,000 ÷ 3) Failure to record sale of fully depreciated machine in 2026 Total effect of errors on net income (overstated)
($ 9,600 8,100 22,000 ( (15,000) ( $24,700
(b) Effect of errors on working capital: $28,900 understatement Computations: Effect on working capital over (under) statement Overstatement of 2026 ending inventory Expensing of insurance premium in 2025 (prepaid insurance) Sale of fully depreciated machine unrecorded Total effect on working capital (understated)
$( 8,100 (22,000) (15,000) $(28,900)
(c) Effect of errors on retained earnings: $26,600 understatement Computations: Effect on retained earnings over (under) statement Overstatement of 2026 ending inventory Understatement of depreciation expense in 2025 Expensing of insurance premium in 2025 Failure to record sale of fully depreciated machine in 2026 Total effect on retained earnings (understated)
$( 8,100 2,300 (22,000) (15,000) $(26,600)
LO: 3, 4, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.19 (20–25 minutes) (a) 1. 2.
3. 4.
5. 6.
7. (b) 1. 2. 3. 4. 5. 6. 7.
Supplies Expense ($2,700 – $1,100) .................. Supplies .......................................................
1,600
Salaries and Wages Expense ............................. ($4,400 – $1,500) Salaries and Wages Payable ......................
2,900
Interest Revenue ($5,100 – $4,350) .................... Interest Receivable......................................
750
Insurance Expense ............................................. ($90,000 – $65,000) Prepaid Insurance .......................................
25,000
Rent Revenue ($28,000 ÷ 2) ................................ Unearned Rent Revenue .............................
14,000
Depreciation Expense ........................................ ($50,000 – $5,000) Accumulated Depreciation—Equipment ...
45,000
Retained Earnings .............................................. Accumulated Depreciation—Equipment ...
7,200
Retained Earnings .............................................. Supplies .......................................................
1,600
Retained Earnings .............................................. Salaries and Wages Payable ......................
2,900
Retained Earnings .............................................. Interest Receivable......................................
750
Retained Earnings .............................................. Prepaid Insurance .......................................
25,000
Retained Earnings .............................................. Unearned Rent Revenue .............................
14,000
Retained Earnings .............................................. Accumulated Depreciation—Equipment ...
45,000
Same as in (a).
1,600
2,900 750
25,000 14,000
45,000 7,200 1,600 2,900 750 25,000 14,000 45,000
Exercise 21.19 (Continued) (c) 6.
7.
Retained Earnings.............................................. Income Taxes Receivable .................................. Accumulated Depreciation—Equipment... *($45,000 .40) less tax expense.
27,000 18,000*
Retained Earnings.............................................. Income Taxes Receivable .................................. Accumulated Depreciation—Equipment... **($7,200 .40) less tax expense.
4,320 2,880**
45,000
7,200
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.20 (20–25 minutes)
Income before tax Corrections: Sales erroneously included in 2025 income Understatement of 2025 ending inventory Adjustment to bond interest expense* Repairs erroneously charged to the Equipment account Depreciation recorded on improperly capitalized repairs (10%)*** Corrected income before tax
2025
2026
$101,000
$77,400
(38,200) 8,640 (1,450) (8,500)
38,200 (8,640) (1,552) (9,400)
850 $ 62,340
1,790 $97,798
Bond interest expense for 2025 and 2026 was computed as follows:
2025 2026
Book Value of Bonds
Stated Interest
$235,000 236,450
$15,000 15,000
Effective Interest $16,450* 16,552****
*$235,000 × .07 **($235,000 + $1,450) x .07 Difference between effective interest at 7% and stated interest (6%): 2025: $1,450 ($16,450 − $15,000) 2026: 1,552 ($16,552 − $15,000) Exercise 21.20 (Continued)
***Erroneous depreciation taken in 2026: on 2025 addition ($8,500 ÷ 10) on 2026 addition ($9,400 ÷ 10) Total excess depreciation 2026
$ 850 940 $1,790
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Exercise 21.21 (10–15 minutes) Item (1) (2) (3) (4) (5)
2025 OverUnderstatement statement
No Effect X
X
2026 OverUnderstatement statement X X
X
X
X
X X
No Effect
X
LO: 3, 4, Bloom: AP, Difficulty: Complex, Time: 10-15, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
* Exercise 21.22 (25-30 minutes) A computation of the ending balance in the investment account of Elton John Corp. is made as follows: Investment in Elton John Corp. 1/1/25 Additional purchase 7/1/26 Income (7/1/26–12/31/26) $815,000 × .30 Dividends (7/1/26–12/31/26) $1.55 × 75,000 (50,000 + 25,000) shares Investment in Elton John Corp. 12/31/26
$1,400,000 3,040,000 244,500 (116,250) $4,568,250
LO: 5, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
* Exercise 21.23 (15–20 minutes) (a)
Prior to January 2, 2025, Aykroyd Corp. carried the Investment in Martin Company under the equity method of accounting as evidenced from the entries in the investment account. Use of the equity method was appropriate because Aykroyd’s interest in Martin exceeded 20%. With the sale of 126,000 shares, Aykroyd’s interest dropped to 12% and it could no longer use the equity method of accounting for the investment. Aykroyd must change to the fair value method. Cessation of the equity method (increasing the investment for the proportionate share of earnings and decreasing it for dividends received) occurs immediately. The carrying value of the remaining 12% interest becomes the carrying amount for the fair value method with adjustments for cumulative excess dividends received after the change from the equity method over its share of Martin Company’s earnings. That carrying amount is transferred from the Investment in Martin account to the Equity Investments account.
* Exercise 21.23 (Continued) (b)
The carrying amount of the Investment in Martin as of December 31, 2025, would be computed as follows: Carrying amount, 12/31/24 (from the given account information) Less portion attributable to 126,000 shares sold 1/2/25 Balance, 1/2/25 Less cumulative excess dividends received over share of Martin earnings Carrying amount, 12/31/25 a
2,214,000a 1,476,000 14,400b $1,461,600*
$3,690,000 × 126/210
b
Computation of Excess Dividends Received over Share of Earnings:
2025 c
$3,690,000
Dividends Received
Share of Martin Co. Income
Excess Dividends Received Over Share of Earnings
$50,400
$36,000c
$(14,400)
$300,000 × .12 = $36,000
Note to instructor: The entry in 2025 to record the receipt of the dividend would be: Cash........................................................................ Equity Investments ........................................ Dividend Revenue ..........................................
50,400 14,400 36,000
(c) The entry to recognize the excess of fair value over the carrying amount of the securities is as follows: December 31, 2025 Fair Value Adjustment ............................................ Unrealized Holding Gain or Loss— Income ($1,570,000 – $1,461,600*) .............
108,400 108,400
LO: 5, Bloom: AP, Difficulty: Complex, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Time and Purpose of Problems Problem 21.1 (Time 30–35 minutes) Purpose—to develop an understanding of the impact that a change in the method of inventory pricing (from LIFO to average cost) has on the financial statements during a five-year period. The student is required to prepare a comparative statement of income and retained earnings for the five years assuming the change in inventory pricing with an indication of the effects on net income and earnings per share for the years involved. Problem 21.2 (Time 30–35 minutes) Purpose—to provide a problem that requires the student to: (1) account for a change in estimate, (2) record a correction of an error, and (3) account for a change in accounting principle. The student is also required to compute corrected/adjusted net income amounts. Problem 21.3 (Time 30–40 minutes) Purpose—to develop an understanding of the way in which accounting changes and error corrections are handled in accounting records. The problem presents descriptions of various situations for which the student is required to indicate the correct accounting treatment and to prepare comparative income statements for a four-year period. Problem 21.4 (Time 30–40 minutes) Purpose—to provide a problem that requires the student to: (1) prepare correcting entries for two years’ unrecorded sales commissions, (2) three years’ inventory errors, and (3) prepare entries for two different accounting changes. Problem 21.5 (Time 40–50 minutes) Purpose—to allow the student to see the impact of accounting changes on income and to examine an ethical situation related to the motivation for change. Problem 21.6 (Time 25–30 minutes) Purpose—to develop an understanding of the journal entries and the reporting which are necessitated by an accounting change or correction of an error. The student is required to prepare the entries to reflect such changes or errors and the comparative income statements and retained earnings statements for a two-year period. Problem 21.7 (Time 25–30 minutes) Purpose—to provide a problem that requires the student to analyze ten transactions and to prepare adjusting or correcting entries for these transactions. Problem 21.8 (Time 30–35 minutes) Purpose—to help a student understand the effect of errors on income and retained earnings. The student must analyze the effects of errors on the current year’s net income and on the next year’s ending retained earnings balance. Problem 21.9 (Time 20–25 minutes) Purpose—to develop an understanding of the effect that errors have on the financial statements. The student is required to prepare a schedule portraying the corrected net income for the years involved with this error analysis.
Time and Purpose of Problems (Continued) Problem 21.10 (Time 50–60 minutes) Purpose—to develop an understanding of the correcting entries and income statement adjustments that are required for changes in accounting policies and accounting errors. This comprehensive problem involves many different concepts such as consignment sales, bonus computations, warranty costs, and bank funding reserves. The student is required to prepare the necessary journal entries to correct the accounting records and a schedule showing the revised income before taxes for each of the three years involved. *Problem 21.11 (Time 20–25 minutes) Purpose—to provide the student with a problem involving an investment that grows from 10% to 40% (from lack of significant influence to significant influence). The student is required to account for the effect of this change on income. *Problem 21.12 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the proper entries to reflect a change from the cost method to the equity method with excess attributable to depreciable assets in accounting for an investment. The student is required to prepare the necessary journal entries for a three-year period with respect to this stock investment and the change in reporting methods.
Solutions to Problems Problem 21.1
UTRILLO INSTRUMENT COMPANY Statement of Income and Retained Earnings For the Years Ended May 31 2021
2022
2023
2024
2025
Sales revenue—net Cost of goods sold Beginning inventory Purchases Ending inventory Total Gross profit Administrative expenses Income before taxes Income taxes (50%) Net income Retained earnings—beginning: As originally reported Adjustment (See note* and schedule) As restated Retained earnings—ending
$13,964
$15,506
$16,673
$18,221
$18,898
1,010 13,000 (1,124) 12,886 1,078 700 378 189 189
1,124 13,900 (1,101) 13,923 1,583 763 820 410 410
1,101 15,000 (1,270) 14,831 1,842 832 1,010 505 505
1,270 15,900 (1,500) 15,670 2,551 907 1,644 822 822
1,500 17,100 (1,720) 16,880 2,018 989 1,029 515 514
1,206
1,388
1,759
2,237
3,005
5 1,211 $ 1,400
12 1,400 $ 1,810
51 1,810 $ 2,315
78 2,315 $ 3,137
132 3,137 $ 3,651
Earnings per share (100 shares)
$
$
$
$
$
1.89
4.10
5.05
8.22
5.14
*Note to instructor: The retained earnings balances are usually reported in the above manner. If desired, only the restated balances might be reported. The adjustments are simply the cumulative difference in income between the two inventory methods, net of tax. For example, the $5 in 2021 reflects the difference in ending inventories in 2020 ($1,000 – $1,010) times the tax rate 50%. In 2022, the difference in income of $7 between the two methods in 2021 is added to the $5 to arrive at a $12 adjustment to the beginning balance of retained earnings in 2022.
Problem 21.1 (Continued) In 2025, the company changed its method of pricing inventory from the last-in, first-out (LIFO) to the average cost method in order to more fairly present the financial operations of the company. The financial statements for prior years have been restated to retrospectively reflect this change, resulting in the following effects on net income and related per share amounts: Increase in Net income Earnings per share
2021
2022
2023
2024
2025
$ 7 $0.07
$ 39 $0.39
$ 27 $0.27
$ 54 $0.54
$ 44 $0.44
2024
2025
Schedule of Income Reconciliation and Retained Earnings Adjustments 2021–2025 2020
2021
Beginning Inventory LIFO Average Cost Difference Tax Effect (50%) Effect on Income*
2022
2023
$1,000 1,010 (10) 5 $ (5)
$1,100.00 $1,000.00 $1,115.00 $1,237.00 1,124.00 1,101.00 1,270.00 1,500.00 (24.00) (101.00) (155.00) (263.00) † † 12.00 50.50 77.50 131.50† $ (12.00) $ (50.50)† $ (77.50)† $ (131.50)
Ending Inventory LIFO Average Cost Difference Tax Effect (50%) Effect on Income**
$1,000 1,010 (10) 5 $ 5
$1,100 1,124 (24) 12 $ 12
$1,000.00 $1,115.00 $1,237.00 $1,369.00 1,101.00 1,270.00 1,500.00 1,720.00 (101.00) (155.00) (263.00) (351.00) † † † 50.50 77.50 131.50 175.50 † † † $ 50.50 $ 77.50 $ 131.50 $ 175.50
Net Effect on Income
$
$
7
$
38.50† $
27.00
$
12
$
50.50† $
77.50† $ 131.50
Cumulative Effect on Beginning Retained Earnings
5
$
54.00
$
44.00†
$ 175.50
*Larger (smaller) beginning inventory has negative (positive) effect on net income. **Larger (smaller) ending inventory has positive (negative) effect on net income. †
The tax effects are rounded up to the next whole dollar in the problem. Therefore, the net effects on income and retained earnings are effectively rounded down to the next whole dollar.
LO: 1, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 21.2
(a) 1.
Cost of equipment........................................................... Less: Salvage value ........................................................ Depreciable cost ............................................................. Depreciation to 2025 2022 ($80,000 / 10) ....................... 2023 ($80,000 / 10) ....................... 2024 ($80,000 / 10) ....................... Depreciation in 2025 Cost of equipment ....................... Less: Depreciation to 2025 ........ Book value (January 1, 2025) ..... Less: Salvage value ................... Depreciable cost ..........................
$85,000 5,000 $80,000
$ 8,000 8,000 8,000 $24,000 $85,000 24,000 61,000 3,000 $58,000
Depreciation in 2025 $58,000 / 4 = $14,500 Depreciation Expense ............................................. Accumulated Depreciation—Equipment........ 2.
14,500 14,500
Cost of Building ................................... $300,000 Less: Depreciation to 2025 2023............................................ 60,000 2024............................................ 48,000 Book value (January 1, 2025) ... $192,000 Less: Salvage value ................. 30,000 Depreciable cost ....................... $162,000 Depreciation in 2025 ($162,000 / 8) = $20,250 Depreciation Expense ............................................ Accumulated Depreciation—Buildings .........
20,250 20,250
Problem 21.2 (Continued) 3.
Depreciation Expense ($120,000 – $16,000) ÷ 8 ..... Accumulated Depreciation—Machinery .........
13,000
Accumulated Depreciation—Machinery ................. Retained Earnings ............................................
3,000
13,000 3,000
Depreciation recorded in 2023: ($120,000 ÷ 8) ×
= $7,500
Depreciation that should be recorded in 2023: ([$120,000 – $16,000] ÷ 8) ×
= $6,500
Depreciation recorded in 2024: ($120,000 ÷ 8) = $15,000 Depreciation that should be recorded in 2024: ($120,000 – $16,000) ÷ 8 = $13,000 Depreciation Depreciation that taken should be taken
(b)
Difference
2023
$ 7,500
$ 6,500
$1,000
2024
15,000
13,000
2,000
$22,500
$19,500
$3,000
HOLTZMAN COMPANY Comparative Income Statements For the Years 2025 and 2024 2025 Income before depreciation expense.................... $300,000 Depreciation expense* ........................................... 47,750 Net income .............................................................. $252,250 *Depreciation Expense
2024 $310,000 69,000 $241,000
2025
Equipment ........................................................ $ 14,500 Buildings .......................................................... 20,250 Machinery ......................................................... 13,000 $ 47,750 LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
2024 $
8,000 48,000 13,000 $ 69,000
Problem 21.3 (a) 1.
Bad debt expense for 2023 should not have been reduced by $10,000. A change in the experience rate is considered a change in estimate, which should be handled prospectively.
2.
A change from LIFO to FIFO is considered a change in accounting principle, which must be handled retrospectively.
3.
(a) The inventory error in 2025 is a prior period adjustment and the 2025 and 2026 financial statements should be restated. (b) The lawsuit settlement is correctly treated.
(b)
BOTTICELLI INC. Comparative Income Statements For the Years 2023 through 2026 Net income (see below) Adjustments
2023 $145,000
2024 $165,000
2023
2024
Net income (unadjusted) $140,000 1. Bad debt expense adjustment (10,000) 2. Inventory adjustment (FIFO) 15,000 3. Inventory overstatement Net income (adjusted) $145,000
$160,000
5,000 $165,000
2025 2026 $201,000 $274,000 2025
2026
$205,000 $276,000
10,000
(16,000)
(14,000) 14,000 $201,000 $274,000
LO: 1, 2, 3, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 21.4
1.
2.
Retained Earnings ..................................................... Sales Commissions Payable ............................. Sales Commission Expense ..............................
3,500
Cost of Goods Sold ($19,000 + $6,700) .................... Retained Earnings .............................................. Inventory .............................................................
25,700
2,500 1,000 19,000 6,700
Income Overstated (Understated) Beginning inventory Ending inventory
3.
2023
2024
2025
$(16,000) $(16,000)
$ 16,000 (19,000) $ (3,000)
$19,000 6,700 $25,700
Accumulated Depreciation—Equipment .................. Depreciation Expense ........................................
4,800 4,800*
*Equipment cost ........................................ $100,000 Depreciation before 2025 ......................... (36,000) Book value ................................................ $ 64,000 Depreciation recorded ............................. $ 12,800 Depreciation to be taken ($64,000 8) .... (8,000) Difference.................................................. $ 4,800 4.
Construction in Process ........................................... Deferred Tax Liability ......................................... Retained Earnings ..............................................
45,000
**($150,000 – $105,000) × 0.20 LO: 1, 2, 3, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
9,000** 36,000
Problem 21.5 (a)
ASTON CORPORATION Projected Income Statement For the Year Ended December 31, 2025 Sales revenue....................................... Interest revenue ................................... Cost of goods sold .............................. $14,000,000 Depreciation expense .......................... 1,600,000a Operating expenses............................. 6,400,000 Income before income taxes ............... Unrealized holding gain....................... Income before taxes and bonus ......... President’s bonus ................................ Income before income taxes ............... Income taxes Current .......................................... $ 1,200,000 Deferred ........................................ 200,000c Net income ...........................................
$28,995,000 5,000 22,000,000 $ 7,000,000 1,000,000b $ 8,000,000 1,000,000 $ 7,000,000 1,400,000 $ 5,600,000
Conditions met: 1. 2.
Income before taxes and bonus > $7,000,000. Payable for income taxes does not exceed $1,200,000.
a
Depreciation for the current year includes $600,000 for the old equipment and $2,000,000 for the robotic equipment. If the robotic equipment is changed to straight-line, its depreciation is only $1,000,000 ($2,000,000 − $1,000,000) and the total is $1,600,000.
b
By urging the Board of Directors to change the classification of Debt investments A and D to Trading securities, income is increased by a $1,000,000 recognition of a holding gain.
c
The unrealized holding gain is not taxable until the securities are sold.
Problem 21.5 (Continued) (b) Students’ answers will vary. There is nothing unethical about changing the first-year election of depreciation back to the straight-line method provided that it meets with the approval of appropriate corporate decision makers. Considering the immediate needs for cash of $1,000,000 for the president’s bonus and $1,200,000 for income taxes, there may be a need to sell some of the marketable securities. Therefore, the transfer of $3,000,000 of availablefor-sale securities to trading securities may also be appropriate. It is naive to believe that corporate officers do no planning for year-end (or interim) financial statements. The slippery slope arises with manipulation of financial statements. The security reclassification for the selected securities clearly manipulates the income to the benefit of the president. While legal and within GAAP guidelines, the ethics of this situation are borderline. Any auditor would automatically bring this transaction to the attention of the board of directors. Some stakeholders and their interests are: Stakeholder
Interests
President
Personal gain of $1,000,000 bonus.
CFO
Placed in ethical dilemma between the interests of the president and the corporation.
Board of Directors
May be subject to the manipulations of the CEO for his personal gain.
Stockholders
Increased income from higher (paper) income may increase demand for dividends. Also, paying a bonus may decrease cash available for dividends.
Employees
President takes a substantial benefit for himself. This could have been used to start a pension plan for all of the employees.
Creditors
The increased income represents a 17% inflation of the true income before income tax of the corporation. This may lead to a misrepresentation of creditworthiness.
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 40-50, Ethics, Analytic, Communication, AICPA PC: Professional Behavior, AICPA AC: Reporting, AICPA PC: Communication
Problem 21.6
(a) 1.
Depreciation Expense ....................................... Accumulated Depreciation—Equipment..
94,500 94,500
Computations: Cost of Equipment ........................................ Less: Depreciation prior to 2025 .................. Book value, January 1, 2025.........................
$540,000 162,000* $378,000
*($540,000 ÷ 10) × 3 Depreciation for 2025: $378,000 × 7/28** = $94,500 **[7 × (7 + 1)] ÷ 2 = 28 2.
Depreciation Expense ....................................... Accumulated Depreciation— Equipment ..............................................
25,800 25,800
Computations: Original cost .............................................. Accumulated depreciation (1/1/25) $12,000 ($180,000 ÷ 15) × 4 ................... Book value (1/1/25) .................................... Estimated salvage value ........................... Remaining depreciable base .................... Remaining useful life (9 years — 4 years taken)...................... Depreciation expense—2025 .................... 3.
$180,000 (48,000) 132,000 (3,000) 129,000 ÷ 5 $ 25,800
Equipment (Asset C) ......................................... Accumulated Depreciation—Equipment (4 × $16,000 [$160,000 ÷ 10]) ................. Retained Earnings .....................................
160,000
Depreciation Expense ....................................... Accumulated Depreciation— Equipment ..............................................
16,000
64,000 96,000
16,000
Problem 21.6 (Continued) (b)
MADRASA INC. Comparative Retained Earnings Statements For the Years Ended
Retained earnings, January 1, as previously reported Add: Error in recording equipment (Asset C) Retained earnings, January 1, as adjusted Add: Net income Retained earnings, December 31
2025
2024
$666,000 208,700** $874,700
$200,000 112,000* 312,000 354,000*** $666,000
*Amount expensed incorrectly in 2021 .................... Depreciation to be taken to January 1, 2024 ($16,000 × 3) .......................................................... Prior period adjustment for income ........................
$160,000
**Income before depreciation expense (2025) Depreciation for 2025 Equipment (Asset A) $94,500 Equipment (Asset B) 25,800 Equipment (Asset C) 16,000 Other 55,000 Income after depreciation expense
$400,000
***Net income as reported ........................................... Depreciation (Asset C) ............................................ Net income as adjusted ...........................................
$370,000 (16,000) $354,000
(48,000) $112,000
LO: 1, 3, 4, Bloom: AP, Difficulty: Complex, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
(191,300) $208,700
Problem 21.7
(1) Depreciation Expense ................................................... Accumulated Depreciation—Equipment ..............
3,200
(2) Cost of Goods Sold ....................................................... Retained Earnings .................................................
19,000
(3) Cash ............................................................................... Accounts Receivable .............................................
5,600
(4) Accumulated Depreciation—Equipment...................... Equipment .............................................................. Gain on Disposal of Plant Assets ......................... (5) Lawsuit Loss.................................................................. Lawsuit Liability ..................................................... (6) Unrealized Holding Gain or Loss—Income ($84,000 – $82,000) ..................................................... Fair Value Adjustment (Trading) ........................... (7) Salaries and Wages Payable ($16,000 – $12,200)........ Salaries and Wages Expense ................................ (8) Depreciation Expense ($40,000 ÷ 8) ............................. Equipment ...................................................................... Maintenance and Repairs Expense ...................... Accumulated Depreciation—Equipment ..............
3,200
19,000
5,600 25,000 21,300 3,700 125,000 125,000
2,000 2,000 3,800 3,800 5,000 40,000 40,000 5,000
Problem 21.7 (Continued) (9) Insurance Expense ($12,000 ÷ 3)....................................... Prepaid Insurance .............................................................. Retained Earnings ......................................................
4,000 6,000
(10) Amortization Expense ($50,000 ÷ 10)................................ Retained Earnings .............................................................. Trademarks .................................................................
5,000 5,000
10,000
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
10,000
Problem 21.8
Net Income for 2024
Retained Earnings 12/31/25
Item
Understated
Overstated
Understated
Overstated
1. 2. 3. 4. 5. 6.
$14,100 $ 3,500 0 $28,000 0 $18,200
0 0 $22,000 0 $24,000 0
0 $ 2,500 0 $28,000 0 0
0 0 $11,000 0 $12,000 0
Although explanations were not required in answering the question, they are included below for your interest. Explanations: 1.
The net income would be understated in 2024 because interest income is understated. The net income would be overstated in 2025 because interest income is overstated. The errors, however, would counterbalance (wash) so that the Balance Sheet (Retained Earnings) would be correct at the end of 2025.
2.
The depreciation expense in 2024 should be $500 for this machine. Since the machine was bought on July 1, 2024, only one-half of a year’s depreciation should be taken in 2024 ($4,000 / 4 × 1/2 = $500). The company expensed $4,000 instead of $500 so net income is understated by $3,500 in 2024. An additional $1,000 of depreciation expense should have been taken in 2025. At the end of 2025, retained earnings would be understated by $2,500 ($3,500 – $1,000).
3.
GAAP requires that all research and development costs should be expensed when incurred. Net income in 2024 is overstated $22,000 ($33,000 research and development costs capitalized less $11,000 amortized). By the end of 2025, only $11,000 of the research and development costs would remain as an asset. Therefore, retained earnings would be overstated by $11,000 ($33,000 research and development costs – $22,000 amortized).
Problem 21.8 (Continued) 4.
The security deposit should be a long-term asset, called refundable deposits. The $8,000 of the last month’s rent is also an asset, called prepaid rent. The net income of 2024 is understated by $28,000 ($20,000 + $8,000) because these amounts were expensed. Retained earnings will continue to be understated by $28,000 until the last year of the lease. The security deposit will then be refunded, and the last month’s rent should be expensed.
5.
$12,000 or one-third of $36,000 should be reported as income each year. In 2024, $36,000 was reported as income when only $12,000 should have been reported. Because $24,000 too much was reported, the net income of 2024 is overstated. By the end of 2025, $24,000 should have been reported as income, so retained earnings is still overstated by $12,000 ($36,000 – $24,000).
6.
The ending inventory would be understated since the merchandise was omitted. Because ending inventory and net income have a direct relationship, net income in 2024 would be understated. The ending inventory of 2024 becomes the beginning inventory of 2025. If beginning inventory of 2025 is understated, then net income of 2025 is overstated (inverse relationship). The omission in inventory over the two-year period will counterbalance and retained earnings at the end of 2025 will be correct.
LO: 3, 4, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 21.9
Net income, as reported Rent received in 2024, earned in 2025 Salaries and wages not accrued, 12/31/23 Salaries and wages not accrued, 12/31/24 Salaries and wages not accrued, 12/31/25 Inventory of supplies, 12/31/23 Inventory of supplies, 12/31/24 Inventory of supplies, 12/31/25 Corrected net income
2024 $29,000
2025 $37,000
(1,000) 1,100 (1,200)
1,000
(1,300) 940 $27,540
1,200 (940) (940) 1,420 $38,740
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
Copyright © 2022 John Wiley & Sons, Inc.
(a)
ROBERTS COMPANY Schedule of Revised Net Income For the Years Ended March 31, 2024, 2025, and 2026 SUMMARY COMPUTATIONS Increases (Decreases) in Income 2024
(For Instructor Use Only)
8. Adjustment for bonus, 1% of income before taxes and bonus Income before income taxes
22-47
*$1,400 – $900 **$900 – $1,120
2024
2025
2026
$71,600
$111,400
$103,580
5,590 1.25 4,472 1,118
(1,300)
1,300 6,100
(1,118) (6,100)
$933,500 $ 4,668 760 $ 3,908
$1,010,000 6,500 6,100 $1,022,600 $ 5,113 1,670 $ 3,443
$1,795,000 (5,590) (6,100) $1,783,310 $ 8,917 3,850 $ 5,067
(3,908)
(3,443)
(5,067)
$
$
$
(1,584) 3,000 (1,400) 66,408
(1,237) 3,900 500* 118,520
(608) 5,100 (220)** 95,567
(664)
(1,185)
(956)
$65,744
$117,335
$ 94,611
$ ÷ $
6,500 1.25 5,200 1,300 $
$940,000 (6,500)
$
2,334 750 1,584
$
2026
$ ÷ 1,300
2,557 1,320 1,237
$
$
4,458 3,850 608
Problem 21.10
Kieso, Intermediate Accounting, 18/e, Solutions Manual
1. Income before income taxes, as reported 2. Elimination of profit on consignments: Billed at 125% of cost Cost Profit error 3. To correct C.O.D. sale 4. Adjustment of warranty expense: Sales per books Correction for consignments Correction for C.O.D. sale Corrected sales Normal warranty expense, one-half of 1% Less costs charged to expense Additional expense 5. Bad debt adjustments: Normal bad debt expense, one-quarter of 1% of sales Less previous write-offs Additional expense 6. Adjustment for contract financing 7. Adjustment for commissions
2025
Problem 21.10 (Continued) (b) 2. Sales Revenue ..................................................... Inventory on Consignment .................................. Cost of Goods Sold ........................................... Accounts Receivable ........................................ (To adjust for consignments treated as sales
5,590 4,472
3. Sales Revenue ..................................................... Retained Earnings ............................................. (To adjust for C.O.D. sales not recorded
6,100
4. Warranty Expense................................................ Retained Earnings ($3,908 + $3,443) .................. Warranty Liability .............................................. (To record accrued warranty Expense – see revised income schedule)
5,067 7,351
5. Retained Earnings ($1,584 + $1,237) .................. Bad Debt Expense ............................................... Allowance for Doubtful Accounts .................... (To set up allowance for uncollectible accounts)
2,821 608
6. Due to Customer .................................................. Finance Expense ............................................... Retained Earnings ($3,000 + $3,900) ................ (To record finance charge reserve held by bank)
12,000
7. Salaries and Wages Expense .............................. Retained Earnings ($1,400 – $500) ..................... Salaries and Wages Payable ............................ (To adjust for accrued commissions)
220 900
8. Retained Earnings ($664 + $1,185) ..................... Salaries and Wages Expense .............................. Salaries and Wages Payable ............................ (To set up accrued bonus payable to manager – see revised income schedule)
1,849 956
4,472 5,590
6,100
12,418
3,429
5,100 6,900
1,120
LO: 3, 4, Bloom: AP, Difficulty: Complex, Time: 50-60, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
2,805
*Problem 21.11
(a)
MILLAY INC. Schedule of Income or Loss from Investment For Year Ending December 31, 2025 Dividend revenue ....................................................................... (10,000 shares × $1.50 dividend/share)
(b)
$15,000
MILLAY INC. Schedule of Income or Loss from Investment For Years Ending December 31, 2026 and 2025
Income from investment in Genso (Schedule 1) Schedule 1
2026
2025
$170,000
$55,000
Millay’s Share of Investee’s Income 2026
Income for 2025 ($550,000 × .10) Income for 2026 ($350,000 × .40) Income for 2026 ($300,000* × .10)
2025 $55,000
140,000 30,000 $170,000
*($650,000 – $350,000) LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
$55,000
*Problem 21.12
January 3, 2024 Equity Investments........................................................ Cash ........................................................................ (To record the purchase of a 10% interest in Renner Corp.)
500,000 500,000
December 31, 2024 Cash ............................................................................... Dividend Revenue .................................................. (To record the receipt of cash dividends from Renner Corp.)
15,000 15,000
December 31, 2024 Fair Value Adjustment ($560,000 − $500,000) .............. Unrealized Holding Gain or Loss—Income .......... (To recognize as part of stockholders’ equity the increase in fair value of equity securities)
60,000 60,000
December 31, 2025 Cash ............................................................................... Dividend Revenue .................................................. (To record the receipt of cash dividends from Renner Corp.)
20,000 20,000
December 31, 2025 Unrealized Holding Gain or Loss—Income ($560,000 − $515,000) ................................................. Fair Value Adjustment ........................................... (To recognize as part of stockholders’ equity the decrease in fair value of the equity securities)
45,000 45,000
*Problem 21.12 (Continued) January 2, 2026 Equity Investment (Renner Corp.).............................. 1,545,000 Cash...................................................................... (To record purchase of additional interest in Renner)
1,545,000
Computation of Prior Period Adjustment January 2, 2026 Equity Investment (Renner Corp.)........................... Equity Investments ........................................... (To reclassify investment carried under fair value method to investment carried under equity method)
500,000
Unrealized Holding Gain or Loss - Income .............
15,000
Fair Value Adjustment ($60,000 - $45,000) ...... (To eliminate accounts and balances used under fair value method accounting)
500,000
15,000
*Problem 21.12 (Continued) December 31, 2026 Equity Investment (Renner Corp.). ............................... Investment Revenue ............................................. (To record equity in net income of Renner—40% of $550,000)
220,000
Cash ............................................................................... Equity Investment (Renner Corp.). ....................... (To record the receipt of cash dividends from Renner Corp.)
70,000
220,000
LO: 5, Bloom: AP, Difficulty: Complex, Time: 20-25, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
70,000
UYJ 21.1 Financial Reporting Problem (a)
New Accounting Pronouncements and Policies
On July 1, 2019, we adopted ASU 2016-02, "Leases (Topic 842)." The new accounting standard requires the recognition of right-of-use assets and lease liabilities for all long-term leases, including operating leases, on the balance sheet. We elected the optional transition method and adopted the new guidance on a modified retrospective basis with no restatement of prior period amounts. As allowed under the new accounting standard, we elected to apply practical expedients to carry forward the original lease determinations, lease classifications and accounting of initial direct costs for all asset classes at the time of adoption. The adoption did not have a material impact on our financial statements, resulting in an increase of approximately 1% to each of our total assets and total liabilities on our balance sheet as of July 1, 2019. See Note 12 for further information. In January 2017, the FASB issued ASU 2017-04, "Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment." The standard simplifies the accounting for goodwill impairment by requiring a goodwill impairment to be measured using a single step impairment model, whereby the impairment equals the difference between the carrying amount and the estimated fair value of the specified reporting units in their entirety. This eliminates the second step of the current impairment model that requires companies to first estimate the fair value of all assets in a reporting unit and measure impairments based on those estimated fair values and a residual measurement approach. The new standard also specifies that any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. We will adopt the standard effective July 1, 2020. The impact of the new standard will be dependent on the specific facts and circumstances of future individual impairments, if any. In March 2020, the FASB issued ASU 2020-04, "Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting." The amendments provide optional guidance for a limited time to ease the potential burden in accounting for reference rate reform. The new guidance provides optional expedients and exceptions for applying U.S. GAAP to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met. The amendments apply only to contracts and hedging relationships that
Financial Reporting Problem (Continued)
reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. These amendments are effective immediately and may be applied prospectively to contract modifications made and hedging relationships entered into or evaluated on or before December 31, 2022. We are currently evaluating our contracts and the optional expedients provided by the new standard. No other new accounting pronouncements issued or effective during the fiscal year or in future years had, or are expected to have, a material impact on our Consolidated Financial Statements. (b)
Use of Estimates
ESTIMATES In preparing our financial statements in accordance with U.S. GAAP, there are certain accounting policies that may require a choice between acceptable accounting methods or may require substantial judgment or estimation in their application. These include revenue recognition, income taxes, certain employee benefits and goodwill and intangible assets. We believe these accounting policies, and others set forth in Note 1 to the Consolidated Financial Statements, should be reviewed as they are integral to understanding the results of operations and financial condition of the Company. The Company has discussed the selection of significant accounting policies and the effect of estimates with the Audit Committee of the Company's Board of Directors. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 21.2 Comparative Analysis Case THE COCA-COLA COMPANY VS. PEPSICO, INC. (a) and (c) for Coca-Cola Company: Coke Recently Adopted Accounting Guidance In August 2017, the Financial Accounting Standards Board ("FASB") issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities ("ASU 2017-12"), which eliminates the requirement to separately measure and report hedge ineffectiveness and requires companies to recognize all elements of hedge accounting that impact earnings in the same line item in the statement of income where the hedged item resides. The amendments in this update include new alternatives for measuring the hedged item for fair value hedges of interest rate risk and ease the requirements for effectiveness testing, hedge documentation and applying the critical terms match method. We adopted ASU 2017-12 effective January 1, 2019 using the modified retrospective method. We recognized a cumulative effect adjustment to decrease the opening balance of reinvested earnings as of January 1, 2019 by $12 million, net of tax. Refer to Note 5 for additional disclosures required by this ASU. In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income ("ASU 2018-02"), which permits entities to reclassify the disproportionate income tax effects of the Tax Cuts and Jobs Act of 2017 ("Tax Reform Act") on items within AOCI to reinvested earnings. These disproportionate income tax effect items are referred to as "stranded tax effects." The amendments in this update only relate to the reclassification of the income tax effects of the Tax Reform Act. Other accounting guidance that requires the effect of changes in tax laws or rates to be included in net income is not affected by this update. We adopted ASU 2018-02 effective January 1, 2019. We recognized a cumulative effect adjustment to increase the opening balance of reinvested earnings as of January 1, 2019 by $558 million related to the effect that the change in the income tax rate had on the gross deferred tax amounts of items remaining in AOCI.
Comparative Analysis Case (Continued)
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. ASU 2014-09, and its amendments, were primarily included in ASC 606,Revenue from Contracts with Customers, which we adopted effective January 1, 2018 using the modified retrospective method. We recognized a cumulative effect adjustment to decrease the opening balance of reinvested earnings as of January 1, 2018 by $257 million, net of tax. In January 2016, the FASB issued ASU 2016-01, which addresses certain aspects of the recognition, measurement, presentation, and disclosure of financial instruments. ASU 2016-01 was effective for the Company beginning January 1, 2018, and we are now recognizing any changes in the fair value of certain equity investments in net income as prescribed by the new standard rather than in other comprehensive income ("OCI"). We recognized a cumulative effect adjustment to increase the opening balance of reinvested earnings as of January 1, 2018 by $409 million, net of tax. In October 2016, the FASB issued ASU 2016-16, Intra-Entity Transfers of Assets Other Than Inventory ("ASU 2016-16"), which requires the Company to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. ASU 2016-16 was effective for the Company beginning January 1, 2018 and was adopted using a modified retrospective basis. We recorded a $2.9 billion cumulative effect adjustment to increase the opening balance of reinvested earnings as of January 1, 2018, with the majority of the offset being recorded in the line item deferred income tax assets in our consolidated balance sheet. In March 2018, the FASB issued ASU 2018-05, Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118. The amendments in this update provide guidance on when to record and disclose provisional amounts for certain income tax effects of the Tax Reform Act. The amendments also require any provisional amounts or subsequent adjustments to be included in net income. Additionally, this ASU discusses required disclosures that an entity must make with regard to the Tax Reform Act. This ASU is effective immediately as new information is available to adjust provisional amounts that were previously recorded. The Company adopted this standard and subsequently finalized the accounting based on the guidance, interpretations, and data available as of December 31, 2018. Refer to Note 14.
Comparative Analysis Case (Continued) Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"), which require management to make estimates, judgments and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. We believe our most critical accounting policies and estimates relate to the following: • • • • •
Principles of Consolidation Recoverability of Current and Noncurrent Assets Pension Plan Valuations Revenue Recognition Income Taxes
Management has discussed the development, selection and disclosure of critical accounting policies and estimates with the Audit Committee of the Company's Board of Directors. While our estimates and assumptions are based on our knowledge of current events and actions we may undertake in the future, actual results may ultimately differ from these estimates and assumptions. For a discussion of the Company's significant accounting policies, refer to Note 1 of Notes to Consolidated Financial Statements. (b) and (c) for Pepsi: Pepsi Recently Issued Accounting Pronouncements - Adopted In 2016, the Financial Accounting Standards Board (FASB) issued guidance that changes the impairment model used to measure credit losses for most financial assets. Under the new model we are required to estimate expected credit losses over the life of our trade receivables, certain other receivables, and certain other financial instruments. The new model replaced the existing incurred credit loss model and generally results in earlier recognition of allowances for credit losses. We adopted this guidance in the first quarter of 2020 and the adoption did not have a material impact on our consolidated financial statements or disclosures. On initial recognition, we recorded an after-tax cumulative effect decrease to retained earnings of $34 million ($44 million pre-tax) as of the beginning of 2020.
Comparative Analysis Case (Continued) Recently Issued Accounting Pronouncements - Not Yet Adopted In 2019, the FASB issued guidance to simplify the accounting for income taxes. The guidance primarily addresses how to (1) recognize a deferred tax liability after we transition to or from the equity method of accounting, (2) evaluate if a step-up in the tax basis of goodwill is related to a business combination or is a separate transaction, (3) recognize all of the effects of a change in tax law in the period of enactment, including adjusting the estimated annual tax rate, and (4) include the amount of tax based on income in the income tax provision and any incremental amount as a tax not based on income for hybrid tax regimes. The guidance is effective in the first quarter of 2021 with early adoption permitted. We will adopt the guidance when it becomes effective in the first quarter of 2021. The guidance is not expected to have a material impact on our consolidated financial statements or related disclosures. Estimates (Note 1) The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and disclosure of contingent assets and liabilities. Estimates are used in determining, among other items, sales incentives accruals, tax reserves, share-based compensation, pension, and retiree medical accruals, amounts and useful lives for intangible assets and future cash flows associated with impairment testing for indefinite lived brands, goodwill, and other long-lived assets. We evaluate our estimates on an ongoing basis using our historical experience, as well as other factors we believe appropriate under the circumstances, such as current economic conditions, and adjust or revise our estimates as circumstances change. The business and economic uncertainty resulting from the COVID19 pandemic has made such estimates and assumptions more difficult to calculate. As future events and their effect cannot be determined with precision, actual results could differ significantly from those estimates.
UYJ 21.3 Accounting, Analysis, and Principles Accounting ABC CO. Balance Sheet at December 31 Cash Inventory PPE Accumulated depreciation Total assets
2025 2024 $ 548 $ 365 Common stock 580 560 Retained earnings 400 400 (120) (80) 1,408 1,245 Total equity
2025 2024 $ 500 $ 500 908 745
$1,408 $1,245
ABC CO. Income Statement for the Year Ended December 31, Sales revenue .................................................................. Cost of goods sold .......................................................... Depreciation expense ..................................................... Compensation expense .................................................. Net income .......................................................................
2025 $550 330 40 17 $163
2024 Purchases: $480 + P – $300 = $500; P = $320 2024 Beginning inventory using FIFO = $480 + $50 = $530 2024 Ending inventory using FIFO = $500 + $60 = $560 2024 Cost of goods sold using FIFO = $530 + $320 – $560 = $290 2024 Retained Earnings = $685 + $60 = $745 2025 Retained Earnings = $745 + $163 = $908 2025 Cost of goods sold = $560 + $350 – $580 = $330 2025 Depreciation Expense = $400/10 = $40 2025 Accumulated Depreciation = $80 + $40 = $120 2025 Cash = $365 + $550 – $350 – $17 = $548
2024 $500 290 40 15 $155
Accounting, Analysis, and Principles (Continued) Analysis Inventory turnover:
LIFO FIFO *($500+$480) / 2
2025 2024 N/A LIFO information not available $300 ÷ $490* = 0.61 $330 ÷ $570** = 0.58 $290 ÷ $545^ = 0.53 **($580 + $560) / 2 ^[$560 + ($480+$50)] / 2
Inventory turnover is lower under FIFO, which leads to ROA being slightly higher. Under FIFO (in this example) COGS is lower because older costs that had been deferred in the inventory balance under LIFO were brought to COGS. The inventory balance is higher because FIFO leaves the most recent inventory costs in the inventory account. Principles The issue is consistency across time. When a company changes accounting policies, financial statements from one period are not comparable to the financial statements of the next period because they are based on different accounting policies. GAAP requires restating past results presented for comparison to the new accounting policy so that financial statement readers can see how the company’s financial position and performance have changed without the effects of an accounting change. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Measurement Analysis and Interpretation, Reporting, Research, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 21.1 (Time 25–35 minutes) Purpose—to provide the student with some familiarity with the applications of GAAP related to accounting changes. This case describes several proposed accounting changes with which the student is required to identify whether the change involves an accounting principle, accounting estimate, or correction of an error, plus the necessary reporting requirements for each proposal. CT 21.2 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the application and reporting requirements of GAAP. This case describes many different accounting changes with which the student is required to identify the type of change involved and to indicate which changes necessitate the restatement of prior years’ financial statements when presented in comparative form with the current year’s statement. CT 21.3 (Time 30–35 minutes) Purpose—to provide the student with an understanding of GAAP and its respective applications. This case describes three independent situations with which the student is required to identify the type of accounting change involved, the reporting which is necessitated under current generally accepted accounting principles, and the effects of each change on the financial statements. CT 21.4 (Time 20–30 minutes) Purpose—to provide the student with an understanding of how changes in accounting can be reflected in the accounting records to facilitate analysis and understanding of financial statements. This case involves several situations with which the student is required to indicate the appropriate accounting treatment that each should be given. CT 21.5 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to explain how to account for various accounting change situations. Explanations for a change in estimate, change in principle, and change in entity are communicated in a written letter. CT 21.6 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to explain the ethical issues related to changes in estimates.
Solutions to Critical Thinking CT 21.1 (a)
1.
Uncollectible Accounts Receivable. This is a change in accounting estimate. Restatement of prior periods is not appropriate.
2.
Depreciation. a. This is a change in accounting estimate. Restatement of opening retained earnings is not appropriate. b. This is a new method for a new class of assets. No change is involved.
(b)
3.
Mathematical Error. This is a correction of an error and prior period treatment would be in order.
4.
Preproduction Costs—Furniture Division. This should probably be construed as an inseparability situation in that the change in accounting estimate (period benefited by deferred costs) has been affected by a change in accounting principle (amortization on a per-unit basis). Consequently, it is treated as a change in accounting estimate. Restatement of opening retained earnings is not appropriate.
5.
FIFO to LIFO Change. This is a change in accounting principle. Restatement of December 31, 2024 retained earnings is not appropriate, given that the effect on net income in prior periods cannot be determined. Note that a LIFO to FIFO change does qualify for restatement of opening retained earnings, but FIFO to LIFO does not qualify in most cases because it is impracticable to determine prior year’s income under LIFO.
6.
Percentage of Completion. This is a change in accounting principle. Retained earnings should be adjusted.
The adjustment to the December 31, 2024 retained earnings balance would be computed as follows: Item 3 .................................................................................................. Item 6 .................................................................................................. Increase in 12/31/24—Retained Earnings ...........................................
$ (235,000) 1,075,000 $ 840,000
LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 21.2
Item Change
Type of Change
Should Prior Years’ Statements Be Retrospectively Applied or Restated?
1.
A change in accounting principle.
Yes
2.
A change in an accounting estimate.
No
3.
An accounting change involving both a change in accounting principle and a change in accounting estimate. Referred to as a change in accounting estimate effected by a change in principle. Handle as a change in estimate.
No
4.
Not an accounting change but rather a change in classification.
Yes
5.
An error correction not involving a change in accounting principle.
Yes
6.
An accounting change involving a change in the reporting entity which is a special type of change in accounting principle.
Yes
7.
Not a change in accounting principle. Simply, a change in tax accounting.
No
8.
An accounting change from one generally accepted accounting principle to another generally accepted accounting principle.
No*
*Generally impracticable to determine what LIFO inventory would be in prior periods. LO: 1, 2, 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BC: None, AICPA AC: Reporting, AICPA PC: None
CT 21.3 Situation 1. (a)
A change from an accounting principle not generally accepted to one generally accepted is a correction of an error.
(b)
When comparative statements are presented, net income, components of net income, retained earnings, and any other affected balances for all periods presented should be restated to correct for the error. When single period statements are presented, the required adjustments should be reported in the opening balance of retained earnings. A description of the change and its effect on income from continuing operations, net income, and the related per share amounts should be disclosed in the period of the change. Financial statements of subsequent periods need not repeat the disclosures.
(c)
The beginning balance of retained earnings in the retained earnings statement is restated. The income statement for the current year should report the correct approach for revenue recognition. If prior years’ financial statements are presented, they should be restated directly.
CT 21.3 (Continued) Situation 2. (a)
The change in method of inventory pricing represents a change in accounting principle, as defined by GAAP.
(b)
Changes in accounting principle are accounted for through retrospective application. Under this approach, the cumulative effect of the new method on the financial statements at the beginning of the period is computed (and recorded in retained earnings at the beginning of the period). Prior statements are changed to be reported on a basis consistent with the new standard.
(c)
As a result of the change to weighted-average costing, the current year balance sheet will reflect weighted-average costing (at relatively higher prices in times of rising prices). Cost of goods sold will also be different (higher), resulting in lower income.
Situation 3. (a)
A change in the depreciable lives of fixed assets is a change in accounting estimate.
(b)
In accordance with GAAP, the change in estimate should be reported in the current period and in future periods. Unlike a change in accounting principle, the change in accounting estimate should not be accounted for by presenting prior earnings data giving effect to the change as if it had been applied retrospectively.
(c)
This change in accounting estimate will affect the balance sheet in that the accumulated depreciation in the current and future years will increase at a different rate than previously reported, and this will also be reflected in depreciation expense in the income statement in the current and future years.
LO: 1, 2, 3, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 21.4 1.
This situation is a change in estimate. Whenever it is impossible to determine whether a change in principle or a change in estimate has occurred, the change should be considered a change in estimate. This is often referred to as a change in accounting estimate effected by a change in accounting principle. A change in estimate employs the current and prospective approach by: (a)
Reporting current and future financial statements on the new basis.
(b)
Presenting prior periods’ financial statements as previously reported.
(c)
Making no adjustments to current opening balances for purposes of catch-up.
2.
This situation is considered a change in estimate because new events have occurred which call for a change in estimate. The accounting should be the same as discussed in 1.
3.
This situation is considered a correction of an error. The general rule is that careful estimates which later prove to be incorrect should be considered changes in estimates. Where the estimate was obviously computed incorrectly because of lack of expertise or in bad faith, the adjustment should be considered an error. Changes due to error should employ the retroactive approach by: (a)
Restating, via a prior period adjustment, the beginning balance of retained earnings for the current period.
CT 21.4 (Continued) (b)
Correcting all prior period statements presented in comparative financial statements. The amount of the error related to periods prior to the earliest year’s statement presented for comparative purposes should be included as an adjustment to the beginning balance of retained earnings of that earliest year’s statement.
4.
No adjustment is necessary—a change in accounting principle is not considered to have happened if a new principle is adopted in recognition of events that have occurred for the first time.
5.
This situation is considered a change in estimate because new events have occurred which call for a change in estimate. The accounting should be the same as discussed in 1.
6.
This situation is considered a change in accounting principle. A change in accounting principle should employ the retrospective approach by: (a)
Reporting current results on the new basis.
(b)
Presenting prior period financial statements on a basis consistent with the newly adopted method.
(c)
Computing the cumulative effect of the new method in beginning retained earnings on the earliest year presented.
LO: 1, 2, 3, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BC: None, AICPA AC: Reporting, AICPA PC: Communication
CT 21.5 Mr. Joe Davison, CEO Sports-Pro Athletics, Inc. Dear Mr. Davison: You recently contacted me about several accounting changes made at Sports-Pro Athletics, Inc. in 2025. This letter details how you should account for each change. Your change from one method of depreciation to another constitutes a change in accounting estimate effected by a change in accounting principle. A change in estimate employs the prospective approach by reporting current and future financial statements on the new basis. Prior periods financial statements are presented as previously reported. Your change in salvage values for your office equipment is considered a change in estimate. This type of change does not really affect previous financial statements and is thus accounted for prospectively. The change is included in the most current period being reported. There is no need to restate prior periods’ financial statements. Finally, your change in specific subsidiaries results in a change in reporting entity which must be reported by restating the financial statements for all periods presented. The effect of this change should be shown on income from continuing operations, net income, and earnings per share amounts. In addition, you must disclose in a footnote the nature of the change as well as the reasons for it. I hope that this information helps you account for the various changes which have taken place at Sports-Pro Athletics. If you need further information, please contact me. Sincerely, LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA PC: Professional Behavior, AICPA AC: Reporting, AICPA PC: Communication
CT 21.6 (a)
The ethical issues are the honesty and integrity of Frost’s financial reporting practices versus the Corporation’s and the accounting manager’s profit motives. Shortening the life of fixed assets from 10 to 6 years may be evidence that depreciation expense during the first five years were understated. Such a practice distorts Frost’s operating results and misleads users of Frost’s financial statements. If this practice is intentional, it is unethical.
(b)
The primary stakeholders in the above situation include Frost’s stockholders and creditors. Crane and his auditing firm are stakeholders because they know of the depreciation practices at Frost.
(c)
Crane should report his finding to the partner-in-charge of the Frost engagement. If this practice is deemed to be intentional and fraudulent, then Crane’s firm has a professional responsibility to report this incident to the highest levels of management within Frost (the Audit Committee of the Board of Directors).
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, Ethics, Analytic, Communication, AICPA PC: Ethical Conduct, AICPA AC: Reporting, AICPA PC: Communication
Codification Exercises
CE21.1 Master Glossary (a)
A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, and warranty obligations.
(b)
A change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle.
(c)
The process of revising previously issued financial statements to reflect the correction of an error in those financial statements.
(d)
The application of a different accounting principle to one or more previously issued financial statements, or to the statement of financial position at the beginning of the current period, as if that principle had always been used, or a change to financial statements of prior accounting periods to present the financial statements of a new reporting entity as if it had existed in those prior years.
LO: 1, 2, 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE21.2 According to FASB ASC 250-10-50-7 (Accounting Changes and Error Corrections—Disclosure): When financial statements are restated to correct an error, the entity shall disclose that its previously issued financial statements have been restated, along with a description of the nature of the error. The entity also shall disclose both of the following: (a)
The effect of the correction on each financial statement line item and any per-share amounts affected for each prior period presented.
(b)
The cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented.
LO: 3, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Exercises (Continued) CE21.3 According to FASB ASC 250-10-45-5 (Accounting Changes and Error Corrections—Other Presentation Matters): An entity shall report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires all of the following: (a)
The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
(b)
An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
(c)
Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE21.4 According to FASB ASC 250-10-S99-4 (Accounting Changes and Error Corrections—SEC Materials): If a registrant justified a change in accounting method as preferable under the circumstances, and the circumstances change, may the registrant revert to the method of accounting used before the change? Any time a registrant makes a change in accounting method, the change must be justified as preferable under the circumstances. Thus, a registrant may not change back to a principle previously used unless it can justify that the previously used principle is preferable in the circumstances as they currently exist. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BC: Technology, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a) According to FASB ASC 250-10-20 (Glossary), a change in accounting estimate that is inseparable from the effect of a related change in accounting principle is a change in estimate effected by a change in principle. An example of a change in estimate effected by a change in principle is a change in the method of depreciation, amortization, or depletion for long-lived, nonfinancial assets. Under FASB ASC 250-10-45 45-17, A change in accounting estimate shall be accounted for in the period of change if the change affects that period only or in the period of change and future periods if the change affects both. A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods. 45-19 Like other changes in accounting principle, a change in accounting estimate that is affected by a change in accounting principle may be made only if the new accounting principle is justifiable on the basis that it is preferable. For example, an entity that concludes that the pattern of consumption of the expected benefits of an asset has changed, and determines that a new depreciation method better reflects that pattern, may be justified in making a change in accounting estimate effected by a change in accounting principle. (See paragraph 250-10-45-12.) (b) According to FASB ASC 250-10-45-18, distinguishing between a change in an accounting principle and a change in an accounting estimate is sometimes difficult. In some cases, a change in accounting estimate is affected by a change in accounting principle. One example of this type of change is a change in method of depreciation, amortization, or depletion for long-lived, nonfinancial assets (hereinafter referred to as depreciation method). The new depreciation method is adopted in partial or complete recognition of a change in the estimated future benefits inherent in the asset, the pattern of consumption of those benefits, or the information available to the entity about those benefits. The effect of the change in accounting principle, or the method of Codification Research Case (Continued)
applying it, may be inseparable from the effect of the change in accounting estimate. Changes of that type often are related to the continuing process of obtaining additional information and revising estimates and, therefore, shall be considered changes in estimates for purposes of applying this Subtopic. (c) According to FASB ASC 250-10-S50—Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant when Adopted in a Future Period S50-1 See paragraph 250-10-S99-5, SAB Topic 11.M, for SEC Staff views regarding disclosure of the impact of recently issued accounting standards. SAB Topic 11.M, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant when Adopted in a Future Period S99-5 The following is the text of SAB Topic 11.M, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant when Adopted in a Future Period. Facts: An accounting standard has been issued that does not require adoption until some future date. A registrant is required to include financial statements in fillings with the Commission after the Issuance of the standard but before it is adopted by the registrant.5 – 5Some registrants may want to disclose the potential effects of proposed accounting standards not yet issued, (e.g., exposure drafts). Such disclosures, which generally are not required because the final standard may differ from the exposure draft, are not addressed by this SAB. See also FRR 26. Question 1: Does the staff believe that these filings should include disclosure of the impact that the recently issued accounting standard will have on the financial position and results of operations of the registrant when such standard is adopted in a future period? Codification Research Case (Continued)
Interpretive Response: Yes. The commission addressed a similar issue with respect to Statement 52 and concluded that “The Commission also believes that registrants that have not yet adopted Statement 52 should discuss the potential effects of adoption in registration statements and reports filed with the Commission.”6 The staff believes that this disclosure guidance applies to all accounting standards which have been issued but not yet adopted by the registrant unless the impact on its financial position and results of operations is not expected to be material.7 MD&A8 requires registrants to provide information with respect to liquidity, capital resources and results of operations and such other information that the registrant believes to be necessary to understand its financial condition and results of operations. In addition, MD&A requires disclosure of presently known material changes, trends and uncertainties that have had or that the registrant reasonably expects will have a material impact on future sales, revenues or income from continuing operations. The staff believes that disclosure of impending accounting changes is necessary to inform the reader about expected impacts on financial information to be reported in the future and, therefore, should be disclosed in accordance with the existing MD&A requirements. With respect to financial statement disclosure, GAAS9 specifically address the need for the auditor to consider the adequacy of the disclosure of impending changes in accounting principles if (a) the financial statements have been prepared on the basis of accounting principles that were acceptable at the financial statement date but that will not be acceptable in the future and (b) the financial statements will be restated in the future as a result of the change. The staff believes that recently issued accounting standards may constitute material matters and, therefore, disclosure in the financial statements should also be considered in situations where the change to the new accounting standard will be accounted for in financial statements of future periods, prospectively or with a cumulative catch-up adjustment.
Codification Research Case (Continued) – 6FRR 6, Section 2. – 7In those instances where a recently issued standard will impact the preparation of, but not materially affect, the financial statements, the registrant is encouraged to disclose that a standard has been issued and that its adoption will not have a material effect on its financial position or results of operations. – 8Item 303 of Regulation S-K. – 9See AU 9410.13-18. Question 2: Does the staff have a view on the types of disclosure that would be meaningful and appropriate when a new accounting standard has been issued but not yet adopted by the registrant? Interpretive Response: The staff believes that the registrant should evaluate each new accounting standard to determine the appropriate disclosure and recognizes that the level of information available to the registrant will differ with respect to various standards and from one registrant to another. The objectives of the disclosure should be to (1) notify the reader of the disclosure documents that a standard has been issued which the registrant will be required to adopt in the future and (2) assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the registrant when adopted. The staff understands that the registrant will only be able to disclose information that is known. The following disclosures should generally be considered by the registrant: – A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier. – A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined.
Codification Research Case (Continued) – A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made. – Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged. LO: 1, Bloom: K, Difficulty: Moderate, Time: 50-60, AACSB: Analytic, Communication, Technology, AICPA BC: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CHAPTER 22 Statement of Cash Flows Assignment Classification Table (By Topic) Topics
Questions
Brief Exercises
Exercises
Critical Problems Thinking
1. Format, objectives purpose, and source of statement.
1, 2, 7, 8, 12
1, 2, 5, 6
2. Classifying investing, financing, and operating activities.
3, 4, 5, 6, 16, 17, 19
1, 2, 3, 8, 12
1, 2, 10, 16
1, 3, 4, 5
3. Direct vs. indirect methods of preparing operating activities.
9, 20
4, 5, 6, 7, 9, 10, 11
3, 4
5
4. Statement of cash flows— 11, 13, 14 direct method.
9
4, 5, 7, 9, 12, 13
3, 4, 6, 7, 8
5. Statement of cash flows— 10, 13, indirect method. 15, 16
9, 10, 11
2, 3, 6, 8, 11, 14, 15, 16, 17, 18
1, 2, 5, 6, 7, 8, 9
2
6. Preparing schedule of noncash investing and financing activities.
18
12
5, 7, 8, 9
5
7. Worksheet adjustments.
21
13
19, 20, 21
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises
Exercises
Critical Thinking
Problems
1.
Describe the usefulness and format of the statement of cash flows.
1, 2, 3, 4
1
1, 2, 10, 16
2.
Prepare a statement of cash flows.
5, 6, 7, 8, 10, 13, 15, 16, 17, 19
2, 3, 8, 9, 10, 11
2, 3, 6, 8, 11, 12, 13, 14, 15, 16, 17, 18
1, 2, 5, 6, 7, 8, 9
1, 2, 3, 4, 5, 6
3.
Contrast the direct and 9, 11, 14, indirect methods 17, 20 of calculating net cash flow from operating activities.
4, 5, 6, 7, 9,
4, 5, 7, 9, 12, 13
3, 4, 6, 7, 8
6
4.
Discuss special problems in preparing a statement of cash flows.
11, 12
8, 9, 10, 18
1, 2, 4, 5, 6, 7, 9
1, 2, 3, 4
5.
Explain the use of a 21 worksheet in preparing a statement of cash flows.
13
19, 20, 21
11, 12, 16, 17, 18
5, 6
Assignment Characteristics Table Level of Difficulty
Time (minutes)
Classification of transactions. Statement presentation of transactions—indirect method. Preparation of operating activities section—indirect method, periodic inventory. Preparation of operating activities section—direct method. Preparation of operating activities section—direct method. Preparation of operating activities section—indirect method. Computation of operating activities—direct method. Schedule of net cash flow from operating activities— indirect method. SCF—direct method. Classification of transactions. SCF—indirect method. SCF—direct method. SCF—direct method. SCF—indirect method. SCF—indirect method. Cash provided by operating, investing, and financing activities. SCF—indirect method and balance sheet. Partial SCF—indirect method. Worksheet analysis of selected accounts. Worksheet analysis of selected transactions. Worksheet preparation.
Moderate Moderate Moderate
10–15 20–30 15–25
Moderate Moderate Moderate Moderate Complex
20–30 20–30 15–20 15–20 20–30
Complex Complex Complex Complex Complex Complex Complex Complex
20–30 25–35 30–35 20–30 30–40 30–40 25–35 30–40
Moderate Complex Moderate Moderate Moderate
30–40 25–30 20–25 20–25 45–55
Complex Complex Complex Complex Complex Complex
40–45 50–60 50–60 45–60 50–65 40–50
Moderate
30–40
P22.8 P22.9
SCF—indirect method. SCF—indirect method. SCF—direct method. SCF—direct method. SCF—indirect method. SCF—indirect method, and net cash flow from operating activities, direct method. SCF—direct and indirect methods from comparative financial statements. SCF—direct and indirect methods. Indirect SCF.
Moderate Moderate
30–40 30–40
CT22.1 CT22.2 CT22.3 CT22.4 CT22.5 CT22.6
Analysis of improper SCF. SCF theory and analysis of improper SCF. SCF theory and analysis of transactions. Analysis of transactions’ effect on SCF. Purpose and elements of SCF. Cash flow reporting.
Moderate Moderate Moderate Moderate Complex Moderate
30–35 30–35 30–35 20–30 30–40 20–30
Item
Description
E22.1 E22.2 E22.3 E22.4 E22.5 E22.6 E22.7 E22.8 E22.9 E22.10 E22.11 E22.12 E22.13 E22.14 E22.15 E22.16 E22.17 E22.18 E22.19 E22.20 E22.21 P22.1 P22.2 P22.3 P22.4 P22.5 P22.6 P22.7
Answers to Questions 1. The main purpose of the statement of cash flows is to provide information about a company’s cash receipts and cash payments in a period. The statement of cash flows provides information about a company’s operating, financing, and investing activities. It reports cash receipts, cash payments, and net change in cash from operating, investing, and financing activities. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
2. Some uses of this statement are: Assessing future cash flows: Income data when augmented with current cash flow data provide a better basis for assessing future cash flows. Assessing reasons for differences between income and net cash flow from operations: Some believe that cash flow information is more reliable than income information because income involves a number of assumptions, estimates, and valuations. Assessing operating capability: Whether a company is able to maintain its operating capability, provide for future growth, and distribute dividends to the owners depends on whether adequate cash is being or will be generated. Assessing financial flexibility and liquidity: Cash flow data indicate whether a company should be able to survive adverse operating problems and whether a company might have difficulty in meeting obligations as they become due, paying dividends, or meeting other recurring costs. Providing information on cash and non-cash investing and financing activities: Cash flows are classified by their effect on balance sheet items; investing activities affect long-term assets while financing activities affect liabilities and stockholders’ equity. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
3. Investing activities generally involve long-term assets and include (1) lending money and collecting on those loans and (2) acquiring and disposing of investments and productive long-lived assets. Financing activities, on the other hand, involve liability and stockholders’ equity items and include (1) obtaining cash from creditors and repaying the amounts borrowed and (2) obtaining capital from owners and providing them with a return on their investment. Operating activities include all transactions and events that are not investing and financing activities. Operating activities involve the cash effects of transactions that enter into the determination of net income. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
4. Examples of sources of cash in a statement of cash flows include cash from operating activities, issuance of debt, issuance of equity securities, the sale of investments, and the sale of property, plant, and equipment. Examples of uses of cash include cash used in operating activities, payment of cash dividends, the redemption of debt, purchase of investments, the redemption of equity securities, and the purchase of property, plant, and equipment. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
5. Preparing the statement of cash flows involves three major steps: (1) Determine the change in cash. This is simply the difference between the beginning and ending cash balances. (2) Determine the net cash flow from operating activities. This involves analyzing the current year’s income statement, current assets and current liabilities on the comparative balance sheets and selected transaction data. (3) Determine net cash flows from investing and financing activities. All other changes in balance sheet accounts are analyzed to determine their effect on cash. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Questions Chapter 22 (Continued) 6. Purchase of land—investing; Payment of dividends—financing; Cash sales—operating; Purchase of treasury stock—financing. LO: 2, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
7. Comparative balance sheets, a current income statement, and certain transaction data all provide information necessary for preparation of the statement of cash flows. Comparative balance sheets indicate how assets, liabilities, and equities have changed during the period. A current income statement provides information about the amount of cash provided or used by from operating activities during the period. Certain transactions provide additional detailed information needed to determine whether cash was provided or used during the period. Knowledge, LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
8. It is necessary to convert accrual-basis net income to a cash basis because net income includes items that do not provide or use cash. An example would be an increase in accounts receivable. If accounts receivable increased during the period, revenues reported on the accrual basis would be higher than the actual cash revenues received. Thus, accrual basis net income must be adjusted to reflect the net cash flow from operating activities. LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
9. Net cash flow from operating activities under the direct method is the difference between cash revenues and cash expenses. The direct method adjusts the revenues and expenses directly to reflect the cash basis. This results in cash net income, which is equal to “net cash flow from operating activities.” The indirect method involves adjusting accrual-based net income. This is done by starting with accrual net income and adding or subtracting noncash items included in net income. Examples of adjustments include depreciation and other noncash expenses and changes in the balances of current asset and current liability accounts from one period to the next. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
10. Net cash flow from operating activities is $3,820,000. Using the indirect method, the solution is: Net income ................................................................................ $3,500,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense .......................................................... $ 520,000 Increase in accounts receivable ........................................... (500,000) Increase in accounts payable ............................................... 300,000 320,000 Net cash provided by operating activities ................................... $3,820,000 LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
11. Accrual basis sales ............................................................. Less: Increase in accounts receivable ............................... Less: Write-off of accounts receivable ............................... Cash sales..........................................................................
$100,000 30,000 70,000 2,000 $ 68,000
LO: 3, 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
12. A number of factors could have caused an increase in cash despite the net loss. These are (1) high cash revenues relative to low cash expenses, (2) sales of property, plant, and equipment, (3) sales of investments and (4) issuance of debt or equity securities. LO: 4, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Questions Chapter 22 (Continued) 13. Declared dividends.............................................................. Add: Dividends payable (beginning of year) ....................... Deduct: Dividends payable (end of year) ........................... Cash paid in dividends during the year ...............................
$260,000 85,000 345,000 90,000 $255,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
14. To determine cash payments to suppliers, it is first necessary to find purchases for the year. To find purchases, cost of goods sold is adjusted for the change in inventory (increased when inventory increases or decreased when inventory decreases). After purchases are computed, cash payments to suppliers are determined by adjusting purchases for the change in accounts payable. An increase (decrease) in accounts payable is deducted from (added to) purchases to determine cash payments to suppliers. LO: 3, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
15. Cash flows from operating activities Net income......................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense................................................. Amortization of patent ................................................ Loss on sale of plant assets ....................................... Net cash provided by operating activities ...........................
$320,000 $124,000 40,000 21,000
185,000 $505,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
16. (a) Cash flows from operating activities Net income .............................................................................. Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of plant assets [($18,000 ÷ 10) x 31/2 ] – $4,000 .................................... Cash flows from investing activities Sale of plant assets .................................................................
XXXX
(b) Cash flows from financing activities Issuance of common stock ...................................................... (c)
$
2,300
$
4,000
$410,000
No effect on cash; not shown in the statement of cash flows or in any related schedules or notes. Note to instructor: The change in net accounts receivable is an adjustment to net income under the indirect method.
(d) Cash flows from operating activities Net loss ................................................................................... Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation expense.............................................................. Gain on sale of available-for-sale debt securities .................... Cash flows from investing activities Sale of available-for-sale securities ......................................... LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$(50,000) $22,000 (9,000) $ 38,000
Questions Chapter 22 (Continued) 17. (a) (b) (c) (d) (e) (f)
Operating activity. Financing activity. Investing activity. Operating activity. Significant noncash investing and financing activities. Financing activity.
(g) Operating activity. (h) Financing activity. (i) Significant noncash investing and financing activities. (j) Financing activity. (k) Investing activity. (l) Operating activity.
LO: 2, 3, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
18. Examples of noncash transactions are (1) issuance of stock for noncash assets, (2) issuance of stock to liquidate debt, (3) issuance of bonds or notes for noncash assets, and (4) noncash exchanges of property, plant, and equipment. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
19. Cash flows from operating activities Net income ..................................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Gain on redemption of bonds payable ..................................... Cash flows from financing activities Redemption of bonds payable ........................................................
XXXX $ (120,000) $(1,880,000)
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
20. Arguments for the indirect or reconciliation method are: (a) By providing a reconciliation between net income and net cash provided by operating activities, the differences are highlighted. (b) The direct method is nothing more than a cash basis income statement which will confuse and create uncertainty for financial statement users who are familiar with the accrual-based income statements. (c) There is some question as to whether the direct method is cost/benefit-justified as this method would probably lead to additional preparation cost because the financial records are not maintained on a cash basis. LO: 3, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
21. A worksheet is desirable because it allows the orderly accumulation and classification of data that will appear on the statement of cash flows. It is an optional but efficient device that aids in the preparation of the statement of cash flows. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Knowledge, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 22.1 (a) (b) (c) (d) (e) (f)
P-I A R-F A R-I R-I, D
(g) (h) (i) (j) (k) (l)
P-F D P-I A D R-F
(m) (n) (o) (p) (q) (r)
N D R-F P-F R-I, A P-F
LO: 1, Bloom: C, Difficulty: Moderate, Time: 3-5, AACSB: Knowledge,, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.2 Cash flows from investing activities Sale of land .................................................................... Purchase of equipment ................................................ Purchase of available-for-sale securities .................... Net cash used by investing activities ..........................
$ 180,000 (415,000) (59,000) $(294,000)
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.3 Cash flows from financing activities Issuance of common stock .......................................... Issuance of bonds payable .......................................... Payment of dividends ................................................... Purchase of treasury stock .......................................... Net cash provided by financing activities ................... LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$ 250,000 510,000 (350,000) (46,000) $ 364,000
Brief Exercise 22.4 Cash flows from operating activities Cash received from customers ($200,000 – $12,000) ..................................... Cash payments: To suppliers ($120,000 + $11,000 – $13,000) ............. For operating expenses ($50,000 – $21,000) ............................... Net cash provided by operating activities .....
$188,000 $118,000 29,000
147,000 $ 41,000
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.5 Cash flows from operating activities Net income ......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ................................ Increase in accounts payable ................... Increase in accounts receivable ............... Increase in inventory ................................. Net cash provided by operating activities .......
$30,000
$21,000 13,000 (12,000) (11,000)
11,000 $41,000
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.6 Sales revenue............................................................. Add: Decrease in accounts receivable ($72,000 – $54,000) .......................................... Cash receipts from customers.................................. LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$420,000 18,000 $438,000
Brief Exercise 22.7 Cost of goods sold.................................................... Add: Increase in inventory ($113,000 – $95,000) ... Purchases .................................................................. Deduct: Increase in accounts payable ($69,000 – $61,000) .................................... Cash payments to suppliers ....................................
$500,000 18,000 518,000 8,000 $510,000
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.8 Net cash provided by operating activities ................. Net cash used by investing activities ........................ Net cash provided by financing activities ................. Net increase in cash ................................................... Cash, 1/1/25 ................................................................. Cash, 12/31/25 .............................................................
$531,000 (963,000) 585,000 153,000 333,000 $486,000
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.9 (a)
Cash flows from operating activities Cash received from customers ..................... Cash payments for expenses ($60,000 – $1,840)....................................... Net cash provided by operating activities ............................................
$90,000* 58,160 $31,840
*[$100,000 – ($29,000 - $20,000) - $1,000] (b)
a
Cash flows from operating activities Net income ..................................................... Increase in net accounts receivable ($26,960a – $18,800b) .................................. Net cash provided by operating activities ............................................
($29,000 – $2,040)
b
($20,000 – $1,200)
LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$40,000 (8,160) $31,840
Brief Exercise 22.10 Cash flows from operating activities Net income ............................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ...................................... $17,000) Increase in accounts payable ......................... 12,300) Increase in accounts receivable ..................... (11,000) Increase in inventory ....................................... (7,400) Net cash provided by operating activities .............
$50,000
10,900 $60,900
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.11 Cash flows from operating activities: Net loss..................................................................... ($70,000) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation expense ...................................... $81,000) Increase in accounts receivable ..................... (8,100) 72,900 Net cash provided by operating activities ............. $ 2,900 LO: 2 4, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Brief Exercise 22.12 (a)
Land…………………………………………………… Common Stock (1,000 x $1) ........................ Paid-in Capital in Excess of Par— Common Stock .......................................
(b)
No effect
(c)
Noncash investing and financing activities: Purchase of land through issuance of common stock ..........................................
40,000
LO: 4, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
10,000 30,000
$40,000
Brief Exercise 22.13 (a) Operating—Net Income ........................................ Retained Earnings .......................................
317,000
(b) Retained Earnings ................................................ Financing—Cash Dividends ........................
120,000
(c) Equipment ............................................................. Investing—Purchase of Equipment ............
114,000
(d) Investing—Sale of Equipment .............................. Accumulated Depreciation—Equipment ............. Equipment .................................................... Operating—Gain on Sale of Equipment .....
10,000 32,000
317,000 120,000 114,000
*$10,000 – ($40,000 – $32,000) LO: 5, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
40,000 2,000*
Solutions to Exercises Exercise 22.1 (10–15 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)
Investing activity. Financing activity. Investing activity. Operating—add to net income. Significant noncash investing and financing activity. Financing activity. Operating—add to net income. Financing activity. Significant noncash investing and financing activity. Financing activity. Operating—deduct from net income. Operating—add to net income.
LO: 1, 4 Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.2 (20–30 minutes) (a)
Plant assets (cost) Accumulated depreciation ([$20,000 10] X 6) Book value at date of sale Sale proceeds Loss on sale
$20,000) 12,000) 8,000) (5,300) $ 2,700)
The loss on sale of plant assets is reported in the operating activities section of the statement of cash flows. It is added to net income to arrive at net cash provided by operating activities. The sale proceeds of $5,300 are reported in the investing activities section of the statement of cash flows as follows: Sale of plant assets (b)
$5,300
Shown in the financing activities section of a statement of cash flows as follows: Sale of common stock ($43 x 10,000)
$430,000
Exercise 22.2 (Continued) (c)
The write-off of the uncollectible accounts receivable of $27,000 is not reported on the statement of cash flows. The write-off reduces the Allowance for Doubtful Accounts balance and the Accounts Receivable balance. It does not affect cash flows. Note to instructor: The change in net accounts receivable is sometimes used to compute an adjustment to net income under the indirect method.
(d)
The net loss of $50,000 should be reported in the operating activities section of the statement of cash flows. Depreciation of $22,000 is reported in the operating activities section of the statement of cash flows. The gain on sale of land also appears in the operating activities section of the statement of cash flows. The proceeds from the sale of land of $39,000 are reported in the investing activities section of the statement of cash flows. These four items might be reported as follows: Cash flows from operating activities Net loss $(50,000) Adjustments to reconcile net income to net cash used in operating activities*: Depreciation expense $22,000 Gain on sale of land (9,000) *Either net cash used or provided depending upon other adjustments. Given only the adjustments in (d), the “net cash used” should be employed. Cash flows from investing activities Sale of land
$39,000
(e)
The purchase of the U.S. Treasury bill is not reported in the statement of cash flows. This instrument is considered a cash equivalent and therefore cash and cash equivalents have not changed as a result of this transaction.
(f)
Patent amortization of $20,000 is reported in the operating activities section of the statement of cash flows. It is added to net income in arriving at net cash provided by operating activities.
Exercise 22.2 (Continued) (g)
The exchange of common stock for an investment in Tabasco is reported as a “noncash investing and financing activity.” It is shown as follows: Noncash investing and financing activities Purchase of investment by issuance of common stock
(h)
$900,000
The purchase of treasury stock for $47,000 is reported as a cash payment in the financing activities section of the statement of cash flows.
LO: 1, 2, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 22.3 (15–25 minutes) VINCE GILL COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Decrease in accounts receivable Decrease in inventory* Increase in prepaid expenses Decrease in accounts payable Decrease in accrued expenses payable Net cash provided by operating activities
$1,050,000 $ 60,000 360,000 300,000 (170,000) (275,000) (100,000)
*(Beginning Inventory, $1,900,000 – Ending Inventory, $1,600,000) LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
175,000 $1,225,000
Exercise 22.4 (20–30 minutes) VINCE GILL COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Cash receipts from customers Cash payments: To suppliers For operating expenses Net cash provided by operating activities
$7,260,000 (a) $4,675,000 (b) 1,360,000 (c)
$1,225,000
Computations: (a) Cash receipts from customers Sales revenue Add: Decrease in accounts Add: receivable Cash receipts from customers (b)
(c)
$6,900,000 360,000 $7,260,000
Cash payments to suppliers Cost of goods sold Deduct: Decrease in inventories Purchases Add: Decrease in accounts Add: payable Cash payments to suppliers Cash payments for operating Expenses Operating expenses, exclusive of depreciation Add: Increase in prepaid Add: expenses Add: Decrease in accrued Add: expenses payable Cash payments for operating expenses
6,035,000
$4,700,000 300,000 4,400,000 275,000 $4,675,000
$1,090,000* $170,000 100,000
270,000 $1,360,000
*$450,000 + ($700,000 – $60,000) LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.5 (20–30 minutes)
KRAUSS COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Cash receipts from customers Cash payments: For operating expenses For income taxes Net cash provided by operating activities (a)
(b)
(c)
$857,000 (a) $614,000 (b) 44,500 (c)
Computation of cash receipts from customers: Service revenue Add: Decrease in accounts receivable Add: ($54,000 – $37,000) Cash receipts from customers Computation of cash payments: Operating expenses per income statement Deduct: Increase in accounts payable Deduct: ($41,000 – $31,000) Cash payments for operating expenses Income tax expense per income statement Add: Decrease in income taxes payable Add: ($8,500 – $4,000) Cash payments for income taxes
658,500 $198,500
$840,000 17,000 $857,000
$624,000 10,000 $614,000 $ 40,000 4,500 $ 44,500
LO: 3, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.6 (15–20 minutes) KRAUSS COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of equipment Decrease in accounts receivable Increase in accounts payable Decrease in income taxes payable Net cash provided by operating activities
$90,000 $60,000 26,000 17,000 10,000 (4,500)
108,500 $198,500
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.7 (15–20 minutes) Situation A: Cash flows from operating activities Cash receipts from customers ($200,000 – $71,000) Cash payments for operating expenses ($110,000 – $29,000) Net cash provided by operating activities Situation B: (a) Computation of cash payments to suppliers Cost of goods sold Plus: Increase in inventory Decrease in accounts payable Cash payments to suppliers (b) Computation of cash payments for operating expenses Operating expenses Deduct: Decrease in prepaid expenses Increase in accrued expenses payable Cash payments for operating expenses LO3, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$129,000 81,000 $ 48,000
$310,000 26,000 17,000 $353,000
$230,000 8,000 11,000 $211,000
Exercise 22.8 (20–30 minutes) Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Gain on sale of investment [($200 – $145) X 100] Decrease in accounts receivable Income from equity method investment ($27,000 X 0.40) Dividends from equity method investment ($2,000 X 0.40) Net cash provided by operating activities
$145,000
$39,000 (5,500) 12,000 (10,800) 800
35,500 $180,500
Other comments: No. 1 is shown as a cash inflow from the issuance of treasury stock and cash outflow for the purchase of treasury stock, both financing activities. No. 2 is shown as a cash inflow from investing activities of $20,000 and the gain of $5,500 is deducted from net income in the operating activities section. No. 3 is a noncash expense (bad debt expense) in the income statement. Bad debt expense is not handled separately when using the indirect method. It is part of the change in net accounts receivable. No. 4 is a significant noncash investing and financing activity. No. 7 (dividends received) is added to net income. Another alternative is to net the company’s pro-rata share of the dividend against the income from equity method investment amount reported in the cash flows from operating activities. No. 8 is not shown on a statement of cash flows. LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 22.9 (20–30 minutes) (a)
(b)
(c)
(d)
(e)
Sales revenue Deduct: Increase in accounts receivable, net of write-offs [$33,000 – ($30,000 – $4,800)] Cash collected from customers
$538,800
Cost of goods sold Deduct: Decrease in inventory ($47,000 – $31,000) Purchases Deduct: Increase in accounts payable ($25,000 – $15,500) Cash payments to suppliers
$250,000 16,000 234,000 9,500
Interest expense Deduct: Decrease in unamortized bond discount ($5,000 – $4,500) Cash paid for interest
$4,300 500
Income tax expense Add: Decrease in income taxes payable ($29,100 – $21,000) Deduct: Increase in deferred tax liability ($5,300 – $4,600) Cash paid for income taxes
$20,400 8,100
Selling expenses Deduct: Depreciation ($1,500* X 1/3) Bad debt expense Cash paid for selling expenses
$141,500
7,800 $531,000
$224,500
$3,800
700 $27,800
$ 500 5,000
*($16,500 – $15,000) LO: 3 4, Bloom: AP, Difficulty: Complex, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
5,500 $136,000
Exercise 22.10 (25–35 minutes) (a) The solution can be determined through the use of a T-account for Property, Plant, and Equipment. Property, Plant & Equipment 12/31/24 Equipment from exchange of B/P Payments for purchase of PP&E
247,000 20,000 ?
12/31/25
277,000
45,000 Equipment sold
Payments = $277,000 + $45,000 – $247,000 – $20,000 = $55,000 GAAP indicates that investing activities include the acquisition and disposition of long-term productive assets. Accordingly, the purchase of property, plant, and equipment is an investing activity. Note that the acquisition of property, plant, and equipment in exchange for bonds payable would be disclosed as a noncash investing and financing activity. (b) The solution can be determined through the use of a T-account for Accumulated Depreciation. Accumulated Depreciation
Equipment sold
167,000 33,000
12/31/24 Depreciation expense
178,000
12/31/25
?
Accumulated depreciation on equipment sold = $167,000 + $33,000 – $178,000 = $22,000 The entry to reflect the sale of equipment is: Cash (proceeds from sale of equipment) ($45,000 + $14,500 – $22,000) Accumulated Depreciation Property, Plant, and Equipment Gain on Sale of Equipment
37,500 22,000 45,000 14,500
(given) (given)
Exercise 22.10 (Continued) The proceeds from the sale of equipment of $37,500 are considered an investing activity. Investing activities include the acquisition and disposition of long-term productive assets. (c) The cash dividends paid can be determined by analyzing T-accounts for Retained Earnings and Dividends Payable. Retained Earnings Dividends declared
?
91,000 31,000
12/31/24 Net income
104,000
12/31/25
Dividends declared = $91,000 + $31,000 – $104,000 = $18,000 Dividends Payable
Cash dividends paid
5,000 18,000
12/31/24 Dividends declared
8,000
12/31/25
?
Cash dividends paid = $5,000 + $18,000 – $8,000 = $15,000 Financing activities include all cash flows involving liabilities and stockholders’ equity other than operating items. Payment of cash dividends is thus a financing activity. (d) The redemption of bonds payable amount is determined by setting up a T-account. Bonds Payable
Redemption of B/P
46,000 20,000
12/31/24 Issuance of B/P for PP&E
49,000
12/31/125
?
Exercise 22.10 (Continued) The problem states that there was no amortization of bond premium or discount; thus, the redemption of bonds payable is the only change not accounted for. Redemption of bonds payable = $46,000 + $20,000 – $49,000 = $17,000 Financing activities include all cash flows involving liabilities and stockholders’ equity other than operating items. Therefore, the redemption of bonds payable is a financing activity. LO: 1, 4, Bloom: AP, Difficulty: Complex, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Exercise 22.11 (30–35 minutes) PAT METHENY COMPANY STATEMENT OF CASH FLOWS For the Year Ended December 31, 2025 (Indirect Method) Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ($1,200 – $1,170) Gain on sale of investments Decrease in inventory Increase in accounts payable Increase in accounts receivable Decrease in accrued liabilities Net cash provided by operating activities Cash flows from investing activities Sale of investments [($1,420 – $1,300) + $80] Purchase of plant assets [($1,900 – $1,700) – $70] Net cash provided by investing activities Cash flows from financing activities Issuance of capital stock [($1,900 – $1,700) – $70] Redemption of bonds payable Payment of cash dividends Net cash used by financing activities
$ 810 $ 30 (80) 300 300 (450) (50)
50 860
200 (130) 70 130 (150) (260) (280)
Net increase in cash Cash, January 1, 2025 Cash, December 31, 2025
650 1,150 $1,800
Noncash investing and financing activities Issuance of common stock for plant assets
$
LO: 2, Bloom: AP, Difficulty: Complex, Time: 30-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
70
Exercise 22.12 (20–30 minutes) PAT METHENY COMPANY STATEMENT OF CASH FLOWS For the Year Ended December 31, 2025 (Direct Method) Cash flows from operating activities Cash receipts from customers Less: Cash paid to suppliers Cash paid for selling/administrative expenses Cash paid for income taxes Net cash provided by operating activities Cash flows from investing activities Sale of investments [($1,420 – $1,300) + $80] Purchase of plant assets [($1,900 – $1,700) – $70] Net cash provided by investing activities Cash flows from financing activities Issuance of capital stock [($1,900 – $1,700) – $70] Redemption of bonds payable Payment of cash dividends Net cash used by financing activities
$6,450* $4,100** 950*** 540 5,590 860
200 (130) 70 130 (150) (260) (280)
Net increase in cash Cash, January 1, 2025 Cash, December 31, 2025
650 1,150 $1,800
Noncash investing and financing activities Issuance of common stock for plant assets
$
*$6,900 – $450 **$4,700 – $300 - $300 ***$930 - $30 + $50 LO3, Bloom: AP, Difficulty: Complex, Time: 20-30, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
70
Exercise 22.13 (30–40 minutes) BRECKER INC. STATEMENT OF CASH FLOWS For the Year Ended December 31, 2025 Cash flows from operating activities Cash received from customers Less cash payments: To suppliers $149,000b For operating expenses 89,000c For interest 11,400c For income taxes 8,750d Net cash provided by operating activities Cash flows from investing activities Sale of equipment [($20,000 X 30%) + $2,000] Purchase of equipment Purchase of investments Net cash used by investing activities
8,000 (44,000) (17,000)
Cash flows from financing activities Principal payment on short-term loan Principal payment on long-term loan Dividend payments Net cash used by financing activities
(2,000) (9,000) (6,000)
258,150a 69,000a
(53,000)
(17,000)
Net decrease in cash Cash, January 1, 2025 Cash, December 31, 2025
(1,000) 7,000 $ 6,000
a
Sales revenue – Increase in accounts receivable Cash received from customers
$338,150 11,000 $327,150
b
$175,000 6,000 20,000 $149,000
Cost of goods sold – Increase in accounts payable – Decrease in inventories Cash payments to suppliers
$327,150a
Exercise 22.13 (Continued) c
Operating expenses + Increase in prepaid rent – Depreciation expense $35,000 – [$25,000 – ($20,000 X .70)] – Amortization of copyrights – Increase in salaries and wages payable Cash paid for operating expenses
$120,000 1,000 24,000 4,000 4,000 $ 89,000
d
Income tax expense + Decrease in income taxes payable Cash payments for income taxes
$6,750 2,000 $8,750
LO: 3, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.14 (30–40 minutes) BRECKER INC. STATEMENT OF CASH FLOWS For the Year Ended December 31, 2025 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Amortization of copyright Gain on sale of equipment Decrease in inventory Increase in salaries and wages payable Increase in accounts payable Increase in prepaid rent Increase in accounts receivable Decrease in income taxes payable Net cash provided by operating activities Cash flows from investing activities Sale of equipment [($20,000 X .30) + $2,000] Purchase of equipment [$154,000 – ($130,000 $20,000)] Purchase of investments Net cash used by investing activities
$27,000 $24,000* 4,000 (2,000) 20,000 4,000 6,000 (1,000) (11,000) (2,000)
42,000 69,000
8,000 (44,000) (17,000) (53,000)
Exercise 22.14 (Continued) Cash flows from financing activities Principal payment on short-term loan Principal payment on long-term loan Dividend payments Net cash used by financing activities
(2,000) (9,000) (6,000)
Net decrease in cash Cash, January 1, 2025 Cash, December 31, 2025
(17,000) (1,000) 7,000 $ 6,000
Supplemental disclosures of cash flow information: Cash paid during the year for: Interest Income taxes
$11,400 8,750**
*$35,000 – [$25,000 – ($20,000 X 70%)] **[$6,750 + ($6,000 - $4,000)] LO: 2, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.15 (25–35 minutes) ALEE COMPANY STATEMENT OF CASH FLOWS For the Year Ended December 31, 2025 Cash flows from operating activities Net income $ 46,000* Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 20,000 Loss on sale of investments 9,000** Loss on sale of plant assets 2,000 Increase in current assets other than cash (25,000) Increase in current liabilities 18,000 24,000 Net cash provided by operating activities 70,000
Exercise 22.15 (Continued) Cash flows from investing activities Sale of plant assets Sale of investments Purchase of plant assets Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable Payment of dividends Net cash provided by financing activities Net increase in cash Cash balance, January 1, 2025 Cash balance, December 31, 2025 *Net income $57,000 – $9,000 – $2,000 = $46,000 ** $43,000 - $34,000 ***Supporting computation (purchase of plant assets) Plant assets, December 31, 2024 Less: Plant assets sold Plant assets, December 31, 2025 Plant assets purchased during 2025
8,000 34,000 (170,000)*** (128,000) 75,000 (10,000) 65,000 7,000 8,000 $15,000
$215,000 50,000 165,000 335,000 $170,000
LO: 2, Bloom: AP, Difficulty: Complex, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.16 (30–40 minutes) (a)
Computation of net cash provided (used) by operating activities: Net income ($8,000 + $10,000) – $5,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of equipment ($6,000 – $3,000) Increase in accounts receivable ($55,000 – $45,000) Increase in inventory ($65,000 – $45,000)
$13,000 $14,000* 3,000 (10,000) (20,000)
Exercise 22.16 (Continued) Decrease in prepaid expenses ($15,000 – $25,000) Increase in accounts payable ($65,000 – $52,000) Decrease in accrued expenses ($15,000 – $18,000) Net cash provided by operating activities
10,000 13,000 (3,000) 7,000 $20,000
*[$18,000 + ($10,000 – $6,000)] – $8,000 (b)
Computation of net cash provided (used) by investing activities: Sale of equipment Purchase of equipment [$90,000 – ($75,000 – $10,000)] Net cash used by investing activities
$ 3,000 (25,000) $(22,000)
(c) Computation of net cash provided (used) by financing activities: Cash dividends paid Payment of notes payable Issuance of bonds payable Net cash used by financing activities
$(10,000) (23,000) 30,000 $ (3,000)
LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.17 (30–40 minutes) (a)
JOBIM INC. STATEMENT OF CASH FLOWS For the Year Ended December 31, 2025
Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Gain on sale of investments Net cash provided by operating activities Cash flows from investing activities Purchase of land Sale of investments Net cash provided by investing activities Cash flows from financing activities Payment of dividends Redemption of bonds payable Issuance of common stock Net cash used by financing activities Net increase in cash Cash, January 1, 2025 Cash, December 31, 2025 Noncash investing and financing activities Issuance of bonds for land
$35,250 $13,500 (2,000)
11,500 46,750
(9,000) 12,875 3,875 (9,375) (15,000) 10,000 (14,375) 36,250 8,500 $44,750
$22,500
Exercise 22.17 (Continued)
(b)
JOBIM INC. BALANCE SHEET December 31, 2025 Assets
Cash Current assets other than cash Investments Plant assets (net) Land
$ 44,750 29,000 9,125a 54,000 71,500b $208,375
Equities Current liabilities $ 15,000 Long-term notes payable 25,500 Bonds payable 32,500c Common stock 85,000 Retained earnings 50,375d $208,375
$20,000 – ($12,875 – $2,000) $40,000 + $9,000 + $22,500 c $25,000 – $15,000 + $22,500 d $24,500 + $35,250 – $9,375 a
b
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.18 (25–30 minutes) ANITA BAKER COMPANY Statement of Cash Flows (partial) For the Year Ended December 31, 2025 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of equipment Net cash provided by operating activities
$ 40,000 $16,800 5,800
22,600 62,600
Exercise 22.18 (Continued) Cash flows from investing activities Purchase of equipment Sale of equipment [($56,000 – $25,200) – $5,800] Major repairs on equipment Cost of equipment constructed Net cash used by investing activities
(62,000) 25,000 (21,000) (48,000) (106,000)
Cash flows from financing activities Payment of cash dividends
(15,000)
Decrease in cash Cash, January 1, 2025 Cash, December 31, 2025
(58,400) xxx $ xxx
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Exercise 22.19 (20–25 minutes) Retained Earnings ........................................................... Financing—Cash Dividends...................................
15,000
Operating—Net Income ................................................... Retained Earnings ..................................................
40,000
Operating—Depreciation Expense ................................. Accumulated Depreciation—Equipment ...............
16,800
Equipment ........................................................................ Investing—Purchase of Equipment ....................... Investing—Construction of Equipment .................
110,000
Accumulated Depreciation—Equipment ........................ Investing—Major Repairs to Equipment ...............
21,000
Operating—Loss on Sale of Equipment ......................... Accumulated Depreciation—Equipment ........................ Investing—Sale of Equipment......................................... Equipment ...............................................................
5,800 25,200 25,000
15,000
40,000
16,800
62,000 48,000
21,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
56,000
Exercise 22.20 (20–25 minutes) 1.
2.
3.
4.
5.
Bonds Payable ...................................................... Common Stock ............................................ (Noncash financing activity)
300,000
Operating—Net Income ........................................ Retained Earnings .......................................
410,000
Operating—Depreciation Expense ...................... Accumulated Depreciation—Buildings ......
90,000
Accumulated Depreciation—Equipment ............. Equipment ............................................................. Operating—Gain on Disposal of Plant Assets .............................................. Investing—Purchase of Equipment ............
30,000 10,000
Retained Earnings ................................................ Dividends Payable .......................................
123,000
300,000
410,000
90,000
6,000 34,000
LO: 5, Bloom: AP, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
123,000
Exercise 22.21 (45–55 minutes) STEVIE WONDER CORPORATION WORKSHEET FOR PREPARATION OF STATEMENT OF CASH FLOWS For the Year Ended December 31, 2025
Debits Cash Short-term investments Accounts receivable Prepaid expenses Inventory Land Buildings Equipment Equipment (Delivery) Patents Total debits Credits Accounts payable Notes payable Accrued payables Allowance for doubtful Accounts Accum. depr.—bldg. Accum. depr.—equip. Accum. depr. Mortgage payable Bonds payable Common stock Paid-in capital in excess of par Retained earnings Total credits
Balance at 12/31/24 $ 21,000 19,000 45,000 2,500 65,000 50,000 73,500 46,000 39,000 ______ 0 $361,000
2025 Balance Reconciling Items at Debit Credit 12/31/25 (17) $ 4,500 $ 16,500 (2)
$ 6,000 (3)
(4) (5)
1,700 16,500
(10) (11)
51,500 7,000
(12)
15,000
$ 16,000
(6)
25,000 2,000 43,000 4,200 81,500 50,000 125,000 53,000 39,000 15,000 $452,200
$10,000 $ 26,000
6,000 (7) 4,600 (8)
$ 2,000 1,600
4,000 3,000
2,000 (3) 23,000 15,500 20,500 53,400 62,500 (16) 102,000
200
1,800 30,000 19,000 22,000 73,000 50,000 140,000
4,000 51,500 (9) $361,000
(13) (13) (13) (14)
7,000 3,500 1,500 19,600
(15)
38,000
(15) 15,000 (1)
6,000 36,900
12,500
10,000 73,400 $452,200
Exercise 22.21 (Continued) Statement of Cash Flows Effects Operating activities Net income Dec. in accounts receivable (net) Inc. in prepaid expenses Inc. in inventory Inc. in accounts payable Dec. in notes payable Dec. in accrued payables Depreciation expense
(1)
36,900*
(3)
1,800
(6) (13)
1,700 16,500
(7) (8)
2,000 1,600
(2) (10) (11) (12)
6,000 51,500 7,000 15,000
(9)
15,000
(16)
12,500 128,800
10,000 12,000
Investing activities Purchase of investments Purchase of building Purchase of equipment Purchase of patents Financing activities Payment of cash dividends Issuance of mortgage payable (14) Sale of stock (15) Redemption of bonds Totals Decrease in cash (17) Totals
(4) (5)
19,600 44,000 124,300 4,500 $128,800
$128,800
*[($73,400 – $51,500) + $15,000] LO: 5, Bloom: AP, Difficulty: Moderate, Time: 45-55, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Time and Purpose of Problems Problem 22.1 (Time 40–45 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the indirect method. Problem 22.2 (Time 50–60 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows, including a schedule of noncash investing and financing activities. The student is required to prepare the statement using the indirect method and consider the proper treatment of an unusual item. Problem 22.3 (Time 50–60 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the direct method. Problem 22.4 (Time 45–60 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the direct method, including a reconciliation schedule. Problem 22.5 (Time 50–65 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows, including the treatment accorded unusual items. The student is required to prepare the statement using the indirect method and include any supporting schedules or computations. Problem 22.6 (Time 40–50 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the indirect method. The student also must calculate the net cash flow from operating activities using the direct method. Problem 22.7 (Time 30–40 minutes) Purpose—Using comparative financial statement data, the student is required to prepare the statement of cash flows, using the direct method. The student must also prepare the operating activities section of the statement of cash flows using the indirect method. Problem 22.8 (Time 30–40 minutes) Purpose—to develop an understanding of both the direct and indirect method. The student is first asked to compute net cash provided by operating activities under the direct method. In addition, a statement of cash flows using the indirect method must be prepared. Problem 22.9 (Time 30–40 minutes) Purpose—to develop an understanding of the indirect method. In the second part, the student is asked to determine how operating, investing and financing sections of the statement of cash flows will change in various situations.
Solutions to Problems Problem 22.1 SULLIVAN CORP. Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Net income ................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation ......................................... Gain on sale of equipment .................. Equity in earnings of Myers Co. ......... Decrease in accounts receivable ....... Increase in inventory ........................... Increase in accounts payable ............. Decrease in income taxes payable ..... Net cash provided by operating activities ...................................................
$370,000
$147,000 (a) (2,000) (b) (35,000) (c) 40,000 (135,000) 60,000 (20,000)
425,000
Cash flows from investing activities: Proceeds from sale of equipment .............. Loan to TLC Co. ........................................... Principal payment of loan receivable ......... Net cash used by investing activities ........
40,000 (300,000) 50,000
Cash flows from financing activities: Dividends paid ............................................. Net cash used by financing activities ........
(100,000)
Net increase in cash ............................................ Cash, January 1, 2025 .......................................... Cash, December 31, 2025 ....................................
55,000
(210,000)
(100,000) 115,000 700,000 $815,000
Problem 22.1 (Continued) Schedule at bottom of statement of cash flows: Noncash investing and financing activities: Issuance of capital lease liability for office building ..............................................
$400,000
Explanation of Amounts (a) Depreciation Net increase in accumulated depreciation for the year ended December 31, 2025 ................................. Accumulated depreciation on equipment sold: Cost .............................................................. Carrying value .............................................. Depreciation for 2025 ..........................................
$125,000 $60,000 (38,000)
22,000 $147,000
(b) Gain on sale of equipment Proceeds ...................................................... Carrying value .............................................. Gain .........................................................
$ 40,000 (38,000) $ 2,000
(c) Equity in earnings of Myers Co. Myers’s net income for 2025 ....................... Sullivan’s ownership ................................... Undistributed earnings of Myers Co...
$140,000 X 25% $ 35,000
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 40-45, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Problem 22.2 HINCKLEY CORPORATION Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Net income...................................................... Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment .................... Gain from flood damage ........................ Depreciation expense ............................ Patent amortization ................................ Gain on sale of investments .................. Increase in accounts receivable (net) ... Increase in inventory ............................. Increase in accounts payable ................ Net cash provided by operating activities ....
$14,750 (a)
$ 4,100 (b) (8,250)* 1,900 (c) 1,250 (1,700) (3,750)** (3,000) 2,000
Cash flows from investing activities Sale of investments ....................................... Sale of equipment .......................................... Purchase of equipment.................................. Proceeds from flood damage to building ..... Net cash provided by investing activities ....
4,700 2,500 (20,000) (d) 32,000
Cash flows from financing activities Payment of dividends .................................... Payment of short-term note payable ............ Net cash used by financing activities ...........
(5,000) (1,000)
Increase in cash ..................................................... Cash, January 1, 2025 ............................................ Cash, December 31, 2025 ...................................... *($30,000 + $2,000) – ($29,750 – $6,000) **($12,250 – $3,000) – ($10,000 – $4,500)
(7,450) 7,300
19,200
(6,000) 20,500 13,000 $33,500
Problem 22.2 (Continued) Supplemental disclosures of cash flow information: Cash paid during the year for: Interest Income taxes:
$2,000 $6,500
Noncash investing and financing activities Retired notes payable by issuing common stock Purchased equipment by issuing notes payable
$10,000 16,000 $26,000
Supporting Computations: (a) Ending retained earnings ..................................... Beginning retained earnings ............................... Net income ............................................................
$20,750 (6,000) $14,750
(b) Cost ....................................................................... Accumulated depreciation (40% X $11,000) ....... Book value ............................................................ Proceeds from sale............................................... Loss on sale ..........................................................
$11,000 (4,400) 6,600 (2,500) $ 4,100
(c) Accumulated depreciation on equipment sold... Decrease in accumulated depreciation ............... Depreciation expense...........................................
$ 4,400 (2,500) $ 1,900
(d) Beginning equipment balance ............................. Cost of equipment sold ........................................ Remaining balance ............................................... Purchase of equipment with note........................ Adjusted balance .................................................. Ending equipment balance .................................. Purchased with cash ............................................
$20,000 (11,000) 9,000 16,000 25,000 (45,000) $20,000
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 50-60, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Problem 22.3 MORTONSON COMPANY Statement of Cash Flows For the Year Ended December 31, 2025 ($000 Omitted) Cash flows from operating activities Cash receipts from customers ...................... Cash payments for: Payments for merchandise ....................... $1,270 (b) Salaries and benefits ................................. 725 Heat, light, and power................................ 75 Property taxes ............................................ 19 Interest........................................................ 30 Miscellaneous ............................................ 10 Income taxes .............................................. 808 (c) Net cash provided by operating activities .... Cash flows from investing activities Sale of investments ........................................ Purchase of buildings and equipment .......... Purchase of land ............................................ Net cash used by investing activities ...........
Sales revenue ................................................. Deduct ending accounts receivable .............. Add beginning accounts receivable ............. Cash receipts (collections) from customers ...........................................
2,937 583
40 (310) (80) (350)
Increase in cash ...................................................... Cash, January 1, 2025 ............................................. Cash, December 31, 2025 ....................................... (a)
$3,520 (a)
233 100 $ 333 $3,800 780 3,020 500 $3,520
Problem 22.3 (Continued) (b) Cost of goods sold ..................................... Add ending inventory ................................. Goods available for sale ............................ Deduct beginning inventory ...................... Purchases ................................................... Deduct ending accounts payable .............. Add beginning accounts payable .............. Cash purchases (payments for merchandise) .................................. (c) Income taxes ............................................... Deduct ending income taxes payable ....... Add beginning income taxes payable ....... Income taxes paid .............................
$1,200 720 1,920 560 1,360 420 940 330 $1,270 $818 40 778 30 $808
LO: 3, Bloom: AP, Difficulty: Complex, Time: 50-60, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 22.4 MICHAELS COMPANY Statement of Cash Flows For the Year Ended December 31, 2025 (Direct Method) Cash flows from operating activities Cash receipts: Cash received from customers ..................... $1,152,450a Dividends received ......................................... 2,400 $1,154,850 Cash payments: To suppliers ...................................................... 765,000b For operating expenses ................................... 226,350c For taxes ........................................................... 38,400d For interest........................................................ 57,300e 1,087,050 Net cash provided by operating activities ............... 67,800 Cash flows from investing activities Sale of short-term investments ($8,000 + $4,000) ............................................ Sale of land ($175,000 – $125,000) + $8,000.. Purchase of equipment .................................. Net cash used by investing activities ........... Cash flows from financing activities Proceeds from issuance of common stock .. Principal payment on long-term debt ........... Dividends paid ................................................ Net cash used by financing activities ...........
12,000 58,000 (125,000) (55,000) 27,500 (10,000) (24,300) (6,800)
Net increase in cash ............................................... Cash, January 1, 2025 ............................................. Cash, December 31, 2025 .......................................
$
a
Sales revenue......................................................... – Increase in Accounts Receivable ........................ Cash received from customers ..............................
$1,160,000 7,550 $1,152,450
b
$ 748,000 7,000 10,000 $ 765,000
Cost of Goods Sold ............................................... + Increase in Inventory ........................................... + Decrease in Accounts Payable ........................... Cash paid to suppliers ............................................
6,000 4,000 10,000
Problem 22.4 (Continued) c
Operating expenses ............................................ – Depreciation/Amortization expense ................. – Decrease in prepaid rent ................................... + Increase in prepaid insurance .......................... + Increase in supplies........................................... – Increase in salaries and wages payable........... Cash payments for operating expenses ......
$276,400 (40,500) (9,000) 1,200 250 (2,000) $226,350
d
Income tax expense ........................................... – Increase in income taxes payable .................... Taxes paid ......................................................
$ 39,400 (1,000) $ 38,400
e
$ 51,750 5,550 $ 57,300
Interest expense ................................................ + Decrease in bond premium ............................... Interest paid ................................................... Reconciliation of Net Income to Net Cash Provided by Operating Activities: Net income ............................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation/amortization expense .............. Decrease in prepaid rent ............................... Increase in income taxes payable ................ Increase in salaries and wages payable ...... Increase in accounts receivable ................... Increase in inventory ..................................... Increase in prepaid insurance ...................... Increase in supplies ...................................... Decrease in accounts payable ...................... Gain on sale of land....................................... Gain on sale of short-term investments....... Amortization of bond premium ..................... Total adjustments .................................. Net cash provided by operating activities ..........
$58,850 $40,500 9,000 1,000 2,000 (7,550) (7,000) (1,200) (250) (10,000) (8,000) (4,000) (5,550)
LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 45-60, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
8,950 $67,800
Problem 22.5 ALEXANDER CORPORATION Statement of Cash Flows For the Year Ended December 31, 2025 (Indirect Method) Cash flows from operating activities Net income ........................................................ Adjustments to reconcile net income to net cash used by operating activities: Loss on sale of machinery ....................... Gain on redemption of bonds .................. Depreciation of machinery ....................... Depreciation of building ........................... Amortization of patents ............................ Amortization of copyrights ...................... Amortization of bond discount ................ Amortization of bond premium ................ Equity in earnings of subsidiary ............. Increase in accounts receivable (net)......................................................... Increase in inventory ................................ Increase in prepaid expenses .................. Increase in income taxes payable ........... Increase in accounts payable .................. Net cash used by operating activities ............. Cash flows from investing activities Sale of machinery ............................................. Investment in subsidiary.................................. Addition to buildings ........................................ Major repairs to building .................................. Purchase of machinery .................................... Purchase of patent ........................................... Increase in cash surrender value of life insurance ....................................................... Net cash used by investing activities .............
$115,000*
$
2,200 (4) (1,425) (5) 48,200 (4) 31,200 (8) 10,000 (3) 10,000 87 (6) (75) (5) (10,500) (7)
(121,124) (131,700) (4,000) 10,650 19,280
(137,207) (22,207)
9,000 (4) (100,000) (7) (127,300) (7,200) (8) (33,400) (4) (15,000) (3) (504) (274,404)
Problem 22.5 (Continued) Cash flows from financing activities Redemption of bonds ..................................... Sale of bonds less expense of sale ............... Sale of stock ................................................... Net cash provided by financing activities .....
(100,900) (5) 120,411 (6) 257,000 276,511
Decrease in cash.................................................... Cash, January 1, 2025 ........................................... Cash, December 31, 2025 ...................................... *Net income per retained earnings statement ($25,000 + $90,000).............................................
(20,100) 298,000 $277,900
$115,000
Supplemental disclosures of cash flow information: Cash paid during the year for: Interest ............................................................ Income taxes ................................................... Noncash investing and financing activities Reduction in stated value of stock to eliminate deficit ...........................................
$10,500 $34,000
$425,000
Comments on Numbered Items (1) Write-off of deficit has no effect on cash. Analysis of the Common Stock account shows the following: Balance 12/31/24 ............................................. $1,453,200 Restatement of stated value of stock ............ (425,000) Balance 4/1/25 ................................................. 1,028,200 (2) Sale of 29,600 shares 11/1/25 for $257,000 with stated value of $5 per share................ Balance 12/31/25 .............................................
148,000 $1,176,200
Problem 22.5 (Continued) (3) A patent was purchased for $15,000 cash. The account activity is analyzed as follows: Balance 12/31/24 .................................................. $64,000 Purchase .............................................................. 15,000 Total ...................................................................... 79,000 Balance 12/31/25 .................................................. (69,000) Amortization charged against income which did not use cash ............................................... $10,000 (4) Analysis of the Machinery account shows the following: Balance 12/31/24 .................................................. Disposition of machinery .................................... Total ............................................................. Balance 12/31/25 .................................................. Additions requiring cash............................ Loss on sale: ($16,400 – $5,200) – $9,000 ......................
$2,200
Cash received from disposition .................
$9,000
Analysis of accumulated depreciation— machinery: Balance 12/31/24 of Accumulated Depreciation ..................................... Amount on asset sold ........................ Balance ................................................ Balance 12/31/25 ................................. Depreciation charged against income which did not use cash...................
$190,000 (16,400) 173,600 (207,000) $ (33,400)
$130,000 (5,200) 124,800 (173,000) $ (48,200)
Problem 22.5 (Continued) (5) Funds to redeem bonds ($100,000 X 1.009) ........
$100,900
Face value of bonds ............................................. Unamortized premium 12/31/24 ........................... Amortization to 3/31/25 not requiring cash ($6,000 ÷ 20) X 1/4 .............................................. Balance at date of redemption ..................... Book value of bonds..................................... Gain on redemption ($102,325 – $100,900)................................
$100,000
(6) Face amount of bonds issued ............................. Discount on $125,000 of bonds sold ($125,000 X .03) ................................................. Expense of issuance ............................................ Total.............................................................. Proceeds of issue ................................................. Beginning discount balance ....................... Amortization Expense (9 months, which did not require cash ................................. Change in discount account .......................
$2,400 75 2,325 $102,325 $ (1,425) $125,000 $3,750 839 (4,589) $120,411 $4,589 (87)* $4,502
*($4,589/477 months (a)) X 9 months = $87 (a) (40 years X 12 months) – 3 (7) Purchase of stock requiring cash ....................... 70% of subsidiary’s income for year ($15,000), which did not provide cash but was credited to income...................... Balance 12/31/25 .......................................... (8) Analysis of Accumulated Depreciation— Building Balance of accumulated depreciation 12/31/24 .. Charge for major repairs which used cash ......... Balance 12/31/25 ................................................... Depreciation charged against income which did not require cash ..........................................
$100,000 10,500 $110,500
$400,000 (7,200) 392,800 (424,000) ($ 31,200)
Problem 22-5 (Continued) Comments on Other Items (not required) Increase in cash surrender value of insurance required cash .... Increase in Buildings required cash .............................................. Decrease in Copyrights was a noncash charge against income . Dividends declared did not require cash ......................................
$ 504 127,300 10,000 70,000
Accrued interest on retired bonds and bond issuance does not affect the statement of cash flows. These items are already recorded in income. LO: 2, 4, Bloom: AP, Difficulty: Complex, Time: 50-65, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
Problem 22.6 (a)
Net Cash Flow from Operating Activities Cash received from customers ............................ Cash payments: Cash payments to suppliers ........................... Cash payments for operating expenses ........ Net cash provided by operating activities ........... 1
$540,000 – $10,500 – $4,650* = $524,850
2
$380,000 + $6,000 – $10,250 = $375,750
3
$120,450 – $8,625 – $750** – $5,400 = $105,675
*Write-off of accounts receivable. ($1,500 + $5,400 – $2,250) **Increase in accrued payables
$524,8501 $375,7502 105,6753
481,425 $ 43,425
Problem 22.6 (Continued) (b)
MARCUS INC. Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Net income .................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ........................... Gain on sale of investments ................. Loss on sale of machinery.................... Increase in accounts receivable (net) .. Increase in inventory............................. Increase in accounts payable ............... Increase in accrued payables ............... Net cash provided by operating activities .. Cash flows from investing activities Purchase of investments $22,250 – ($38,500 – $25,000) .................. Purchase of machinery $30,000 – ($18,750 – $3,750) .................... Purchase of buildings .................................. Sale of investments ...................................... Sale of machinery ......................................... Net cash used by investing activities ......... Cash flows from financing activities Reduction in long-term note payable .......... Cash dividends paid ..................................... Net cash used by financing activities .........
$42,500
$ 8,625 (3,750) 800 (9,750)* (6,000) 10,250 750
925 43,425
(8,750) (15,000) (11,250) 28,750 2,200 (4,050) (10,000) (21,125)
Net increase in cash ............................................ Cash, January 1, 2025 ......................................... Cash, December 31, 2025 ................................... *($70,500 – $2,250) – ($60,000 – $1,500) LO: 2, 3, 4, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
(31,125) 8,250 33,750 $42,000
Problem 22.7 (a) Both the direct method and the indirect method for reporting cash flows from operating activities are acceptable in preparing a statement of cash flows according to GAAP; however, the FASB encourages the use of the direct method. Under the direct method, the statement of cash flows reports the major classes of cash receipts and cash disbursements, and FASB requires a separate schedule of reconciliation of net income to net cash flow from operating activities; this may be the statement’s principal advantage. Under the indirect method, net income on the accrual basis is adjusted to the cash basis by adding or deducting noncash items included in net income, thereby providing a useful link between the statement of cash flows and the income statement and balance sheet. (b) The Statement of Cash Flows for Chapman Company, for the year ended May 31, 2025, using the direct method, is presented below. CHAPMAN COMPANY Statement of Cash Flows For the Year Ended May 31, 2025 Cash flows from operating activities Cash received from customers ....................... Cash payments: To suppliers ............................................. $684,000 To employees .......................................... 276,850 For interest .............................................. 73,000 For other expenses ................................. 10,150 For income taxes..................................... 43,000 Net cash provided by operating activities ......
$1,238,250
1,087,000 151,250
Cash flows from investing activities Purchase of plant assets ................................. Cash flows from financing activities Cash received from common stock issue ...... Cash paid: For dividends........................................... To retire bonds payable .......................... Net cash used by financing activities ............. Net increase in cash ................................................. Cash, June 1, 2024 .................................................... Cash, May 31, 2025 ...................................................
(28,000) 20,000 (105,000) (30,000) (115,000)
$
8,250 20,000 28,250
Problem 22.7 (Continued) Note 1:
Noncash investing and financing activities: Issuance of common stock for plant assets $70,000.
Supporting Calculations: Cash collected from customers Sales revenue................................................. Less: Increase in accounts receivable ......... Cash collected from customers ..........
$1,255,250 17,000 $1,238,250
Cash paid to suppliers Cost of goods sold ........................................ Less: Decrease in inventory ......................... Increase in accounts payable ............. Cash paid to suppliers ........................
$ 722,000 30,000 8,000 $ 684,000
Cash paid to employees Salaries and wages expense......................... Add: Decrease in salaries and wages payable ...................................... Cash paid to employees ....................... Cash paid for other expenses Other expenses .............................................. Add: Increase in prepaid expenses .............. Cash paid for other expenses .............. Cash paid for interest Interest expense ............................................ Less: Increase in interest payable ................ Cash paid for interest .......................... Cash paid for income taxes: Income tax expense (given) ..........................
$ 252,100 24,750 $ 276,850
$ $
$
8,150 2,000 10,150
$
75,000 2,000 73,000
$
43,000
Problem 22.7 (Continued) (c) The calculation of the cash flow from operating activities for Chapman Company, for the year ended May 31, 2025, using the indirect method, is presented below. CHAPMAN COMPANY Statement of Cash Flows For the Year Ended May 31, 2025 Cash flows from operating activities Net income ....................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ............................ $25,000 Decrease in inventory ............................ 30,000 Increase in accounts payable................ 8,000 Increase in interest payable .................. 2,000 Increase in accounts receivable ........... (17,000) Increase in prepaid expenses ............... (2,000) Decrease in salaries and wages payable .................................... (24,750) Net cash provided by operating activities...... LO: 2, 3, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
$130,000
21,250 $151,250
Problem 22.8
(a)
Net Cash Provided by Operating Activities Cash receipts from customers Cash payments: To suppliers For operating expenses For income taxes Net cash provided by operating activities
$925,000 (1) $608,000 (2) 226,000 (3) 43,000 (4) 877,000 $ 48,000
(1) (Sales Revenue) less (Increase in Accounts Receivable) $950,000 – $25,000 = $925,000 (2) (Cost of Goods Sold) plus (Increase in Inventory) less (Increase in Accounts Payable) $600,000 + $14,000 – $6,000 = $608,000 (3) (Operating Expenses) less (Depreciation Expense) less (Bad Debt Expense) $250,000 – $22,000* – $2,000 = $226,000 (4) (Income Taxes) less (Increase in Income Taxes Payable) $45,000 – $2,000 = $43,000 *$21,000 – [$14,000 – ($10,000 X .60)] = $13,000 Equipment depreciation $37,000 – $28,000 = 9,000 Building depreciation $22,000
Problem 22.8 (Continued) (b)
SHARPE COMPANY Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income ......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ............................... Gain on sale of investments ..................... Loss on sale of equipment ....................... Increase in accounts receivable (net) ...... Increase in inventory................................. Increase in accounts payable ................... Increase in income taxes payable ............ Net cash provided by operating activities ....... Cash flows from investing activities Purchase of investments [$55,000 – ($85,000 – $35,000)] ..................... Purchase of equipment [$70,000 – ($48,000 – $10,000)] ..................... Sale of investments ($35,000 + $15,000) .......... Sale of equipment [$10,000 – ($10,000 X 60%)] – $3,000 ............ Net cash provided by investing activities ....... Cash flows from financing activities Payment of long-term notes payable ............... Cash dividends paid [($95,000 + $67,000) – $92,000] ..................... Issuance of common stock .............................. Net cash used by financing activities ..............
$67,000
$22,000 (15,000) 3,000 (23,000) (14,000) 6,000 2,000
(19,000) 48,000
(5,000) (32,000) 50,000 1,000 14,000 (8,000) (70,000) 35,000* (43,000)
Net increase in cash .................................................. Cash, January 1, 2025 ............................................... Cash, December 31, 2025 ..........................................
19,000 51,000 $70,000
Noncash investing and financing activities Issuance of common stock for land ................
$15,000
*$310,000 – $260,000 = $50,000; $50,000 – ($40,000 – $25,000) = $35,000 LO: 2, 3, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
Problem 22.9 (a)
DINGEL CORPORATION Statement of Cash Flows For the Year Ended December 31, 2025
Cash flows from operating activities Net income .......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment......................... Gain from flood damage ............................ Depreciation expense................................. Copyright amortization .............................. Gain on sale of investment ........................ Increase in accounts receivable (net) ....... Increase in inventory .................................. Increase in accounts payable .................... Net cash flow provided by operating activities ...
$15,750(a) $ 5,200(b) (13,250)* 800(c) 250 (1,500) (3,750) (2,000) 1,000
Cash flows from investing activities Sale of investments............................................ Sale of equipment .............................................. Purchase of equipment (cash) .......................... Proceeds from flood damage to building ......... Net cash provided by investing activities ........
4,500 2,500 (15,000) 37,000
Cash flows from financing activities Payment of dividends Payment of short-term notes payable Net cash used by financing activities ...............
(5,000) (1,000)
Increase in cash ...................................................... Cash, January 1, 2025 ............................................ Cash, December 31, 2025 ....................................... Supplemental disclosures of cash flow information: Cash paid during the year for: Interest .......................................... $2,000 Income taxes ................................. $5,000 *[($33,000 + $4,000) – ($29,750 – $6,000)]
(13,250) 2,500
29,000
(6,000) 25,500 13,000 $38,500
Problem 22.9 (Continued) Noncash investing and financing activities: Retired note payable by issuing common stock ........ Purchased equipment by issuing notes payable ........
$ 5,000 16,000 $21,000
Supporting Computations: (a) Ending retained earnings ............................................. Beginning retained earnings ........................................ Net income .............................................................
$20,750 (5,000) $15,750
(b) Cost ................................................................................ Accumulated depreciation (.30 X $11,000) .................. Book value ..................................................................... Proceeds from sale ....................................................... Loss on sale ...........................................................
$11,000 (3,300) 7,700 (2,500) $ 5,200
(c) Accumulated depreciation on equipment sold ........... Decrease in accumulated depreciation ....................... Depreciation expense............................................
$ 3,300 (2,500) $ 800
(b) (1) For a severely financially troubled firm: Operating: Investing: Financing:
Probably a small cash inflow or a cash outflow Probably a cash inflow as assets are sold to provide needed cash Probably a cash inflow from debt financing (borrowing funds) as a source of cash at high interest cost
(2) For a recently formed firm which is experiencing rapid growth: Operating: Investing: Financing:
Probably a cash outflow Probably a large cash outflow as the firm expands Probably a large cash inflow to finance expansion
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, AICPA BB: None, AICPA AC: Reporting, AICPA PC: None
UYJ 22.1 Financial Reporting Problem (a)
P&G uses the indirect method to compute and report net cash provided by operating activities. The amounts of net cash provided by operating activities for 2020, 2019, and 2018 are $17,403 million, $15,242 million, and $14,867 million, respectively. The two items most responsible for the increase in cash provided by operating activities in 2020 are the Depreciation and amortization ($3,013) and change in accounts payable, accrued and other liabilities ($1,923).
(b)
The most significant item in the investing activities section is the $6,151 million for “Proceeds from sales and maturities of investment securities.” The most significant item in the financing activities section is the $7,789 million in dividends that P&G paid to shareholders.
(c)
Deferred taxes are reported in the operating activities section of P&G’s statement of cash flows. The $596 million is reported as a decrease to net income because it is a noncash benefit in the income statement.
(d)
Depreciation and amortization are reported in the operating activities section of P&G’s statement of cash flows. It is added back to net income because it is a noncash charge (of $3,013) in the income statement.
LO: 2 4, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 22.2 Comparative Analysis Case (a)
Both Coca-Cola and PepsiCo use the indirect method of computing and reporting net cash provided by operating activities in 2018–2020. (In millions)
Coca-Cola
PepsiCo
Net cash provided by operating activities
$9,844
$10,613
(b) The most significant investing activities items in 2020: Coca-Cola Disposals of investments
$13,835 million
PepsiCo Acquisitions and investments in noncontrolled affiliates $6,372 million The most significant financing activities items in 2020:
(c)
Coca-Cola Payments of debt
$28,796 million
PepsiCo Proceeds from issuance of long-term debt
$13,809 million
The Coca-Cola Company’s net cash provided by operating activities has increased from 2018 to 2020 by $2,217 million ($9,844 - $7,627) or 29.1%. PepsiCo, Inc. has increased net cash provided by operating activities by $1,198 million ($10,613 - $9,415) or 12.7%.
(d) Both Coca-Cola and PepsiCo report depreciation and amortization in the operating activities section: Coca-Cola, $1,536 million PepsiCo, $2,548 million Depreciation and amortization are reported in the operating activities section because it is a noncash charge in the income statement.
Comparative Analysis Case (Continued) (e)
(f)
Coca-Cola
PepsiCo
1.
Current cash debt coverage
$9,844 ($14,601 + $26,973) = 0..47:1 2
$10,613 ($23,372 + $20,461) = 0.48:1 2
2.
Cash debt coverage
$9,844 ($66,012 + $65,283) = 0.15:1 2
$10,613 ($79,366 + $63,679) = 0.15:1 2
The current cash debt coverage ratio uses cash generated from operations during the period and provides a better representation of liquidity on an average day. Both companies have essentially the same result. The cash debt coverage ratio shows a company’s ability to repay all its liabilities from cash generated from operating activities without having to liquidate the assets employed in its operations. Both companies have the same result.
LO: 1, 3, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 22.3 Financial Statement Analysis Case VERMONT TEDDY BEAR CO. (a)
Even though prior year income exceeded the current year income by $821,432 ($838,955 – $17,523), the current year cash flow from operations exceeded prior year’s cash flow from operations by $937,437 [$236,480 – ($700,957).]. This apparent paradox can be explained by evaluating the components of net cash flow from operating activities. Significant contributors to the positive cash flow figure in the current year were (1) the depreciation and amortization add-back of $316,416 versus $181,348 in the prior year, and (2) accounts payable increase of $2,017,059 in the current year versus a decline of $284,567 in the prior year. An increase in accounts payable causes an increase in net cash from operating activities; thus, the majority of the increase in cash is explained by the company’s dramatic increase in accounts payable. An investor or creditor would want to investigate this increase to ensure that the company is not delinquent on its payments. However, it should be noted that inventories did increase by $1,599,014.
(b)
Liquidity: current cash debt coverage ratio (net cash provided by operating activities ÷ average current liabilities) $236,480 ÷ [($4,055,465 + $1,995,600) ÷ 2] = .078:1 Solvency: cash debt coverage (net cash provided by operating activities ÷ average total liabilities) $236,480 ÷ (($4,620,085 + $2,184,386) ÷ 2) = .070:1 Profitability: cash return on sales ratio (net cash provided by operating activities ÷ net sales) $236,480 ÷ $20,560,566 = 1.15% All of these ratios are very low. This is not surprising, however, for a company like the Vermont Teddy Bear Company that may be in the early stages of its life. When a company is in the introductory phase of its main product, it will not typically generate significant net cash flow from operating activities. However, because of the precarious nature of companies in this stage of their lives, the company’s cash position should be monitored closely to ensure that it does not slide into a distressed financial state due to cash shortages.
LO: 1, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
UYJ 22.4 Accounting, Analysis, and Principles
Accounting LASKOWSKI COMPANY Statement of Cash Flows For the Year Ended December 31, 2025 Cash flows from operating activities Net income ............................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ...................................... Loss on sale of machinery .............................. Increase in accounts receivable ...................... Decrease in inventory ...................................... Increase in accounts payable .......................... Net cash provided by operating activities .......... Cash flows from investing activities Sale of machinery ................................................. Purchase of machinery......................................... Net cash used by investing activities ..................
$ 430,000 $ 880,000 24,000 (165,000) 33,000 20,000
792,000 1,222,000
270,000 (750,000) (480,000)
Cash flows from financing activities Payment of cash dividends ..................................
(200,000)
Net increase in cash .................................................. Cash at beginning of period ..................................... Cash at end of period ................................................
542,000 130,000 $ 672,000
Analysis Laskowski’s free cash flow is: Net cash provided by operating activities ...... $1,222,000 Less: Purchase of machinery ......................... 750,000 Dividends ............................................... 200,000 Free cash flow .................................................. $ 272,000
Accounting, Analysis, and Principles (Continued) Laskowski’s free cash flow for the current year ($272,000) is less than the amount needed for expansion next year ($500,000), mostly due to the acquisition of machinery for $750,000. Thus, assuming operations at roughly the same level in future periods, Laskowski’s free cash flow could be sufficient to fund the expansion plan, if the expansion is the only capital investment. The company might explore reducing the dividend or securing additional funds for the expansion through a borrowing. Principles According to Statement of Financial Accounting Concepts No. 8 paragraph 37-OB2-3, "The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit. Decisions by existing and potential investors about buying, selling, or holding equity and debt instruments depend on the returns that they expect from an investment in those instruments; for example, dividends, principal and interest payments, or market price increases. Similarly, decisions by existing and potential lenders and other creditors about providing or settling loans and other forms of credit depend on the principal and interest payments or other returns that they expect. Investors', lenders', and other creditors' expectations about returns depend on their assessment of the amount, timing, and uncertainty of (the prospects for) future net cash inflows to the entity. Consequently, existing and potential investors, lenders, and other creditors need information to help them assess the prospects for future net cash Inflows to an entity." By reporting the cash provided by operations, and the inflows and outflows of cash from investing and financing decisions, the statement of cash flows provides information relevant to assessing a company’s future cash flows. LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, Research, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 22.1 (Time 30–35 minutes) Purpose—to develop an understanding of the proper composition and presentation of the statement of cash flows. The student is required to analyze a statement of sources and application of cash and indicate the proper treatment of various transactions. CT 22.2 (Time 30–35 minutes) Purpose—to illustrate the proper form of the statement of cash flows. The student is required to prepare the statement using the indirect method and to discuss the rationale behind the statement. CT 22.3 (Time 30–35 minutes) Purpose—to help a student identify whether a transaction creates a cash inflow or a cash outflow. The student is required to indicate whether a cash inflow or a cash outflow results from the transaction. The student must also discuss the proper disclosure of the transaction. CT 22.4 (Time 20–30 minutes) Purpose—to help the student identify the sections of the statement of cash flows. The student is required to indicate whether a transaction belongs in the investing, financing, or operating section of the statement. CT 22.5 (Time 30–40 minutes) Purpose—to identify and explain reasons and purposes for preparing a statement of cash flows, to identify the categories of activities reported in the statement of cash flows, to identify and describe the two methods of reporting cash flows from operations, and to describe the presentation of noncash transactions. CT 22.6 (Time 20–30 minutes) Purpose—provides the student with the opportunity to examine the effects of securitization on the statement of cash flows, including ethical dimensions.
Solutions to Critical Thinking CT 22.1 (a) The main purpose of the statement of cash flows is to show the change in cash from one period to the next. Another objective of a statement of the type shown is to summarize the financing and investing activities of the entity, including the extent to which the company has generated cash or near cash assets from operations during the period. Another objective is to complete the disclosure of changes in financial position during the period. The information shown in such a statement is useful to a variety of users of financial statements in making economic decisions regarding the company. (b) The following are weaknesses in form and format of Maloney Corporation’s Statement of Sources and Application of Cash: 1. The title of the statement should be Statement of Cash Flows. 2. The statement should add back to (or deduct from) net income certain items that did not use (or provide) cash during the period. The resulting total should be described as net cash provided by operating activities. The only apparent adjustments in this situation are the amounts to be added back to net income for the depreciation and depletion expense, for any wage or salary expense related to the employee stock option plans, and for changes in current assets and liabilities. 3. The format used should separate the cash flows into investing, financing, and operating activities. Noncash investing and financing activities, if significant, should be shown in a separate schedule or note. 4. Individual items should not be grouped together, as was the case for the $14,000 item. (c) 1. (i) The $25,000 of salaries and wages expense attributable to the stock option plan should be included in the statement as an amount added back to net income, an expense not requiring the outlay of cash during the period. (ii) Since the statement balances and no reference is made to the $25,000 salaries and wages expense, it appears the expense was not recorded or that there is an offsetting error elsewhere in the statement. 2. The expenditures for plant asset acquisitions should not be reported net of the proceeds from plant asset retirements. Both the outlay for acquisitions and the proceeds from retirements should be reported as investing activities. The details provide useful information about changes in financial position during the period. 3. Stock dividends or stock splits need not be disclosed in the statement because these transactions do not significantly affect the financial position. 4. The issuance of the 16,000 shares of common stock in exchange for the preferred stock should be shown as a noncash financing activity. Since these transactions significantly change the corporation’s capital structure, they should be disclosed. 5. The presentation of the combined total of depreciation and depletion is probably acceptable. The general rule is that related items should be shown separately in proximity when the result contributes information useful to the user of the statement, but immaterial items may be combined. In this situation, it is likely that no additional relevant information would be added by showing depletion as a separate item. The total should be added back to net income in the computation of the net cash flow from operating activities.
CT 22.1 (Continued) 6. The details of changes in long-term debt should be shown separately. Payments should not be netted against increases in long-term borrowings. The long-term borrowing of $620,000 should be shown as cash provided and the retirement of $441,000 of debt should be shown as use of cash from financing activities. LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 22.2 (a) From the information given, it appears that from an operating standpoint Pacific Clothing Store did not have a superb first year, having suffered an $11,000 net loss. Lenny is correct; the statement of cash flows is not prepared in the correct form. The sources and uses format is not an acceptable form. The correct form classifies cash flows from three activities—operating, investing, and financing; and it presents significant noncash investing and financing activities in a separate schedule. Lenny is wrong, however, about the actual increase in cash—$109,000 is the correct increase in cash.
(b)
PACIFIC CLOTHING STORE Statement of Cash Flows For the Year Ended January 31, 2025
Cash flows from operating activities Net loss .............................................................. Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense................................ Gain from sale of investment.................... Net cash provided by operating activities ....... Cash flows from investing activities Sale of investment ............................................. Purchase of fixtures and equipment ................ Purchase of investment .................................... Net cash used by investing activities .............. Cash flows from financing activities Sale of common stock ...................................... Purchase of treasury stock............................... Net cash provided by financing activities ....... Net increase in cash .................................................. Supplemental disclosure of cash flow information: Cash paid for interest ........................................
$ (11,000)*
$ 80,000 (25,000)
55,000 44,000
120,000 (330,000) (95,000) (305,000) 380,000 (10,000) 370,000 $109,000
$3,000
CT 22.2 (Continued) Note to Instructor: The data provided do not allow reconciliation of other working capital accounts. Noncash investing and financing activities Issuance of note for truck..................................... *Computation of net income (loss) Sales of merchandise ........................................... Interest revenue .................................................... Gain on sale of investment ($120,000 – $95,000) ... Total revenues ............................................... Merchandise purchases ....................................... $253,000 Operating expenses ($170,000 – $80,000) ........... 90,000 Depreciation .......................................................... 80,000 Interest expense .................................................... 3,000 Total expenses............................................... Net loss ..................................................................
$ 30,000 $382,000 8,000 25,000 415,000
(426,000) $ (11,000)
LO: 2, 4, Bloom: AP, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 22.3 1.
The earnings are treated as an inflow of cash and should be reported as part of the net cash provided by operating activities in the statement of cash flows.
2.
The $315,000 depreciation expense is neither an inflow nor an outflow of cash. Because depreciation is an expense, it was deducted in the computation of net income. Accordingly, the $315,000 must be added back to income in the operating activities section because it was deducted in determining earnings, but it was not a use of cash.
3.
The write-off of uncollectible accounts receivable against the allowance account has no effect on cash because the net accounts receivable remain unchanged. An adjustment to income is only necessary if the net receivable amount increases or decreases. Because the net receivable amount is the same before and after the write-off, an adjustment to income would not be made. The $51,000 of bad debt expense does not affect cash but would be added back to income because it affects the amount of net accounts receivable. The recording of bad debt expense reduces the net receivable because the allowance account increases. Although bad debt expense is not usually treated as a separate item to be added back to income from operations, it is accounted for by analyzing the accounts receivable at the net amount and then making the necessary adjustment to income based on the change in the net amount of receivables.
4.
The $6,000 gain realized on the sale of the machine must be deducted from net income to arrive at net cash provided by operating activities. The proceeds of $36,000 ($30,000 + $6,000) are shown as a cash inflow from investing activities.
5.
In this case, no cash flow resulted from the lightning damage. The net loss (a noncash event) must be added back to net income (under the indirect method) as one of the adjustments to reconcile net income to net cash provided by operating activities.
CT 22.3 (Continued) 6.
The $75,000 use of cash should be reported as a cash outflow from investing activities. The $200,000 issuance of common stock and the $425,000 issuance of the mortgage note, neither of which affects cash, should be reported as noncash financing and investing activities.
7.
This conversion is not an inflow or an outflow of cash, but it is a significant noncash financing activity and should be reported in a separate schedule or note.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 22.4 Where to Present
How to Present
1.
Investing and operating
Cash provided by the sale of fixed assets, $4,750 as an investing activity. In addition, the loss of $2,250 ([($20,000 x 31/2) ÷ 10] – $4,750) on the sale would be added back to net income.
2.
Operating
The impairment reduced earnings from operations but did not use cash. The amount of $15,000 is added back to net income.
3.
Financing
Cash provided by the issuance of capital stock of $16,000.
4.
Operating
The net loss of $2,100 is presented as loss from operations, and depreciation of $2,000 and amortization of $400 are added back to the loss from operations. Net cash provided by operating activities is $300.
5.
Not reported in statement.
6.
Investing and operating
Cash provided by the sale of the investment, $10,600 as an investing activity. The loss of $1,400 is added back to net income.
7.
Financing and operating
The redemption is reported as cash used by financing activities of $24,240. Additionally, the gain ($1,760 = $26,000 – $24,240) is deducted from net income in the operating activities section.
LO: 2, 4, Bloom: AN, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 22.5 (a) The primary purpose of the statement of cash flows is to provide information concerning the cash receipts and cash payments of a company during a period. The information contained in the statement of cash flows, together with related disclosures in other financial statements, may help investors and creditors 1. assess the company’s ability to generate future net cash inflows. 2. assess the company’s ability to meet its obligations, e.g., pay dividends and meet needs for external financing. 3. assess the reasons for differences between net income and net cash flow from operating activities. (b) The statement of cash flows classifies cash inflows and outflows as those resulting from operating activities, investing activities, and financing activities.
CT 22.5 (Continued) Cash inflows from operating activities include receipts from the sale of goods and services, receipts from returns on loans and equity securities (interest and dividends), and all other receipts that do not arise from transactions defined as financing and investing activities. Cash outflows for operating activities include payments to buy goods for manufacture and resale, payments to employees for services, tax payments, payments to creditors for interest, and all other payments that do not arise from transactions defined as financing and investing activities. Cash inflows from investing activities include receipts from collections or sales of debt and stock instruments of other companies, from collecting principal on loans made, and from sales of various productive fixed assets. Cash outflows for investing activities include payments for stocks and debt instruments of other companies, purchase of productive fixed assets, and lending money. Cash inflows from financing activities include proceeds from the company issuing its own stock or its own debt. Cash outflows for financing activities include payments to shareholders and debtholders for dividends or retirement of its own stocks and bonds (i.e., treasury stock). (c) Cash flows from operating activities may be presented using the direct method or the indirect method. Under the direct method, the major classes of operating cash receipts and cash payments are shown separately. The indirect method involves adjusting net income to net cash flow from operating activities by removing the effects of deferrals of past cash receipts and payments, accruals of future cash receipts and payments, and noncash items from net income. (d) Noncash investing and financing transactions are to be reported in the related disclosures, either in a narrative form or summarized within a schedule. Examples of noncash transactions are the conversion of debt to equity, acquiring assets by assuming directly related liabilities, and exchanging noncash assets or liabilities for other noncash assets or liabilities. For transactions that are part cash and part noncash, only the cash portion should be reported in the statement of cash flows. LO: 1, 2, Bloom: AP, Difficulty: Complex, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication
CT 22.6 (a) It is true that selling current assets, such as receivables and notes to factors, will generate cash flows for the company, but this practice does not cure the systemic cash problems for the organization. In short, it may be a bad business practice to liquidate assets, incurring expenses and losses, in order to “window dress” the cash flow statement. The ethical implications are that Brockman creates a short-term cash flow at the longer-term expense of the company’s operations and financial position. Barbara’s idea creates the deceiving illusion that the company is successfully generating positive cash flows. (b) Barbara Brockman should be told that if she executes her plan, the company may not survive. While the factoring of receivables and the liquidation of inventory will indeed generate cash, the actual amount of cash the company receives will be less than the carrying value of the receivables and the raw materials. In addition, the company would still have the future expenditure of replenishing its raw materials inventories, at a cost higher than the sales price. As chief accountant for Brockman Guitar, it is your responsibility to work with the company’s chief financial officer to devise a coherent strategy for improving the company’s cash flow problems. One strategy may be to downsize the organization by selling excess property, plant, and equipment to repay long-term debt. In addition, Brockman Guitar may be a good candidate for a quasireorganization discussed on KWW website. LO: 1, 2, 3, Bloom: E, Difficulty: Moderate, Time: 20-30, AACSB: Ethics, Analytic, Communication, AICPA BB: None, AICPA AC: Reporting, AICPA PC: Communication, Ethical Conduct
Codification Exercises CE22.1 Master Glossary (a)
Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: 1. 2.
Readily convertible to known amounts of cash So near their maturity that they present insignificant risk of changes in value because of changes in interest rates.
Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment. For example, both a three-month U.S. Treasury bill and a three-year Treasury note purchased three months from maturity qualify as cash equivalents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three months. Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations). (b)
Financing activities include obtaining resources from owners and providing them with a return on, and a return of, their investment; receiving restricted resources that by donor stipulation must be used for long-term purposes; borrowing money and repaying amounts borrowed, or otherwise settling the obligation; and obtaining and paying for other resources obtained from creditors on long-term credit.
(c)
Investing activities include making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, and equipment and other productive assets, that is, assets held for or used in the production of goods or services by the entity (other than materials that are part of the entity’s inventory). Investing activities exclude acquiring and disposing of certain loans or other debt or equity instruments that are acquired specifically for resale, as discussed in paragraphs 230-10-45-12 and 230-10-45-21.
(d)
Operating activities include all transactions and other events that are not defined as investing or financing activities (see paragraphs 230-10-45-12 through 45-15). Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.
LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE22.2 According to FASB ASC 230-10-45-14 (Statement of Cash Flow—Other Presentation Matters—Cash Flows from Financing Activities): All of the following are cash inflows from financing activities: (a)
Proceeds from issuing equity instruments.
(b)
Proceeds from issuing bonds, mortgages, notes, and from other short- or long-term borrowing.
CE22.2 (Continued) (c)
Receipts from contributions and investment income that by donor stipulation are restricted for the purposes of acquiring, constructing, or improving property, plant, equipment, or other long-lived assets or establishing or increasing a permanent endowment or term endowment.
(d)
Proceeds received from derivative instruments that include financing elements at inception, whether the proceeds were received at inception or over the term of the derivative instrument, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments.
(e)
Cash retained as a result of the tax deductibility of increases in the value of equity instruments issued under share-based payment arrangements that are not included in the cost of goods or services that is recognizable for financial reporting purposes. For this purpose, excess tax benefits shall be determined on an individual award (or portion thereof) basis.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE22.3 According to FASB ASC 230-10-45-11 (Statement of Cash Flows—Other Presentation Matters—Cash Flows from Investing Activities): Cash flows from purchases, sales, and maturities of available-for-sale securities shall be classified as cash flows from investing activities and reported gross in the statement of cash flows. LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CE22.4 According to FASB ASC 230-10-50-3 (Statement of Cash Flows—Disclosure—Noncash Investing and Financing Activities): Information about all investing and financing activities of an entity during a period that affect recognized assets or liabilities but that do not result in cash receipts or cash payments in the period shall be disclosed. Those disclosures may be either narrative or summarized in a schedule, and they shall clearly relate the cash and noncash aspects of transactions involving similar items. LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
Codification Research Case (a) According to FASB ASC 230-10-10 (Statement of Cash Flows/Overall/ Objectives): 10-1 The primary objective of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during a period. As indicated in the glossary at this same section (230-10-20), cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank’s granting of a loan by crediting the proceeds to a customer’s demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made. Thus, the basis for the statement of cash flows is cash, not broader measures of liquidity, like working capital. (b) See FASB ASC 230-10-10 (Statement of Cash Flows—Objectives) 10-2 The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, should help investors, creditors, and others (including donors) to do all of the following: a. Assess the entity’s ability to generate positive future net cash flows b. Assess the entity’s ability to meet its obligations, its ability to pay dividends, and its needs for external financing c. Assess the reasons for differences between net income and associated cash receipts and payments
Codification Research Case (Continued) d. Assess the effects on an entity’s financial position of both its cash and noncash investing and financing transactions during the period. (c) According to FASB ASC 230-10-45-16 to 17: 45-16 All of the following are cash inflows for operating activities: a. Cash receipts from sales of goods or services, including receipts from collection or sale of accounts and both short- and long-term notes receivable from customers arising from those sales. The term “goods” includes certain loans and other debt and equity instruments of other entities that are acquired specifically for resale, as discussed in paragraph 23010-45-21. b. Cash receipts from returns on loans, other debt instruments of other entities, and equity securities—interest and dividends. c. All other cash receipts that do not stem from transactions defined as investing or financing activities, such as amounts received to settle lawsuits; proceeds of insurance settlements except for those that are directly related to investing or financing activities, such as from destruction of a building; and refunds from suppliers. 45-17 All of the following are cash outflows for operating activities: a. Cash payments to acquire materials for manufacture or goods for resale, including principal payments on accounts and both short- and long-term notes payable to suppliers for those materials or goods. [FAS 095, paragraph 23, sequence 101] [The term goods includes certain loans and other debt and equity instruments of other entities that are acquired specifically for resale, as discussed in paragraph 230-10-45-21, and securities that are classified as trading securities, as discussed in Topic 320.] b. Cash payments to other suppliers and employees for other goods or services. Codification Research Case (Continued)
c. Cash payments to governments for taxes, duties, fines, and other fees or penalties and the cash that would have been paid for income taxes if increases in the value of equity instruments issued under share-based payment arrangements that are not included in the cost of goods or services recognizable for financial reporting purposes also had not been deductible in determining taxable income. (This is the same amount reported as a financing cash inflow pursuant to paragraph 230-10-4514(e).) d. Cash payments to lenders and other creditors for interest, including the portion of the payments made to settle zerocoupon debt instruments that is attributable to accreted interest related to the debt discount or the portion of the payments made to settle other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing that is attributable to accreted interest related to the debt discount. For all other debt instruments, an issuer shall not bifurcate cash payments to lenders and other creditors at settlements for amounts attributable to accreted interest related to the debt discount, nor classify such amounts as cash outflows for operating activities. e. Cash payment, or the portion of the payments, not made soon after the acquisition date of a business combination by an acquirer to settle a contingent consideration liability that exceeds the amount of the contingent consideration liability recognized at the acquisition date, including measurementperiod adjustments, less any amounts paid soon after the acquisition date to settle the contingent consideration liability. See also paragraph 230-10-45-15(f). f. All other cash payments that do not stem from transactions defined as investing or financing activities, such as payments to settle lawsuits, cash contributions to charities, and cash refunds to customers. LO: 1, 2, 3, Bloom: K, Difficulty: Simple, Time: 50-60, AACSB: Analytic, Communication, Technology, AICPA BB: None, AICPA AC: Reporting, Research, Technology and Tools, AICPA PC: Communication
CHAPTER 23 Full Disclosure in Financial Reporting Assignment Classification Table (By Topic) Topics
Brief Questions Exercises
* 1.
The disclosure principle; type of disclosure.
2, 3
* 2.
Role of notes that accompany financial statements.
1, 4, 5
1, 2
* 3.
Subsequent events.
6
3
1, 2
1
4, 12
* 4.
Segment reporting; diversified firms.
7, 8, 9, 10, 11
4, 5, 6, 7
3
2
5, 6, 7
* 5.
Discussion and analysis.
12, 13
* 6.
Interim reporting.
14, 15, 16, 17
8, 9
* 7.
Audit opinions and fraudulent reporting.
18, 19
11
* 8.
Earnings forecasts.
20, 21
10
*9.
Interpretation of ratios.
22, 23, 24
*10.
Impact of transactions on ratios.
*11.
Liquidity ratios.
*12.
Profitability ratios.
*13.
Coverage ratios.
*14.
Activity ratios.
*15.
Comprehensive ratio problems.
*16.
Percentage analysis.
Exercises
Problems
1, 2, 3 1, 2, 3, 4
4, 5, 6
5
8
4, 5, 6
3
8
4, 5, 6
3, 5
4, 5, 6
3, 5
28
4, 5, 6 25, 26
Critical Thinking
8, 9
24, 27
*This material is dealt with in an Appendix to the chapter.
4, 5, 6
3
4, 5, 6
3, 5 3, 4
13
Assignment Classification Table (By Learning Objective) Learning Objectives Questions
Brief Exercises 1, 2
Exercises
Problems
1.
Review the full disclosure principle and describe how it is implemented.
1, 2, 3
2.
Discuss the disclosure requirements for related party transactions, postbalance-sheet events, major business segments, and interim reporting.
4, 5, 6, 7, 8, 3, 4, 5, 6, 7 9, 10, 11, 14, 15, 16, 17
3.
Identify the major disclosures in the auditor’s report and understand management’s responsibilities for the financial statements.
12, 13, 18
4.
Identify reporting issues related to fraudulent financial reporting and financial forecasts.
19, 20, 21
*5.
Describe the approach to financial statement analysis.
22, 23
*6.
Identify major analytic ratios and describe their calculation.
24, 25, 26
*7.
Explain the limitations of ratio analysis.
28
*8.
Describe techniques of comparative analysis.
24, 27
3
*9.
Describe techniques of percentage analysis.
24, 25, 27
4
Critical Thinking 1, 2, 3
1, 2, 3
1, 2
1, 2, 3, 4, 5, 6, 7, 8, 9, 12
10, 11
8, 9
4, 5, 6
3, 5
13
Assignment Characteristics Table Item
Description
Level of Difficulty
Time (minutes)
E23.1 E23.2 E23.3 *E23.4 *E23.5 *E23.6
Post-balance-sheet events. Post-balance-sheet events. Segmented reporting. Ratio computation and analysis; liquidity. Analysis of given ratios. Ratio analysis.
Moderate Moderate Moderate Simple Moderate Moderate
10–15 10–15 5–10 20–30 20–30 30–40
P23.1 P23.2 *P23.3 *P23.4 *P23.5
Subsequent events. Segmented reporting. Ratio computations and additional analysis. Horizontal and vertical analysis. Dividend policy analysis.
Difficult Moderate Moderate Moderate Difficult
40–50 24–30 35–45 40–60 40–50
CT23.1
General disclosures; inventories; property, plant, and equipment. Disclosures required in various situations. Disclosures, conditional and contingent liabilities. Post-balance-sheet events. Segment reporting. Segment reporting—theory. Segment reporting—theory. Interim reporting. Treatment of various interim reporting situations. Financial forecasts. Disclosure of estimates. Reporting of subsequent events. Effect of transactions on financial statements and ratios.
Simple
10–20
Moderate Simple Moderate Moderate Simple Moderate Simple Moderate Moderate Moderate Simple Moderate
20–25 24–30 20–25 30–35 20–25 24–30 20–25 30–35 24–30 15–20 10–15 24–35
CT23.2 CT23.3 CT23.4 CT23.5 CT23.6 CT23.7 CT23.8 CT23.9 CT23.10 CT23.11 CT23.12 *CT23.13
Answers to Questions 1.
As indicated in the text, the major advantages are: (1) additional information pertinent to specific financial statements can be explained in qualitative terms, or supplementary data of a quantitative nature can be provided to expand on the information in the financial statements, and (2) restrictions on basic contractual agreements can be explained. The types of items normally found in footnotes are: (1) disclosure of accounting methods used, (2) disclosure of contingent assets and liabilities, (3) examination of creditor claims, (4) claims of equity holders, and (5) executory commitments.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
2.
The full disclosure principle in accounting calls for reporting in financial statements any financial facts significant enough to influence the judgment of an informed reader. Disclosure has increased because of the complexity of the business environment, the necessity for timely information, and the desire for more information on the enterprise for control and monitoring purposes.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
3.
The benefit of disclosing the reconciliation of the effective tax rate and the federal statutory rate is that an investor can determine the actual taxes paid by the enterprise. Such a determination is particularly important if the enterprise has substantial fluctuations in its effective tax rate caused by unusual or infrequent transactions. In some cases, companies only have income in a given period because of a favorable tax treatment that is not sustainable. Such information should be extremely useful to a financial statement reader.
LO: 1, Bloom: K, Difficulty: Moderate Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
4.
(a) The increased likelihood that the company will suffer a costly strike requires no disclosure in the financial statements. The possibility of a strike is an inherent risk of many businesses. It, along with the risks of war, recession, etc., is in the category of general news. (b) A note should provide a description of the unusual and infrequent loss in order that the financial statement user has some understanding of the nature of this item. (c)
Contingent assets which may materially affect a company’s financial position must be disclosed when the surrounding circumstances indicate that, in all likelihood, a valid asset will materialize. In most situations, an asset would not be recognized until the court settlement had occurred.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
5.
Transactions between related parties are disclosed to ensure that the users of the financial statements understand the basic nature of some of the transactions. Because it is often difficult to separate the economic substance from the legal form in related party transactions, disclosure is used extensively in this area. Purchase of a substantial block of the company’s common stock by Holland, coupled with the use of a Holland affiliate to act as food broker, suggests that disclosure is needed.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
6.
“Subsequent events” are of two types: (1) Those which affect the financial statements directly and should be recognized therein through appropriate adjustments. (2) Those which do not affect the financial statements directly and require no adjustment of the account balances but whose effects may be significant enough to be disclosed with appropriate figures or estimates shown.
(a) Probably adjust the financial statements directly. (b) Disclosure. (c) Disclosure. (d) Disclosure. Questions Chapter 23 (Continued)
(e) (f) (g) (h)
Neither adjustment nor disclosure necessary. Neither adjustment nor disclosure necessary. Probably adjust the financial statements directly. Neither adjustment nor disclosure necessary.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
7.
Diversified companies are enterprises whose activities are segmented into unrelated industries. The accounting problems related to diversified companies are: (1) the problem of defining a segment for financial reporting purposes, (2) the difficulty of allocating common or joint costs to various segments, and (3) the problem of evaluating segment results when a great deal of transfer pricing is involved.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
8.
After the company decides on the segments for possible disclosure, a quantitative test is made to determine whether the segment is significant enough to warrant actual disclosure. A segment is identified as a reportable segment if it satisfies one or more of the following tests. (a) Its revenue (including both sales to unaffiliated customers and intersegment sales or transfers) is 10% or more of the combined revenue (sales to unaffiliated customers and intersegment sales or transfers) of all the enterprise’s industry segments. (b) The absolute amount of its operating profit or operating loss is 10% or more of the greater, in absolute amount, of 1. the combined operating profit of all industry segments that did not incur an operating loss, or 2. the combined operating loss of all industry segments that did incur an operating loss. (c) Its identifiable assets are 10% or more of the combined identifiable assets of all segments. In applying these tests, two additional factors must be considered. First, segment data must explain a significant portion of the company’s business. Specifically, the segmented results must equal or exceed 75% of the combined sales to unaffiliated customers for the entire enterprise. This test prevents a company from providing limited information on only a few segments and lumping all the rest into one category. Second, the profession recognized that reporting too many segments may overwhelm users with detailed information. Although the FASB did not issue any specific guidelines regarding how many segments are too many, this point is generally considered reached when a company has 10 or more reportable segments.
LO: 2, Bloom: K, Difficulty: Simple, Time: 7-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
9.
GAAP requires that a company report: (a) (b) (c) (d) (e) (f)
General information about its operating segments. Segment profit and loss and related information. Segment assets. Reconciliations (reconciliations of total revenues, income before income taxes, and total assets). Information about products and services and geographic areas. Major customers.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
10.
An operating segment is a component of an enterprise: (a) That engages in business activities from which it earns revenues and incurs expenses. (b) Whose operating results are regularly reviewed by the company’s chief operating decision maker to assess segment performance and allocate resources to the segment.
Questions Chapter 23 (Continued)
(c)
For which discrete financial information is available, which is generated by or based on the internal financial reporting system. Information about two operating segments can be aggregated only if the segments have the same basic characteristics related to the: (1) nature of the products and services provided, (2) nature of the production process, (3) type or class of customer, (4) methods of product or service distribution, and (5) nature of the regulatory environment. LO: 2, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
11.
One of the major reasons for not providing segment information is that competitors will then be able to determine the profitable segments and enter that product line themselves. If this occurs and the other company is successful, then the present stockholders of Lafayette Inc. may suffer. This question should illustrate to the student that the answers are not always black and white. Disclosure of segments undoubtedly provides some needed information, but some disclosures are confidential.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
12.
The management discussion and analysis section covers three financial aspects of an enterprise’s business—liquidity, capital resources, and results of operations. It requires management to highlight favorable or unfavorable trends and to identify significant events and uncertainties that affect these three factors.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
13.
Management has the primary responsibility for the preparation, integrity, and objectivity of the company’s financial statements. If management wishes to present information in a certain way, it may do so. If the auditor objects because GAAP is violated, some type of audit exception is called for.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
14.
Interim reports are unaudited financial statements normally prepared four times a year. Interim balance sheets are often not provided because this information is not deemed crucial over a short period of time; the income figure has much more relevance to interim reporting.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
15.
The accounting problems related to the presentation of interim data are as follows: (a) (b) (c) (d)
The difficulty of allocating costs, such as income taxes, pensions, etc., to the proper quarter. The problem of LIFO inventory valuation. Presentation of EPS figures. Problems of fixed cost allocation.
LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
16.
The problem when a LIFO base is used for quarterly reporting is that the LIFO base might be reduced in a given quarter, but for the year, this base is not reduced. If the inventory base will be replaced before the year ends, then a purchase reserve (equalization account) should be set up to reflect a higher cost of sales and to achieve a more realistic interim statement for net income.
LO: 2, Bloom: K, Difficulty: Moderate, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
17.
One suggestion to overcome seasonality problems in interim reporting has been to normalize the fixed nonmanufacturing costs on the basis of predicted sales. The problem with this method is that future sales are unknown and hence, a great deal of subjectivity is involved. Another approach is to charge, as a period charge, those costs that are impossible to allocate to any one period. Under this approach, reported results for a quarter would only indicate the contribution toward fixed costs and profits, which is essentially a contribution margin approach. To alleviate the problem of
Questions Chapter 23 (Continued) seasonality, the profession recommends companies subject to material seasonal variations disclose the seasonal nature of their business and consider supplementing their annual reports with information for 12-month periods ended at the interim dates for the current and preceding years. LO: 2, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
18.
The CPA expresses a “clean” or unqualified opinion when the client’s financial statements present fairly the client’s financial position and results of operations on the basis of an examination made in accordance with generally accepted auditing standards, and the statements are in conformity with generally accepted accounting principles and include all informative disclosures necessary to make the statements not misleading. The CPA expresses a qualified opinion when he/she must take exception to the presentation of one or more components of the financial statements but the exception or exceptions are not serious enough to negate his/her expression of an opinion or to express an “adverse” opinion.
LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
19.
Fraudulent financial reporting is intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements. Fraudulent financial reporting can involve many factors and take many forms. It may entail gross and deliberate distortion of corporate records, such as inventory count tags, or falsified transactions, such as fictitious sales or orders. It may entail the misapplication of accounting principles. Company employees at any level may be involved, from top to middle management to lower-level personnel. If the conduct is intentional, or so reckless that it is the legal equivalent of intentional conduct, and results in fraudulent financial statements, it comes within the operating definition of the term fraudulent financial reporting. Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors. Fraudulent financial reporting is distinguished from other corporate improprieties, such as employee embezzlements, violations of environmental or product safety regulations, and tax fraud, which do not necessarily cause financial statements to be materially inaccurate. Fraudulent financial reporting usually occurs as the result of certain environmental, institutional, or individual forces and opportunities. These forces and opportunities add pressures and incentives that encourage individuals and companies to engage in fraudulent financial reporting and are present to some degree in all companies. If the right combustible mixture of forces and opportunities is present, fraudulent financial reporting may occur. A frequent incentive for fraudulent financial reporting that improves the company’s financial appearance is the desire to obtain a higher price from a stock or debt offering or to meet the expectations of investors. Another incentive may be the desire to postpone dealing with financial difficulties and thus, avoid, for example, violating a restrictive debt covenant. Other times the incentive is personal gain: additional compensation, promotion, or escape from penalty for poor performance. Situational pressures on the company or an individual manager also may lead to fraudulent financial reporting. Examples of these situational pressures include: Sudden decreases in revenue or market share. A single company or an entire industry can experience these decreases. Unrealistic budget pressures, particularly for short-term results. These pressures may occur when a company arbitrarily determines profit objectives and budgets without taking actual conditions into account.
Questions Chapter 23 (Continued) Financial pressure resulting from bonus plans that depend on short-term economic performance. This pressure is particularly acute when the bonus is a significant component of the individual’s total compensation. Opportunities for fraudulent financial reporting are present when the fraud is easier to commit and when detection is less likely. Frequently these opportunities arise from: The absence of a board of directors or audit committee that vigilantly oversees the financial reporting process. Weak or nonexistent internal accounting controls. This situation can occur, for example, when a company’s revenue system is overloaded from a rapid expansion of sales, an acquisition of a new division, or the entry into a new, unfamiliar line of business. Unusual or complex transactions. Examples include the consolidation of two companies, the divestiture or closing of a specific operation, and agreements to buy or sell government securities under a repurchase agreement. Accounting estimates requiring significant subjective judgment by company management. Examples include allowance for loan losses and the yearly provision for warranty expense. LO: 4, Bloom: K, Difficulty: Simple, Time: 10-15, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
20.
Arguments against providing earnings projections: (a) No one can foretell the future. Therefore, forecasts, while conveying an impression of precision about the future, will nevertheless, inevitably be wrong. (b) Organizations will not strive to produce results that are in the stockholders’ best interest, but merely to meet their published forecasts. (c) When forecasts are not met, there will be recriminations and probably legal actions. (d) Disclosure of forecasts will be detrimental to organizations because it will fully inform not only investors but also competitors (foreign and domestic).
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
21.
Arguments for providing earnings forecasts are: (a) Investment decisions are based on future expectations; therefore, information about the future facilitates better decisions. (b) Forecasts are already circulated informally. This situation should be regulated to ensure that forecasts are available to all investors. (c) Circumstances now change so rapidly that historical information is no longer adequate for prediction.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*22. It has been said that “everything is relative,” and this is certainly true of financial statement data. The chief significance of financial statement data is not so much in the absolute amounts presented but in their relative significance; that is, in the conclusions reached after comparing each item with similar items and after association with related data. Financial statements present measures of quantity (this is not to exclude the qualitative aspects of things that dollar quantities reflect). Whether any amount is adequate or not in view of the company’s needs, whether it represents an amount out of proportion to the company’s other amounts, or whether it represents an improvement over previous years cannot be determined from the absolute amount alone. LO: 5, Bloom: C, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 23 (Continued) *23. Your friend should be advised that in order to interpret adequately and to evaluate financial statement data, an individual must: (a) (b) (c) (d)
Understand the nature and limitations of accounting. Understand the terminology of accounting and business. Have some knowledge of business. Be acquainted with the nature and tools of financial statement analysis.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*24. Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base while ratio analysis is the computation of a specific ratio of one figure to another within the reported data. Percentage analysis facilitates comparison and is helpful in evaluating the relative size of a series of items. Ratio analysis points out the existence of a specific relationship and then, proceeds to measure the relationship in terms of either a percentage figure or a single proportion. LO: 6, 9, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*25. Cost of goods sold is used for two reasons: first, cost must be used rather than retail value because the average inventory figures are on a cost basis. Second, since measurement of the turnover involves determination of the number of times inventory was sold this period in comparison to the total cost incurred, cost of goods sold must be used as representative of total cost incurred. An increasing inventory turnover may be an indication of stockouts or inventory shortages. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*26. The relationship of asset turnover to the rate of return on assets is as follows: X
=
An increase in the asset turnover, holding profit margin constant, results in an increase in rate of return on assets and vice versa. LO: 6, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*27. (a) Common-size analysis is reduction of all dollar amounts in the financial statements to a percentage of a base amount. (b) Vertical analysis is the expression, percentage-wise, of each item on a financial statement in a given period relative to a base figure. (c)
Horizontal analysis is the computation of the percentage change over time.
(d) Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base. This type of analysis facilitates comparisons and is helpful in evaluating the relative size of items such as expenses, current assets, or net income. LO: 8, 9, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*28. Some believe that the FASB should not be involved in developing standards related to the presentation of ratios. A basic concern expressed by this group is: how far should the FASB go? That is, where does financial reporting end and financial analysis begin? Furthermore, we know so little concerning which ratios are used and in what combinations that attempting to require disclosure of certain ratios in this area would not be helpful. One reason for the profession’s reluctance to mandate disclosures of ratios on the financial statements is that research regarding the use and usefulness of summary indicators is still limited. LO: 7, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Solutions to Brief Exercises Brief Exercise 23.1 The reader should recognize that the firm has an annual obligation for lease payments of approximately $5,711,000 for the next three years. In certain situations, this information is very important in determining: (1) the ability of the firm to use additional lease financing, and (2) the nature of maturing commitments and the amount of cash expenditures involved. Off-balancesheet financing is common, and the investor should be cognizant that the company has a commitment even though it is not reflected in the liability section of the balance sheet. The rental income from the subleases also provides useful information concerning the company’s ability to generate revenues in the near future. LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 23.2 The reader should recognize that there are dilutive securities outstanding, which may have an effect on earnings per share. In addition, the purchase of treasury stock enabled the company to increase its earnings per share. The important point concerning this note is that information is provided about potential dilution related to some dilutive securities outstanding. LO: 1, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 23.3 Net income will decrease by $10,000 ($160,000 – $170,000) as a result of the adjustment of the liability. The settlement of the liability is the type of subsequent event that provides additional evidence about conditions that existed at the balance sheet date. The flood loss ($80,000) is an event that provides evidence about conditions that did not exist at the balance sheet date but are subsequent to that date and does not require adjustment of the financial statements. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 23.4 It should be emphasized that because a company discloses its segmental results, this does not diminish the necessity for providing consolidated results as well. Sometimes, individuals become confused because they believe that use of segment reporting means that consolidated statements should not be presented. There appears to be a need to provide both types of information. The consolidated results provide information on overall financial position and profitability, while the segmental results provide information on the specific details that comprise the overall results. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Brief Exercise 23.5 $600 + $650 + $250 + $275 + $225 + $200 + $700 = $2,900 = total revenue. $2,900 X .10 = $290. Penley, Konami, and Molina meet this test, since their revenues equaled or exceeded $290. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 23.6 $90 + $25 + $50 + $34 + $150 = $349 = total profits of profitable segments. $349 X .10 = $34.90. Penley, Konami, Red Moon, and Molina meet this test, since their absolute profit or loss is equal to or greater than $34.90. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Brief Exercise 23.7 $500 + $550 + $250 + $400 + $200 + $150 + $475 = $2,525 = total assets. $2,525 X .10 = $252.50. Penley, Konami, Red Moon, and Molina meet this test, since their identifiable assets equal or exceed $252.50. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 23.8 (a) X + $500,000 = 5X $500,000 = 4X $125,000 = Current liabilities (b) Cost of goods sold last year = $200,000 X 5 = $1,000,000 $1,000,000 ÷ 8 = $125,000 = Average inventory in current year (c) $ 90,000 ÷ $40,000 = Current ratio of 2.25:1 $ 50,000 ÷ $40,000 = Acid-test ratio of 1.25:1 $105,000 ÷ $55,000 = Current ratio of 1.91:1 $ 65,000 ÷ $55,000 = Acid-test ratio of 1.18:1 (d) $600,000 ÷ $420,000 = 1.43:1 after declaration, but before payment After payment, $420,000 ÷ $240,000 = 1.75:1 LO: 6, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Brief Exercise 23.9 Cost of Goods Sold = Inventory Turnover Average Inventory $99,000,000 =9 Average Inventory Average inventory (current) therefore, equals $11,000,000 ($99,000,000 ÷ 9). $99,000,000 Average Inventory
= 12
Average inventory (new) equals $8,250,000 ($99,000,000 ÷ 12). $11,000,000 – $8,250,000 = $2,750,000 $2,750,000 X .10 = $275,000 interest cost savings. LO: 6, Bloom: AP, Difficulty: Moderate, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Solutions to Exercises Exercise 23.1 (10–15 minutes) (a) The issuance of common stock is an example of a subsequent event that provides evidence about conditions that did not exist at the balance sheet date but arose subsequent to that date. Therefore, no adjustment to the financial statements is recorded. However, this event should be disclosed either in a note, a supplemental schedule, or even pro forma financial data. (b) The changed estimate of income taxes payable is an example of a subsequent event that provides additional evidence about conditions that existed at the balance sheet date. The income tax liability existed at December 31, 2025, but the amount was not certain. This event affects the estimate previously made and should result in an adjustment of the financial statements. The correct amount ($1,270,000) would have been recorded at December 31 if it had been available. Therefore, Madrasah should increase income tax expense in the 2025 income statement by $170,000 ($1,270,000 – $1,100,000). In the balance sheet, income taxes payable should be increased and retained earnings decreased by $170,000. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Exercise 23.2 (10–15 minutes) 1. 2. 3.
(a) (c) (b)
4. 5. 6.
(b) (c) (c)
7. 8. 9.
(c) (b) (a)
10. 11. 12.
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
(c) (a) (b)
Exercise 23.3 (5–10 minutes) (a) Revenue test: .10 X $102,000 = $10,200. Segments W ($60,000) and Y ($23,000) both meet this test. (b) Operating profit test: .10 X ($15,000 + $3,000 + $1,000) = $1,900. Segments W ($15,000), X ($3,000), and Y ($2,000 absolute amount) all meet this test. (c) Identifiable assets test: .10 X $290,000 = $29,000. Segments W ($167,000) and X ($83,000) both meet this test. LO: 2, Bloom: AP, Difficulty: Moderate, Time: 5-10, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Exercise 23.4 (20–30 minutes) Computations are given below which furnish some basis of comparison of the two companies:
Composition of current assets Cash Receivables Inventories
Computation of various ratios Current ratio ($910 ÷ $305) Acid-test ratio [($120 + $220) ÷ $305] Accounts receivable turnover ($930 ÷ $220) Inventory turnover Cash to current liabilities ($120 ÷ $305) a($930 X .70) ÷ $570
Toulouse Co.
Lautrec Co.
13% 24% 63% 100%
28% 27% 45% 100%
2.98 to 1 1.11 to 1 4.23 times 1.14a times .39 to 1
($1,140 ÷ $350) 3.26 to 1 [($320 + $302) ÷ $350] 1.78 to 1 ($1,500 ÷ $302) 4.97 times 1.74b times ($320 ÷ $350) .91 to 1
b($1,500 X .60) ÷ $518
Lautrec Co. appears to be a better short-term credit risk than Toulouse Co. Analysis of various liquidity ratios demonstrates that Lautrec Co. is stronger financially, all other factors being equal, in the short-term. Comparative risk could be judged better if additional information were available relating to such items as net income, purpose of the loan, due date of current and long-term liabilities, future prospects, etc. LO: 6, Bloom: AP, Difficulty: Simple, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 23.5 (20–30 minutes) (a) The acid-test ratio is the current ratio with the deduction of inventory and prepaid expenses (generally, insignificant relative to inventory) from current assets. Any divergence in trend between these two ratios would therefore, be dependent upon the inventory account. Inventory turnover has declined sharply in the three-year period, from 4.91 to 3.42. During the same period, sales to fixed assets have increased and total sales have increased 7 percent. The decline in the inventory turnover is therefore not due to a decline in sales. The apparent cause is that investment in inventory has increased at a faster rate than sales, and this has accounted for the divergence between the acid-test and current ratios. (b) Financial leverage has definitely declined during the three-year period. This is shown by the steady drop in the long-term debt to assets ratio, and the debt to assets ratio. Apparently, the decline of debt as a percentage of this firm’s capital structure is accounted for by a reduction in the long-term portion of the firm’s indebtedness. This reduction of leverage accounts for the decrease in the return on common stock equity ratio. This conclusion is reinforced by the fact that net income to sales and return on total assets have both increased. (c) The company’s net investment in plant and equipment has decreased during the three-year period, 2023–2025. This conclusion is reached by using the sales-to-fixed-assets (fixed asset turnover) and sales-as-apercent-of-2023-sales ratios. Because sales have grown each year, the sales-to-fixed-assets could be expected to increase unless fixed assets grew at a faster rate. The sales-to-fixed-assets ratio increased at a faster rate than the 3 percent annual growth in sales; therefore, net investment in plant and equipment must have declined. LO: 6, Bloom: AP, Difficulty: Moderate, Time: 20-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Exercise 23.6 (30–40 minutes) (a) The current ratio measures overall short-term liquidity and is an indicator of the short-term debt-paying ability of the firm. The quick ratio also is a measure of short-term liquidity. However, it is a measure of more immediate liquidity than the current ratio and is an indicator of a firm’s ability to pay all of its immediate debts from cash or near-cash assets. The quick ratio is also an indicator of the degree of inventories in its current assets when compared to the current ratio. Inventory turnover is an indicator of the number of times a firm sells its average inventory level during the year. A low inventory turnover may indicate excessive inventory accumulation or obsolete inventory. Net sales to stockholders’ equity is an activity ratio that measures the number of times the stockholders’ equity was turned over in sales volume. This ratio could also be referred to as a net asset turnover ratio that measures net asset management. Thus, it is a measure of operational efficiency. This ratio is similar to asset turnover. Return on common stockholders’ equity is a profitability ratio. It measures the return on stockholders’ investment and is used to evaluate the company’s success in generating income for the benefit of its stockholders (i.e., management effectiveness). Total liabilities to stockholders’ equity compares the amount of resources provided by creditors to the resources provided by stockholders. Thus, it measures the extent of leverage in the company’s financial structure and is used to evaluate or judge the degree of financial risk. This ratio is similar to the debt to assets ratio. (b) The two ratios that each of the four entities would specifically use to examine Edna Millay Inc. are as follows: Archibald MacLeish Bank might employ the current or quick ratio and the total liabilities to stockholders’ equity ratio. Robert Lowell Company might employ either the current or quick ratios in conjunction with either the inventory turnover or total liabilities to stockholders’ equity ratio. Robert Penn Warren might employ net sales to stockholders’ equity and return on common stockholders’ equity.
*Exercise 23.6 (Continued) The Working Capital Management Committee might review the current or quick ratio and the inventory turnover. (c) Edna Millay Inc. appears to have a strong liquidity position as evidenced by the current and quick ratios that have been improving over the three-year period. In addition, the current ratio is greater than the industry average and the quick ratio is just slightly below. However, the increase in the current ratio could be due to an increase in inventory levels. This fact is confirmed by the deteriorating inventory turnover ratio that is also below the industry average. Overstock or obsolete inventory conditions may exist. Edna Millay’s profitability is good as indicated by the profitability ratios that have been increasing. Both profitability ratios are greater than the industry average. The profit margin on sales (net income to net sales) can be derived from these two ratios (return on common stockholders’ equity divided by net sales to stockholders’ equity), and Millay’s margin has increased each year (2023: 5.17%; 2024: 5.36%; 2025: 5.69%) and exceeds the industry average (3.86%). The total liabilities to equity ratio has increased over the three-year period and exceeds the industry average, indicating a heavy reliance on debt. This high leverage position could be dangerous if sales volume, sales margin, or income falls because interest expense is a fixed cash outlay. LO: 6, Bloom: AP, Difficulty: Moderate, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Time and Purpose of Problems Problem 23.1 (Time 40–50 minutes) Purpose—to provide the student with various post-balance-sheet or subsequent events to evaluate and to prepare the proper disclosures for each item, if necessary. Problem 23.2 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the rules for segment reporting. The student must determine which of five segments are subject to segment reporting rules and describe the required disclosures. *Problem 23.3 (Time 35–45 minutes) Purpose—to provide the student with an understanding of certain key ratios. In addition, the student is asked to identify and explain what other financial reports or financial analysis might be employed, and to determine whether the company can finance the plant expansion internally and whether an extension on the note should be made. *Problem 23.4 (Time 40–60 minutes) Purpose—to provide the student with an understanding of the conceptual merits in the presentation of financial statements by both horizontal analysis and vertical analysis. The student is required to prepare a comparative balance sheet for the given financial information under each of the two approaches. The student is then asked to discuss the merits of each of the presentations. *Problem 23.5 (Time 40–50 minutes) Purpose—to provide the student with a situation in which ratio analysis is used in a decision concerning payment of dividends.
Solutions to Problems Problem 23.1
ALMADEN CORPORATION Balance Sheet December 31, 2025 Assets Current assets Cash ($571,000 – $300,000a) ... Accounts receivable ($480,000c + $30,000b) .......... Less allowance for doubtful accounts ......... Notes receivable ...................... Inventories (LIFO) ................... Prepaid expenses .................... Total current assets ....
$ 271,000 $510,000 30,000b
$1,620,800
Long-term investments Investments in land ................. Cash surrender value of life insurance policy ............. Cash restricted for plant expansion ............................. Property, plant, and equipment Plant and equipment (pledged as collateral for bonds) ($4,130,000d + $1,430,000e) .. Less accumulated depreciation ................... Land ......................................... Intangible assets Goodwill, at cost ..................... Total assets .................
480,000c 162,300 645,100 62,400
185,000 84,000 300,000a
569,000
4,130,000d 446,200
4,576,200
5,560,000 1,430,000e
252,000 $7,018,000
Problem 23.1 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable ....................... Unearned revenue ...................... Dividends payable ...................... Salaries and wages payable ...... Income taxes payable ................ Interest payable ($750,000f X .08 X 8/12) ............ Total current liabilities .....
$ 510,000 489,500 200,000 225,000 145,000 40,000g $1,609,500
Long-term liabilities Notes payable (due 2028) .......... 8% bonds payable (secured by plant and equipment) ......... $ 750,000f Less unamortized bond discount* ............................ 29,900 Total liabilities ................ Stockholders’ equity Common stock, par value $10 per share; authorized 200,000 shares; 184,000 shares issued and outstanding .............................. Paid-in capital in excess of par .... Retained earnings ...................... Total stockholders’ equity ........................... Total liabilities and stockholders’ equity ...
1,840,000 150,000
157,400
720,100
877,500 2,487,000
1,990,000 2,541,000** 4,531,000 $7,018,000
**($34,500 ÷ 5 = $6,900; $6,900 X 8/12 = $4,600h; $34,500 – $4,600h = $29,900) **Retained earnings $2,810,600 Accrued wages omitted (225,000) Accrued interest (40,000g) Bond amortization (4,600h) $2,541,000
Problem 23.1 (Continued) Additional comments: 1.
The information related to the competitor should be disclosed because this innovation may have a significant effect on the company. The value of the inventory is overstated because of the need to reduce selling prices. This factor along with the net realizable value of the inventory should be disclosed.
2.
The pledged assets should be described in the balance sheet as indicated or in a footnote.
3.
The error in calculating inventory will have been offset, so no adjustment is needed.
4.
Salaries and wages payable is included as a liability and retained earnings is reduced.
5.
The fact that the gain on sale of certain plant assets was credited directly to retained earnings has no effect on the balance sheet presentation.
6.
Technically, the plant and equipment account should be separately disclosed and depreciation computed on each item individually. However, the information to divide the accounts was not given in this problem.
7.
Interest payable on the bonds ($750,000 X .08 X 8/12 = $40,000) was never recorded. This amount will also reduce retained earnings. The related discount amortization [($34,500 ÷ 60) X 8 months = $4,600] will reduce both the discount account and retained earnings.
8.
Since the loss from heavy damage was caused by a fire after the balance sheet date, this event does not reflect conditions existing at that date. Thus, adjustment of the financial statements is not necessary. However, the loss should be disclosed in a note, especially since users of the financial statements, who may have read about the fire in the newspaper, would likely be looking for disclosure of the financial implications.
LO: 2, Bloom: AP, Difficulty: Complex, Time: 40-50, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Problem 23.2
(a) Determination of reportable segments: 1.
Revenue test: .10 X $785,000* = $78,500. Only Segment C ($580,000) meets this test. *$40,000 + $75,000 + $580,000 + $35,000 + $55,000
2.
Operating profit test: .10 X ($11,000 + $75,000 + $4,000 + $7,000) = $9,700. Segments A ($11,000), B ($15,000 absolute value), and C ($75,000) all meet this test.
3.
Identifiable assets test: .10 X $730,000** = $73,000. Segments B ($80,000) and C ($500,000) meet this test. **$35,000 + $80,000 + $500,000 + $65,000 + $50,000
(b) Disclosures required by GAAP:
External Revenues Intersegment Revenues Total Revenues Cost of Goods Sold Operating Expenses Total Expenses Operating Profit (Loss) Identifiable Assets
A
B
C
Other
Totals
$40,000
$ 55,000 20,000 75,000 50,000 40,000 90,000 $(15,000) $ 80,000
$480,000 100,000 580,000 270,000 235,000 505,000 $ 75,000 $500,000
$ 90,000
$665,000 120,000 $785,000
40,000 19,000 10,000 29,000 $11,000 $35,000
90,000 49,000 30,000 79,000 $ 11,000 $115,000
Reconciliation of revenues Total segment revenues ........................................................ Revenues of immaterial segments ....................................... Elimination of intersegment revenues ................................. Revenues from reportable segments ...................................
$ 82,000 $730,000
$785,000 (90,000) (120,000) $575,000
Problem 23.2 (Continued) Reconciliation of profit or loss Total segment operating profit ............................................. Profits of immaterial segments............................................. Profits from reportable segments ........................................
$ 82,000 (11,000) $ 71,000
Reconciliation of assets Total segment assets ............................................................ Assets of immaterial segments ............................................ Assets from reportable segments ........................................
$730,000 (115,000) $615,000
LO: 2, Bloom: AP, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*Problem 23.3
(a)
BRADBURN CORPORATION Ratio Analysis 1.
Current ratio =
2025:
2.
$320,000 = 2.02 to 1 $158,500
2026:
$403,000 = 2.46 to 1 $164,000
Acid test (Quick) ratio = Current assets – Inventories Current liabilities 2025:
3.
Current assets Current liabilities
$270,000 = 1.70 to 1 $158,500
Inventory turnover =
2026:
$298,000 = 1.82 to 1 $164,000
Cost of goods sold Average inventory
$1,530,000 2026: ($50,000 + $105,000) = 19.74 times (every 18.49 days) 2 4.
Return on assets =
Net income Average total assets
2025:
$297,000 ($1,688,500 + $1,740,500) = 17.32% 2
2026:
$366,000 ($1,740,500 + $1,852,000) 2
= 20.38%
*Problem 23.3 (Continued) 5. Percent Changes
Amounts (000s omitted) 2026 2025
Percent Increase
Sales revenue
$3,000
$2,700
Cost of goods sold
1,530
1,425
Gross margin
1,470
1,275
366
297
$300 $2,700 $105 $1,425 $195 $1,275 $69 $297
Net income after taxes
= 11.11% = 7.37% = 15.29% = 23.23%
(b) Other financial reports and financial analyses that might be helpful to the commercial loan officer of Topeka National Bank include: 1. The Statement of Cash Flows would highlight the amount of cash provided by operating activities, the other sources of cash, and the uses of cash for the acquisition of long-term assets and long-term debt requirement. 2. Projected financial statements for 2027 including a projected Statement of Cash Flows. In addition, a review of Bradburn’s comprehensive budgets might be useful. These items would present management’s estimates of operations for the coming year. 3. A closer examination of Bradburn’s liquidity by calculating some additional ratios, such as day’s sales in receivables, accounts receivable turnover, and day’s sales in inventory. 4. An examination as to the extent that leverage is being used by Bradburn. (c) Bradburn Corporation should be able to finance the plant expansion from internally generated funds as shown in the calculations presented on the next page.
*Problem 23.3 (Continued)
Sales revenue Cost of goods sold Gross margin Operating expenses Income before income taxes Income taxes (40%) Net income Add: Depreciation Deduct: Dividends Note repayment Funds available for plant expansion Plant expansion Excess funds
2026
(000 omitted) 2027
2028
$3,000.0 1,530.0 1,470.0 860.0 610.0 244.0 $ 366.0
$3,333.3 1,642.8 1,690.5 948.2 742.3 296.9 $ 445.4
$3,703.6 1,763.8 1,939.8 1,045.5 894.3 357.7 $ 536.6
102.5 (260.0) (6.0) 281.9 (150.0) $ 131.9
102.5 (260.0) 379.1 (150.0) $ 229.1
Assumptions: Sales revenue increases at a rate of 11.11%. Cost of goods sold increases at rate of 7.37%, despite depreciation remaining constant. Other operating expenses increase at the same rate experienced from 2025 to 2026; i.e., at 10.26% ($80,000 ÷ $780,000).
Depreciation remains constant at $102,500. Dividends remain at $2 per share. Plant expansion is financed equally over the two years ($150,000 each year). Loan extension is granted.
(d) Topeka National Bank should probably grant the extension of the loan, if it is really required, because the projected cash flows for 2027 and 2028 indicate that an adequate amount of cash will be generated from operations to finance the plant expansion and repay the loan. In actuality, there is some question whether Bradburn needs the 24-month extension because the excess funds generated from 2027 operations might cover the $70,000 loan repayment. However, Bradburn may want the loan extension to provide a cushion because its cash balance is low. The financial ratios indicate that Bradburn has a solid financial structure. If the bank wanted some extra protection, it could require Bradburn to appropriate retained earnings for the amount of the loan and/or restrict cash dividends for the next two years to the 2026 amount of $2.00 per share. LO: 6, 8, Bloom: AP, Difficulty: Moderate, Time: 35-45, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Problem 23.4
(a)
GILMOUR COMPANY Comparative Balance Sheet December 31, 2026 and 2025 December 31 Assets Cash Accounts receivable (net) Short-term Investments Inventories Prepaid expenses Plant and equipment Accumulated depreciation Total Liabilities and Stockholders’ Equity Accounts payable Accrued expenses Bonds payable Common stock Retained earnings Total
2026
2025
$ 180,000 220,000 270,000 1,060,000 25,000 2,585,000 (1,000,000) $3,340,000
5.39% 6.59 8.08 31.74 .75 77.39 (29.94) 100.00%
$ 275,000 155,000 150,000 980,000 25,000 1,950,000 (750,000) $2,785,000
9.87% 5.57 5.38 35.19 .90 70.02 (26.93) 100.00%
$
1.50% 5.09 13.47 62.87 17.07 100.00%
$
2.69% 7.18 6.82 63.56 19.75 100.00%
50,000 170,000 450,000 2,100,000 570,000 $3,340,000
75,000 200,000 190,000 1,770,000 550,000 $2,785,000
*Problem 23.4 (Continued) (b)
GILMOUR COMPANY Comparative Balance Sheet December 31, 2026 and 2025 Assets Cash Accounts receivable (net) Short-term investments Inventories Prepaid expenses Plant and equipment Accumulated depreciation Total Liabilities and Stockholders’ Equity Accounts payable Accrued expenses Bonds payable Capital stock Retained earnings Total
December 31 Increase or (Decrease) 2026 2025 $ Change % Change $ 180,000 $ 275,000 $ (95,000) (34.55) 220,000 155,000 65,000 41.94 270,000 150,000 120,000 80.00 1,060,000 980,000 80,000 8.16 25,000 25,000 0 0 2,585,000 1,950,000 635,000 32.56 (1,000,000) (750,000) (250,000) 33.33 $ 3,340,000 $2,785,000 $ 555,000 19.93%
$
50,000 $ 75,000 170,000 200,000 450,000 190,000 2,100,000 1,770,000 570,000 550,000 $3,340,000 $2,785,000
$ (25,000) (33.33) (30,000) (15.00) 260,000 136.84 330,000 18.64 20,000 3.64 $555,000 19.93%
(c) The component percentage (common-size) balance sheet makes easier analysis possible. It actually reduces total assets and total liabilities and stockholders’ equity to a common base. Thus, the statement is simplified into figures that can be more readily grasped. It can also show relationships that might be out of line. For example, management might believe that accounts receivable of 6.59% is rather low. Perhaps the company is not granting enough credit. The increased percentage of bonds payable from 6.82% to 13.47% indicates increased leverage which may reflect negatively on the company’s debt-paying ability and long-run solvency. These percentages can be compared with those of other successful firms to see how the firm stands and to see where possible improvements could be made. (d) A statement such as that in part (b) is a good analysis and breakdown of the total change in assets and liabilities and stockholders’ equity. The statement breaks down the 19.93% increase and makes it easier for analysts to spot any unusual items. The increase is explained on the asset side by an increase in accounts receivable, short-term investments, and fixed assets and on the liability side by an increase in bonds payable and capital stock. This statement makes analysis of the year’s operations generally easier. LO: 9, Bloom: AP, Difficulty: Moderate, Time: 40-60, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*Problem 23.5
(a) In establishing a dividend policy, the following are factors that should be taken into consideration: 1.
The expansion plans or goals of the organization and the need for funds to finance new activities.
2.
The investment opportunities available to the company versus the return available to stockholders on earnings distributed by way of a cash dividend.
3.
The possible effect on the market value of the company’s shares of instituting a dividend, and the possible effect on financing alternatives.
4.
The earnings ability and stability of the company—past and future.
5.
The ability of the organization to maintain a given dividend in future years. To offer a dividend this year that cannot be maintained may be harmful. It could also be harmful to establish a policy seeming to call for increasing dividends over the years in the event the increase could not be kept up.
6.
The current position of the company. Is cash available to pay the dividend? Will working capital be decreased to a dangerous level?
7.
The possibility of offering a stock dividend in addition to or rather than a cash dividend.
8.
The dividend policies of other similar organizations.
9.
The general condition of the economy in the area where the company operates, as well as in the United States in general.
10.
The tax situation of the company.
11.
Legal restrictions, such as a restrictive covenant in a bond indenture.
*Problem 23.5 (Continued) 12.
Personal tax situations of stockholders if known—whether preference for dividends or capital gains.
13.
Degree of dispersion of stockholdings and stockholders’ needs or preference for dividends.
(b) Return on assets
Profit margin on sales
Earnings per share
Price-earnings ratio
Current ratio
2026 $2,400 $22,000 10.9%
2025 $1,400 $19,000 7.4%
2024 $800 $11,500 7.0%
2023 $700 $4,200 16.7%
2022 $250 $3,000 8.3%
$2,400 $20,000 12.0%
$1,400 $16,000 8.8%
$800 $14,000 5.7%
$700 $6,000 11.7%
$250 $4,000 6.3%
$2,400 2,000 $1.20
$1,400 2,000 $.70
$800 2,000 $.40
$700 20 $35.00
$250 20 $12.50
$9 $1.20 7.5 times
$6 $.70 8.6 times
$4 $.40 10 times
$8,000 $6,000 $3,000 $1,200 $1,000 $4,400* $2,800 $1,800 $700 $600 1.82 times 2.14 times 1.67 times 1.71 times 1.67 times
*$8,000 – $3,600
(c)
While the return on assets, profit margin on sales, and earnings per share have been increasing, the market price of the shares has not given full recognition to these increases. This suggests that market factors (and perhaps industry factors) are having a depressing effect on the market price of the shares. It may be suggested that the relatively low market price of the shares may be due, in part, to the fact that dividends have not been paid in the past. It may be concluded that the enterprise is in an improving operating position and appears to be able to pay a dividend (though the amount of cash is not given). It would, however, be wise to examine as many as possible of the other internal and external factors outlined in part (a) to this case.
*Problem 23.5 (Continued) A dividend in the range of 12¢ to 36¢ being 10% to 30% of earnings per share for 2026, would appear to be reasonable. Cash required would be $240,000 ($0.12 X 2,000,000) to $720,000 ($0.36 X 2,000,000). Payments considerably in excess of $720,000 would appear to have a serious impact on working capital. This would provide a yield of between 1.3% and 4% on the average 2026 market value. LO: 6, Bloom: AN, Difficulty: Complex, Time: 40-50, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
UJY 23.1 Financial Reporting Problem (a) Proctor & Gamble (P&G) commented on the following items in its note on accounting policies: Nature of operations Basis of presentation Use of estimates Revenue recognition Cost of products sold Selling, general and administrative expense Currency translation Other non-operating income, net
Cash flow presentation Investments Inventory valuation Property, plant and equipment Goodwill and other intangible assets Fair values of financial instruments New accounting pronouncements and policies
(b) P&G had the following reportable segments: Fabric Care Shave Care Baby Care Feminine Care Home Care Personal Health Care Skin and Personal Care All other Hair Care Family Care Oral Care The fabric care segment is the largest in net sales. Wal-Mart Stores, Inc. is P&G’s largest customer, accounting for 15% of 2020 net sales (Note 2). (c) In Note 15, P&G reported quarterly information for net sales, operating income, gross margin, net earnings, and diluted net earnings per common share. LO: 1, 2, Bloom: AN, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 23.2 Comparative Analysis Case THE COCA-COLA COMPANY VERSUS PEPSICO, INC. (a) 1.
Coca-Cola commented on the following list of items in its note on accounting policies: The Coca-Cola Company and Subsidiaries (Note 1) • • • • • • • • • • • • • • • • • • • • • •
2.
Description of Business Basis of Presentation Principles of Consolidation Revenue Recognition Advertising Costs Shipping and Handling Costs Sales, Use, Value-Added and Excise Taxes Net Income Per Share Cash, Cash Equivalents, Restricted Cash, and Restricted Cash Equivalents Short-term Investments Investments in Equity and Debt Securities Trade Accounts Receivable Inventories Derivative Instruments Leases Property, Plant and Equipment Goodwill, Trademarks and Other Intangible Assets Contingencies Stock-Based Compensation Income Taxes Translation and Remeasurement Recently Adopted Accounting Guidance
PepsiCo commented on the following list of items in its note on accounting policies: PepsiCo, Inc. and Subsidiaries Note 2—Our Significant Accounting Policies Revenue Recognition Total Marketplace Spending Distribution Costs
Comparative Analysis Case (Continued) Software Costs Commitments and Contingencies Research and Development Goodwill and Other Intangible Assets Other Significant Accounting Policies Recently Issued Accounting Pronouncements – Adopted Recently Issued Accounting Pronouncements – Not Yet Adopted (b) Coca-Cola divided its operations into seven operating segments: (1) Europe, Middle East and Africa, (2) Latin America, (3) North America, (4) Asia Pacific, (5) Global Ventures, (6) Bottling Investments, and (7) Corporate. PepsiCo divided its operations into six segments, with geographic subsegments: (1) Frito-Lay North America, (2) Quaker Foods North America, (3) North American Beverages (4) Latin America, (5) Europe (6) Africa, the Middle East & South Asia (7) Asia Pacific, Australia, New Zealand, and China. (c) Coca-Cola’s independent auditors are Ernst & Young LLP, while PepsiCo’s independent auditors are KPMG LLP. Coca-Cola’s audit report expresses an unqualified opinion on the financial statements and a separate report that expressed an opinion on the internal controls. PepsiCo’s audit report is a combined report that expresses an unqualified opinion on both the financial statements and the internal controls. Their report, therefore, has additional detail on the audit of internal controls. LO: 2, 3, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 23.3 *Financial Statement Analysis Case RNA INC. (a) The calculation of selected financial ratios for RNA for the fiscal year 2026 is as follows: Current ratio
=
Current assets Current liabilities
= $9,900 $6,300 =
Acid-test ratio
1.57
Short-term Net = Cash + investments + receivables Current liabilities = $3,900 $6,300 = .62
Times interest earned
Profit margin on sales
=
Income before income taxes and interest expense Interest expense
=
($7,060 + $900) $900
=
8.84
= Net income Net sales =
$4,260 $30,500
= 13.97%
*Financial Statement Analysis Case (Continued) Asset turnover
Inventory turnover
=
Net sales Average total assets
=
$30,500 [($17,000 + $16,000) ÷ 2]
=
1.85 times
=
Cost of goods sold Average inventory
=
$17,600 [($6,000 + $5,400) ÷ 2]
=
3.09 times
(b) The analytical use of each of the six ratios presented above and what investors can learn about RNA’s financial stability and operating efficiency are presented below. Current ratio • Measures the ability to meet short-term obligations using shortterm assets. •
RNA’s current ratio has declined over the last three years from 1.62 to 1.57. This declining trend, coupled with the fact that it is below the industry average, is not yet a major concern; however, the company should be watched in the future as the ratio assumes that noncash current assets (particularly inventory) can be quickly converted to cash at or close to book value.
Acid-test ratio • Measures the ability to meet short-term debt using the most liquid assets. •
RNA’s acid-test ratio has remained stable over the last three years; however, it is still below the industry average. Furthermore, a quick ratio below 1 indicates that RNA may have difficulty meeting its shortterm obligations if inventory does not turn over fast enough. *Financial Statement Analysis Case (Continued)
Times interest earned • Measures the ability to meet interest commitments from current earnings. The higher the ratio, the more safety for long-term creditors. • RNA’s ratio has been improving over the last three years and is above the industry average. This provides an indication that RNA has been paying down or refinancing debt and/or increasing sales and profits, which indicates long-term stability. Profit margin on sales • Measures the net income generated by each dollar of sales. It provides some indication of the ability to absorb cost increases or sales declines. • RNA’s profit margin has been improving and is currently above the industry average, indicating a trend towards marginal operating efficiency. Furthermore, it improves the ability to absorb soft economic periods, pay down debt, or take on additional debt for expansion. Asset turnover • Measures the efficiency of resource use; i.e., the ability to generate sales through the use of assets. • RNA’s ratio has been improving slightly and is just above the industry average, indicating a reasonable use of assets and ability to generate sales. Inventory turnover • Measures how quickly inventory is sold, as well as how effectively investment in inventory is used. It also provides a basis for determining if obsolete inventory is present or pricing problems exist. • RNA’s ratio has been steadily declining and is below the industry average. This slower-than-average situation may indicate a decline in operating efficiency, hidden obsolete inventory, or overpriced stock items.
*Financial Statement Analysis Case (Continued) (c) Limitations of ratio analysis include: • Difficulty making comparisons among firms in the same industry due to accounting differences. Different accounting methods may cause different results in straight-line depreciation versus accelerated methods, LIFO versus FIFO, etc. • The fact that no one ratio is conclusive. LO: 6, 7, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, Research, AICPA PC: Communication
UYJ 23.4 Accounting, Analysis, and Principles Accounting Integral Approach
Sales Less: Variable manufacturing costs Fixed manufacturing costs Variable non-manufacturing costs Fixed non-manufacturing costs Net income
1st Quarter $320,000
2nd Quarter
3rd Quarter
4th Quarter
$600,000
$2,200,000
$480,000
32,000 64,000
60,000 120,000
220,000 440,000
48,000 96,000
28,000
52,500
192,500
42,000
96,000 $100,000
180,000 $187,500
660,000 $ 687,500
144,000 $150,000
Sales = (Number of units X $4.00) Variable manufacturing costs = (Number of units X $0.40) Variable non-manufacturing costs = (Number of units X $0.35) Fixed manufacturing costs = Number of units X ($720,000 ÷ 900,000) Fixed non-manufacturing costs = Number of units X ($1,080,000 ÷ 900,000) Discrete Approach 1st Quarter Sales Less: Variable manufacturing costs Fixed manufacturing costs Variable non-manufacturing costs *Fixed non-manufacturing costs Net income (Loss)
*$1,080,000 ÷ 4
3rd Quarter $2,200,000
4th Quarter
$320,000
2nd Quarter $600,000
32,000 64,000
60,000 120,000
220,000 440,000
48,000 96,000
28,000 270,000 ($ 74,000)
52,500 270,000 $ 97,500
192,500 270,000 $1,077,500
42,000 270,000 $ 24,000
$480,000
Accounting, Analysis, and Principles (Continued) Analysis Profit margin on sales = Net income ÷ Net sales Integral approach:
Net income (Loss) Net sales Profit margin on sales
1st Quarter $100,000 320,000 31.3%
2nd Quarter $187,500 600,000 31.3%
3rd Quarter $ 687,500 2,200,000 31.3%
4th Quarter $150,000 480,000 31.3%
1st Quarter $(74,000) 320,000 (23.1%)
2nd Quarter $97,500 600,000 16.3%
3rd Quarter $1,077,500 2,200,000 49.0%
4th Quarter $ 24,000 480,000 5.0%
Discrete approach:
Net income (Loss) Net sales Profit margin on sales
The integral approach smooths variation in profit margin on sales across quarters relative to the discrete approach. This smoothing happens because the integral approach allocates fixed costs across quarters according to the sales occurring in the quarter. The discrete approach, however, allocates fixed costs across quarters evenly (an equal amount each quarter). Because the sales vary from quarter-to-quarter, an even allocation of fixed costs to the quarter’s results in more variation in net income. Principles The concept underlying the integral approach is that an individual quarter is part of a larger time interval about which we have more information. In this problem, for example, we know that sales are seasonal. Therefore, we know that a greater proportion of the revenue generating process occurs in the third quarter than in the other quarters. Arguably, then, a greater proportion of the fixed costs for the year should be allocated to the third quarter than to the other quarters. Part of the reason we incur fixed costs at the level we do is so that we can handle the volume of the third quarter. Allocating the same amount of fixed costs to each quarter paints a picture of the firm’s profitability across quarters that is arguably inaccurate. LO: 2, Bloom: SYN, Difficulty: Complex, Time: 30-40, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Time and Purpose of Critical Thinking CT 23.1 (Time 10–20 minutes) Purpose—to provide the student with an understanding of the necessary information that must be disclosed in the financial statements with regard to certain asset classifications. The student is required to discuss each of these respective disclosures for Inventories and Property, Plant, and Equipment in the audited financial statements issued to the stockholders. CT 23.2 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the necessary information that should be disclosed in the financial statements and notes. The student is required to evaluate the facts of four items concerning the company’s operations and to discuss any additional disclosures in the financial statements and notes that the auditor should recommend with respect to these items. CT 23.3 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the types of disclosures that are necessitated under certain circumstances. This case involves three independent situations dealing with such concepts as warranty claims, a self-insurance contingency, and the discovery of a probable loss subsequent to the date of the financial statements. The student is required to discuss the accrual treatment and type of disclosure necessary and the reasons why such disclosure is appropriate for each of the three situations. CT 23.4 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the proper accounting for subsequent event transactions. Bankruptcy, issue of debt, strikes, and other typical subsequent event transactions are presented. CT 23.5 (Time 30–35 minutes) Purpose—to provide the student with an understanding of segment reporting requirements, including providing explanations as to which segments are reportable. CT 23.6 (Time 20–25 minutes) Purpose—to provide the student with an understanding of segment reporting. The case explores why a company did not have to prepare certain segment information. In addition, examination of when export sales should be disclosed is discussed. Finally, the student is asked to determine why international segments should be reported if significant international operations exist. CT 23.7 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the concepts underlying the applications of segment reporting. The student is required to identify the reasons for requiring financial data to be reported by segments, the possible disadvantages of this requirement, and the accounting difficulties inherent in segment reporting. CT 23.8 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the applications and requirements of interim financial reporting. The student is required to explain how a company’s operating results would be reflected in a quarterly report and describe what financial information must be disclosed to a company’s stockholders in the quarterly reports.
Time and Purpose of Critical Thinking (Continued) CT 23.9 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the concepts of interim reporting and its respective applications to specific financial information. This case involves six independent examples on how accounting facts might be reported on a company’s quarterly reports. The student is required to evaluate each example and state whether the method proposed to be used for interim reporting would be acceptable under generally accepted accounting principles applicable to interim financial data. CT 23.10 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the conceptual merits underlying the preparation of financial forecasts. The student is required to discuss the arguments for preparing profit forecasts, the purpose of the “safe harbor” rule, and the reasons why corporations are concerned about presenting financial forecasts. CT 23.11 (Time 15–20 minutes) Purpose—to provide the student with an understanding of an ethical dilemma that may arise in the future. In this case, the reason for the profit margin increasing is not properly described by the financial vice president and the controller realizes the misstatement. The question is what should the controller do? CT 23.12 (Time 10–15 minutes) Purpose—to provide the student with an understanding of an ethical dilemma that may arise in the future. In this case, the company decides to delay the issuance of a debt offering to make their ratios look more impressive. *CT 23.13 (Time 24–35 minutes) Purpose—to provide the student with an understanding of the effects which various transactions have on a company’s financial status. The student is required to decide for each of these transactions the respective effect on the company’s net income, retained earnings, current ratio, stockholders’ equity, and stockholders’ equity per share of stock.
Solutions to Critical Thinking CT 23.1 Koch Corporation must disclose the following information regarding inventories: 1. The dollar amount assigned to inventory. 2. The method of inventory pricing; e.g., FIFO, LIFO, weighted average. 3. The basis of valuation; i.e., cost or lower-of-cost-or-net realizable value or lower-of-cost-or-market; if an amount other than cost is presented, then cost should still be presented by stating the amount of cost or by stating the amount of the valuation allowance. 4. The composition of the inventory into raw materials, work-in-process, and finished goods. The following information must be disclosed for property, plant, and equipment: 1. The balance of major classes of depreciable assets (assets classified by nature or function). 2. Accumulated depreciation, either by major classes of depreciable assets or in total. 3. A general description of the methods used in computing depreciation on major classes of depreciable assets. 4. The amount of depreciation expense for the period. The information regarding inventories and property, plant, and equipment will be disclosed in the body of the financial statements and in the notes, which are an integral part of the statements. LO: 1,2 Bloom: AN, Difficulty: Simple, Time: 10-20, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.2 Item 1 The staff auditor reviewing the loan agreement misinterpreted its requirements. Retained earnings are restricted in the amount of $420,000, which was the balance of retained earnings at the date of the agreement. The nature and amount of the restriction should be disclosed in the balance sheet or a note to the financial statements. Item 2 Unless cumulative preferred dividends are involved, no recommendation by the CPA is required. Common stock dividend policy is understood by readers of financial statements to be discretionary on the part of the board of directors. The company need not commit itself to a prospective common stock dividend policy or explain its historical policy in the financial statements, particularly since dividend policy is to be discussed in the president’s letter. If cumulative preferred dividends are omitted, this should be disclosed in the financial statements or a note. Note that the SEC encourages companies to disclose their dividend policy in their annual report. Those that: (1) have earnings but fail to pay dividends or (2) do not expect to pay dividends in the foreseeable future are encouraged to report this information. In addition, companies that show a consistent pattern of paying dividends are encouraged to indicate whether they intend to continue this practice in the future. Item 3 A competitive development of this nature normally is considered to be the type of subsequent event that provides evidence with respect to a condition that did not exist at the date of the balance sheet. In some circumstances, the auditor might conclude that Ace’s poor competitive situation was evident at yearend. In any event, the development should be disclosed to users of the financial statements because the economic recoverability of the new plant and inventory are in doubt and Ace may incur substantial expenditures to modify its facilities. Because the economic effects probably cannot be determined, the usual disclosure will be in a note to the financial statements. If the present recoverable value of the plant can be determined, Ace should consider disclosure of the company’s revised financial position in a pro-forma balance sheet, assuming that this event is concluded to be evidence of a condition that did not exist at year-end. (Only if circumstances were such that it was concluded that this condition did exist at year-end should the financial statements for the year ended December 31, 2026, be adjusted for the ascertainable economic effects of this development.)
CT 23.2 (Continued)
Item 4 The lease agreement with Wichita National Bank meets the criteria for a finance lease because it contains a bargain purchase option (a 25-year-life building can be purchased at the end of 10 years for $1). Additionally, unless the fair value of the building is considerably greater than its $2,400,000 cost, the present value of the lease payments probably exceeds 90% of the fair value of the building. The lessee, therefore, capitalizes the leased asset and the related obligation in the balance sheet at the appropriate discounted amount of the future rental payments under the lease agreement. Via note, the lessee must disclose: (1) the gross amount of the leased asset and the accumulated depreciation thereon, (2) the future minimum lease payments as of the latest balance sheet date, in the aggregate and for each five succeeding fiscal years and for the amount of imputed interest necessary to reduce the lease payments to present value, (3) a general description of the lease arrangement, and (4) the existence of the terms of the purchase option. The income statement should contain a charge for depreciation of the leased asset plus an interest charge. LO: 1,2, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.3 Situation 1 When a company sells a product subject to a warranty, it is probable that there will be expenses incurred in future accounting periods relating to revenues recognized in the current period. As such, a liability has been incurred to honor the warranty at the same date as the recognition of the revenue. Based on prior experience or technical analysis, the occurrence of warranty claims can be reasonably estimated, and a probable dollar estimate of the liability can be made. The contingent liability for warranties meets both of the requirements for the accrual of a loss contingency, and the estimated amount of the loss should be reflected in the financial statements. In addition to recording the accrual, it may be advisable to disclose the factors used in arriving at the estimate by means of a note, especially when there is a possibility of a greater loss than was accrued. Situation 2 Even though: (1) there is a probable loss on the contract, (2) the amount of the loss can be reasonably estimated and (3) the likelihood of the loss was discovered prior to the issuance of the financial statements, the fact that the contract was entered into subsequent to the date of the financial statements precludes accrual of the loss contingency in financial statements for periods prior to the incurrence of the loss. However, the fact that a material loss has been incurred subsequent to the date of the financial statements but prior to their issuance should be disclosed by means of a note in the financial statements. The disclosure should contain the nature of the contingency and an estimate of the amount of the probable loss or a range into which the loss will probably fall. Situation 3 The fact that a company chooses to self-insure the contingency of injury to others caused by its vehicles is not enough of a basis to accrue a loss contingency that has not occurred at the date of the financial statements. An accrual or “reserve” cannot be made for the amount of insurance premium that would have been paid had a policy been obtained to insure the company against this particular risk. A loss contingency may only be accrued if prior to the date of the financial statements a specific event has occurred that will impair an asset or create a liability and an amount related to that specific occurrence can be reasonably estimated. The fact that the company is self-insuring this risk should be disclosed by means of a note to alert the financial statement reader to the exposure created by the lack of insurance. LO: 1,2 Bloom: AN, Difficulty: Simple, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.4 1.
The financial statements should be adjusted for the expected loss pertaining to the remaining receivable of $240,000. Such adjustment should reduce accounts receivable to their realizable value as of December 31, 2025.
2.
Report the fire loss in a footnote to the balance sheet and refer to it in connection with the income statement, since earnings power is presumably affected.
3.
Strikes are considered general knowledge and therefore, disclosure is not required. Many auditors, however, would encourage disclosure in all cases.
4.
If this event is of the second type, which provides evidence with respect to conditions that did not exist at December 31, 2025, then appropriate disclosures should indicate that: (a) (b) (c)
Recovery of costs invested in plant and inventory is in doubt. The company may incur additional costs to modify the existing facility. Due to this situation, future economic events cannot be determined. (If we could determine them, pro-forma information might be appropriate.)
If it is the type of subsequent event for which the condition existed at December 31, 2025, then the financial statements must be adjusted. The provisions of GAAP accounting related to contingencies would govern if amounts could not be estimated. It should be emphasized in class that no right answer exists for this problem. Judgment must play a major role in determining the adjustment or disclosure necessary for this transaction. 5.
Adjust the inventory figure as of December 31, 2025, as required by a market price of $2.00 instead of $1.40, applying the lower-of-cost-or-market principle. The actual quotation was a transitory error and no purchases had been made at this quotation.
6.
Report the action of the new stock issue in a footnote to the balance sheet.
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.5 To:
Anthony Reese, Accountant
From:
Student
Date:
Current date
Subject:
Determination of reportable segments for Winsor Corporation International.
I have analyzed the segment information that you gave me and determined that the funeral, the cemetery, and the real estate segments must be reported separately. The remaining three—the limousine, floral, and dried whey segments—can be combined under the category of other. To make this determination, I applied three criteria put forth by the FASB to the information provided for 2026. First, a segment must be reported separately if its revenue is greater than or equal to 10 percent of the enterprise’s combined revenue. This is the case with both the funeral and the cemetery segments as revenue for both is greater than $40,600 (10 percent of combined revenue).
CT 23.5 (Continued) Second, a segment is considered significant enough to be reported separately if its absolute operating profit or operating loss is 10% or more of the greater, in absolute amount of: (a) the combined operating profit of all segments without an operating loss or (b) the combined operating loss of all segments that incurred a loss. Combined operating profit for all profitable segments totals $96,000. Both the funeral and the cemetery segments have operating profits exceeding 10% of total profits whereas the real estate segment’s operating loss in absolute amount is greater than 10 percent of total profits. Thus, all three must be separately reported. Third, a segment must be reported separately if its identifiable assets are greater than or equal to 10 percent of the combined identifiable assets for all segments. Again, the funeral, the cemetery, and the real estate segments meet this test. Note that the limousine, floral, and dried whey segments meet none of the above criteria, so they are not reported separately. The three reportable segments do possess more than 75% of the combined sales to unaffiliated customers for the entire company. When reporting segment information, you must include the following items: revenues, operating profit (loss), identifiable assets, depreciation expense, and amount of capital expenditures. Furthermore, all segment information must be prepared on the same accounting basis as the consolidated entity’s. I hope that this information helps you in determining future reportable segments. If you have any other questions, please contact me. LO: 2, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: Marketing/ Client Perspective, AICPA FC: Reporting, AICPA PC: Communication, Professional Demeanor
CT 23.6 (a)
Some companies such as H. J. Heinz have only one dominant line of business and therefore, it is impossible to provide segmented data in a meaningful fashion. Dominant means that a given segment has 90% of all the sales, profit, and identifiable assets of the company. In this case, segmented data are not provided, but the industry in which the dominant segment operates must be identified.
(b)
Export sales are sales to customers in foreign countries by a domestic operation. Export sales must be reported when a company derives 10% or more of its revenue (consolidated revenue) from this source.
(c)
Reporting sales by geographical area is extremely important. Many countries are both unstable politically and economically, and, as a result, sales to these areas should be evaluated carefully. Conversely, sales to countries that appear politically and economically stable suggest a high rate of continuance of sales to these areas.
LO: 2, Bloom: AN, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.7 (a)
Financial reporting for segments of a business enterprise involves reporting financial information on a less-than-total enterprise basis. These segments may be defined along organizational lines, such as divisions, branches, or subsidiaries. Segmentation could be based on areas of economic activity, such as industries in which the enterprise operates, product lines, types of services rendered, markets, types of customers, or geographical areas. In addition to these possible individual definitions of an enterprise’s segments, a company may use more than one of the above-cited bases of segmentation.
(b)
The reasons for requiring financial data to be reported by segments include the following:
CT 23.7 (Continued) 1. 2. 3. 4. 5. 6. 7. (c)
The possible disadvantages of requiring financial data to be reported by segments include the following: 1. 2. 3. 4.
5. 6.
(d)
They would provide more detailed disclosure of information needed by investors, creditors, and other users of financial statements. Appraisers can evaluate major segments of a business enterprise before considering the business in its entirety. In addition to being useful and desirable, such information is practical to compute. The growth potential of an enterprise can be evaluated by reviewing the growth potential of its major segments. Users can better assess management decisions to drop or add a segment. Projection of future earning power is made more effective when approached on a segment basis because different segments may have differing rates of growth, profitability, and degrees of risk. Managerial ability is better assessed with segment data because managerial responsibility within the enterprise is frequently decentralized.
They could be misinterpreted due to the public’s general lack of appreciation of the limitations of the somewhat arbitrary bases for most allocations of common costs. They may disguise the interdependence of all the segments. They might result in misleading comparisons of segments of different enterprises. Confidential information would be revealed to competitors about profitable or unprofitable products, plans for new products or entries into new markets, apparent weaknesses that might induce competitors to increase their own efforts to take advantage of the weakness, and the existence of advantages not otherwise indicated. Information thus made available might cause customers to challenge prices to the disadvantage of the company. Operating data reported by segments might be misleading to those who read them. Segment data prepared for internal management purposes often include arbitrary judgments that are known to those using the data and taken into account in making evaluations. The difficulty of making such background information available and understandable to outside users is considered by many to be insurmountable.
The accounting difficulties inherent in segment reporting include the following: 1. 2.
The transfer prices must be determined. Transfer prices are those charged when one segment deals with another segment of the same enterprise. Various possible transfer prices exist, and the company must select one. The computation of segment net income must be defined. The net income may be merely a contribution margin, that is, sales less variable costs, or a more conventional measure of net income. If a contribution-margin approach is used, the variable costs must be identified. If a more conventional measure of net income is used, the treatment of various items for each segment’s net income must be established. Such items include the following: (a) (b) (c)
3.
Determining whether common costs should be allocated to segments. Selecting allocation bases if common costs are to be allocated. Determining which costs of capital (interest, preferred dividends, etc.) should be attributed to segments. (d) Determining whether the effect of a change in accounting principle should be attributed to segments. (e) Determining how income tax should be allocated to segments. (f) Determining how a minority interest’s share of income, and income from investee companies, should be attributed to segments. The treatment of segment information in interim financial reports must be established.
CT 23.7 (Continued) 4. 5. 6.
The method of presenting segment information in financial statements must be established. Such presentation may be by notes or by separate financial statements. The additional disclosures required, such as accounting policies used, must be established. The effect of annual comparisons must be considered. This would entail retroactive restatement of previously reported segment information presented currently for comparative purposes.
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 25-30, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.8 (a)
1.
The company should report its quarterly results as if each interim period is an integral part of the annual period, although the discrete approach is used for some items.
2.
The company’s revenue and expenses would be reported as follows on its quarterly report prepared for the first quarter of the 2025–2026 fiscal year: Sales revenue ........................................................................................... Cost of goods sold .................................................................................... Variable selling expenses ......................................................................... Fixed selling expenses Advertising ($2,000,000 ÷ 4)............................................................. Other ($3,000,000 – $2,000,000) .....................................................
$60,000,000 36,000,000 1,000,000 500,000 1,000,000
Sales revenue and cost of goods sold receive the same treatment as if this were an annual report. Costs and expenses other than product costs should be charged to expense in interim periods as incurred or allocated among interim periods. Consequently, the variable selling expense and the portion of fixed selling expenses not related to the television advertising should be reported in full. One-fourth of the television advertising is reported as an expense in the first quarter, assuming TV advertising is constant throughout the year. These costs can be deferred within the fiscal period if the benefits of the expenditure clearly extend beyond the interim period in which the expenditure is made. (b)
The financial information to be disclosed to its stockholders in its quarterly reports as a minimum include: 1. 2. 3. 4. 5. 6. 7. 8.
Sales revenue or gross revenues, provision for income taxes, and net income. Basic and diluted earnings per share. Seasonal revenue, costs, or expenses. Significant changes in estimates or provisions for income taxes. Disposal of a component of a business and unusual, or infrequently occurring items. Contingent items. Changes in accounting principles or estimates. Significant changes in financial position.
LO: 2, Bloom: AN, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.9 (a)
Acceptable. The use of gross profit rates to estimate the cost of goods sold is acceptable for interim reporting purposes as long as the method and rates utilized are reasonable. The
CT 23.9 (Continued) company should disclose the method employed and any significant adjustments that result from reconciliations with annual physical inventory. (b)
Acceptable. Pension costs are more identifiable with a time period rather than with the sale of a product or service. Companies are encouraged to make quarterly estimates of those items that usually result in year-end adjustments. Consequently, it is acceptable to allocate this expense to each of the four interim periods.
(c)
Acceptable. Any loss in inventory value should be reported when the decline occurs. Any recoveries of the losses on the same inventory in later periods should be recognized as gains in the later interim periods of the same fiscal year. However, the gains should not exceed the previously recorded losses.
(d)
Not acceptable. Gains on the sale of investments would not be deferred if they occurred at yearend. Consequently, they should not be deferred to future interim periods but should be reported in the quarter the gain was realized.
(e)
Acceptable. The annual audit fee is an expense that benefits the company’s entire year. Companies are encouraged to make quarterly estimates of these items that usually result in year-end adjustments. Therefore, this expense can be prorated over the four quarters.
(f)
Not acceptable. Revenue from products sold should be recognized during the interim period on the same basis as followed for the full year. Because the company normally recognizes a sale when shipment occurs, it should recognize the revenue in the second quarter and not defer the revenue recognition. To do otherwise would be an inconsistent application of company accounting policy and violate general accounting rules for revenue recognition.
LO: 2, Bloom: AN, Difficulty: Moderate, Time: 30-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
CT 23.10 (a)
Arguments for requiring published forecasts: 1. 2. 3.
Investment decisions are based on future expectations; therefore, information about the future would facilitate better decisions. Forecasts are already circulated informally, but are uncontrolled, frequently misleading, and may not be available equally to all investors. This confused situation should be brought under control. Circumstances now change so rapidly that historical information is no longer adequate as a base of prediction.
(b)
The purpose of a safe harbor rule is to provide protection to an enterprise that presents an erroneous projection as long as the projections were prepared on a reasonable basis and were disclosed in good faith. An enterprise’s concern with the safe harbor rule is that a jury’s definition of reasonable might be at some variance from a company’s or, for that matter, the SEC’s.
(c)
An enterprise’s concerns about preparing a forecast are as follows: 1. 2. 3.
No one can foretell the future. Therefore, forecasts, while conveying an impression of precision about the future, will inevitably be wrong. Organizations will strive only to meet their published forecasts, not to produce results that are in the stockholders’ best interest. When forecasts are not proved to be accurate, there will be recriminations and probably legal actions. Even with a safe harbor rule, enterprises are concerned because the definition of reasonable is subjective.
CT 23.10 (Continued) 4.
Disclosure of forecasts will be detrimental to enterprises because it will fully inform not only investors, but also competitors (foreign and domestic).
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication, Professional Demeanor
CT 23.11 (a)
The controller notes that the financial vice president is misrepresenting the financial condition of the company by suggesting that the company has become more efficient when, in fact, the improved ratio is gained through manipulation of estimates. The controller, however, hesitates because estimating does not follow precise, clear-cut rules. The dilemma exists because Lilly is asked to weigh the benefits that may accrue to the company if its profit margin on sales appears much improved against the accountant’s normal requirement to present financial information fairly (that is, in a manner that is consistent with previous reporting).
(b)
No, the controller should oppose the release of the publicity. The company has not improved its financial condition, and the claim of increased efficiency is not supported by the financial information.
(c)
The favorable media release enhances the current stockholders’ position, as well as boosting the image of management. Such publicity may well contribute to an increased stock price. Future investors and stockholders are harmed because the media release depicts a misleading perspective on the financial condition of the company.
(d)
The controller is responsible for both the accuracy and the clarity of financial reporting. If the media release obscures how an accounting decision has influenced the apparent improvement of the company’s financial condition, the controller cannot let this matter slide. Lilly must protest and not let her name be connected to the misinformation.
LO: 4, Bloom: AN, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, Communication, Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication, Professional Demeanor
CT 23.12 (a)
The ethical issues involved are profitability, long-term versus short-term performance, and integrity of financial reporting.
(b)
Form should not dictate substance. The bonds should be issued when the company needs the cash to help improve its performance. Though ratios may be lower than desired if the bonds are issued immediately, the investors and creditors are served best when the company is performing at the highest possible level. If immediate cash inflow will assist enhanced performance, McElroy should not delay issuance.
LO: 2, Bloom: AN, Difficulty: Simple, Time: 10-15, AACSB: Analytic, Communication. Ethics, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
*CT 23.13 1. 2. 3.
b, j a, e, i e, h, i
4. 5. 6.
b, j j e
7. 8. 9.
a, e, i b, e, j d, j
LO: 6, Bloom: AP, Difficulty: Complex, Time: 25-35, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
Codification Exercises CE23.1 Master Glossary (a)
Ordinary income (or loss) refers to income (or loss) from continuing operations before income taxes (or benefits) excluding significant unusual or infrequently occurring items. Discontinued operations, and cumulative effects of changes in accounting principles are also excluded from this term. The term is not used in the income tax context of ordinary income vs. capital gain.
(b)
An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of generally accepted accounting principles (GAAP), or oversight or misuse of facts that existed at the time the financial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error.
(c)
The amount of earnings attributable to each share of common stock. For convenience, the term is used to refer to either earnings or loss per share.
(d)
A business entity that has any of the following characteristics: a. Whose securities are traded in a public market on a domestic stock exchange or in the domestic over-the-counter market (including securities quoted only locally or regionally) b. That is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets) c. Whose financial statements are filed with a regulatory agency in preparation for the sale of any class of securities in a domestic market.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE23.2 According to FASB ASC Glossary: Related parties include: a. Affiliates of the entity b. Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity c. Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management d. Principal owners of the entity and members of their immediate families e. Management of the entity and members of their immediate families f. Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests g. Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE23.3 According to FASB ASC 280-10-50-12 (Segment Reporting—Overall—Disclosure): A public entity shall report separately information about an operating segment that meets any of the following quantitative thresholds (see Example 2, Cases C, D, and E [paragraphs 280-10-55-39 through 55-45]): (a)
Its reported revenue, including both sales to external customers and intersegment sales or transfers, is 10 percent or more of the combined revenue, internal and external, of all operating segments.
(b)
The absolute amount of its reported profit or loss is 10 percent or more of the greater, in absolute amount, of either: 1. The combined reported profit of all operating segments that did not report a loss. 2. The combined reported loss of all operating segments that did report a loss.
(c)
Its assets are 10 percent or more of the combined assets of all operating segments.
Operating segments that do not meet any of the quantitative thresholds may be considered reportable, and separately disclosed, if management believes that information about the segment would be useful to readers of the financial statements. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
CE23.4 No. According to FASB ASC 270-10-S99-2 (Interim Reporting— Overall—SEC Materials): Question 2: The staff believes disclosure of inventory components is important to investors. In reaching this decision, the staff recognizes that registrants may not take inventories during interim periods and that managements, therefore, will have to estimate the inventory components. However, the staff believes that management will be able to make reasonable estimates of inventory components based upon their knowledge of the company’s production cycle, the costs (labor and overhead) associated with this cycle as well as the relative sales and purchasing volume of the company. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication
Codification Research Case (a) According to FASB ASC 235-10-50: 50-3 Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. A selection from existing acceptable alternatives b. Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry c. Unusual or innovative applications of GAAP. (b) According to FASB ASC 235-10-50. Examples of Disclosures 50-4 Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. Basis of consolidation b. Depreciation methods c. Amortization of intangibles d. Inventory pricing e. Accounting for recognition of profit on long-term constructiontype contracts f. Recognition of revenue from franchising and leasing operations. LO: 1, 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Analytic, Communication, AICPA BB: Technology, AICPA FC: Reporting, Research, Technology, AICPA PC: Communication