SOLUTION MANUAL FOR Financial Accounting, (International Edition), 11 EDITION. Marian Powers, Belver by StudyGuide

CHAPTER 1—Solutions USES OF ACCOUNTING INFORMATION AND THE FINANCIAL STATEMENTS Chapter 1, SE 1. 1. 2. 3. 4. 5.

g f b c e

6. 7. 8. 9. 10.

i d a j h

4. 5.

b a

4. 5. 6.

c a c

Chapter 1, SE 2. 1. 2. 3.

b c a

Chapter 1, SE 3. 1. 2. 3.

a c b

Chapter 1, SE 4. 1. 2. 3.

Assets = Stockholders' Equity = Liabilities =

$120,000 $ 72,000 $100,000

Chapter 1, SE 5. 1.

Assets $480,000 $480,000 Stockholders' Equity

= = – =

Liabilities + Stockholders' Equity $180,000 + Stockholders' Equity $180,000 = $300,000 $300,000

Assets Assets – 0.2 Assets 0.8 Assets Assets Assets Liabilities

= = = = = =

0.2 Assets + $80,000 $80,000 $80,000 $80,000 ÷ 0.8 $100,000 $100,000 × 0.2 = $20,000 1

Chapter 1, SE 6. Beginning:

Change: End: Beginning:

Change: End:

$ 90,000 Liabilities $ 90,000 + 60,000 $150,000 Stockholders' Equity

= = =

Assets Assets $292,000 + 80,000 $372,000 Stockholders' Equity

= = =

Liabilities + $50,000 $ 40,000 $ 40,000 + $50,000 + 10,000 $ 50,000 + Stockholders' Equity $100,000

= =

$100,000 $292,000 $100,000 – 60,000 $ 40,000 $332,000

= =

+ $192,000 + $192,000 + Stockholders' Equity

Chapter 1, SE 7. Net income = $108,000 Beginning of year

Assets = $280,000 =

During year

Investment Dividends Net Income*

End of year

$400,000

$260,000 –

Liabilities $120,000

+ Stockholders' Equity $160,000 + $ 40,000 48,000 108,000

$160,000 ) –

$140,000 $40,000

$260,000

+ +

$48,000

= $108,000

Chapter 1, SE 8. Globe Company Balance Sheet June 30, 2011 Assets Cash * Accounts receivable Building

Total assets

Liabilities $ 5,800 1,600 22,000

$29,400

Wages payable Stockholders' Equity Common stock $24,000 4,700 Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

* To balance 2 .

700

28,700 $29,400

Chapter 1, SE 9. Tarech Corporation Income Statement For the Year Ended December 31, 2011 Revenue Service revenue Expenses Total expenses

$4,800 2,450 $2,350

Net income Tarech Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income for the year Subtotal Less dividends

$ — 2,350

Retained earnings, December 31, 2011

$1,940

$2,350 410

Tarech Corporation Balance Sheet December 31, 2011 Assets Cash Other assets

Liabilities $1,890 1,000

Accounts payable

$ 450

Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and Total assets

$2,890

stockholders' equity

3 .

$ 500 1,940 2,440 $2,890

Chapter 1, SE 10. Anatole Company Balance Sheet April 30, 2011 Assets Cash * Accounts receivable Building

Liabilities $12,800 Wages payable 3,200 40,000 Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and

Total assets

$56,000

stockholders' equity

*To balance

4 .

$ 1,000

$48,000 7,000 55,000 $56,000

Chapter 1, SE 11. Patel Corporation Income Statement For the Year Ended December 31, 2011 Revenue Service revenue Expenses Total expenses

$9,600 4,900 $4,700

Net income Patel Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2011 Net income for the year Subtotal Less dividends

$ — 4,700

Retained earnings, December 31, 2011

$3,880

$4,700 820

Patel Corporation Balance Sheet December 31, 2011 Assets Cash Other assets

Liabilities $3,780 2,000

Accounts payable

$ 900

Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and Total assets

$5,780

stockholders' equity

5 .

$1,000 3,880 4,880 $5,780

Chapter 1, SE 12. AICPA: American Institute of Certified Public Accountants Securities and Exchange Commission SEC: PCAOB: Public Company Accounting Oversight Board GAAP: Generally accepted accounting principles Financial Accounting Standards Board FASB: International financial reporting standards IFRS: Internal Revenue Service IRS: GASB: Governmental Accounting Standards Board International Accounting Standards Board IASB: Institute of Management Accountants IMA: Certified public accountant CPA: Chapter 1, SE 13. Net Income Revenues Profit Margin =

$ 30,000 $220,000 Net Income Revenues

6 .

$30,000 $220,000

0.136 or 13.6%

Chapter 1, E 1. 1. The primary purpose of accounting is to provide decision makers with the financial information they need to make intelligent decisions. It is a valuable discipline because of the usefulness of the information it generates. 2. Like managers of profit-seeking businesses, managers of government and notfor-profit organizations must report to those who fund them, and they must operate their organizations in a financially prudent way. 3. No, not all economic events involve exchanges of value between a business and someone else. For example, when a customer places an order, it is an economic event, but until the order is fulfilled, no exchange of value has taken place. 4. Accounting treats sole proprietorships, partnerships, and corporations as entities separate and apart from their owners because each form represents a business for which financial performance must be measured and reported. Chapter 1, E 2. 1. Expenses and dividends are the same in that they both reduce the retained earnings component of stockholders' equity. They are different in that expenses are also a component of net income, whereas dividends are a distribution of assets to stockholders resulting from net income. 2. CVS and Southwest are comparable in that like all companies, they have two main goals: profitability and liquidity. How companies such as CVS and Southwest achieve these goals may make them incomparable in certain ways. For instance, CVS is a retail (pharmacy and related) company, whereas Southwest is a service (air transportation) company. CVS buys and leases retail stores, whereas Southwest buys and leases aircraft. 3. GAAP differ from the laws of science in that they are not unchanging but rather are constantly evolving. They may change as business conditions change or as improved methods of accounting are introduced. 4. Unethical ways of accounting include recording and reporting business transactions that did not occur or being dishonest in recording those that did occur. Financial statements are unethically prepared when they misrepresent a company's financial situation or contain false information.

7 .

Chapter 1, E 3. 1. 2. 3. 4.

a l c i

5. 6. 7. 8.

k e b j

9. g 10. d 11. f 12. h

Chapter 1, E 4. People who are interested in Cellhealth's financial statements are the following: Management Investors (stockholders in the company) Creditors Tax authorities Regulators Labor unions Customers Economic planners A partnership is a business that has two or more owners. A corporation is a business unit that has been granted a charter from the state and is legally separate from its owners (stockholders). A major advantage of the corporate form of business over the partnership is that the stockholders' liability is limited to the amount of the stockholders' investments in the company, whereas the personal assets of partners can be called upon to pay the obligations of the partnership. Also, the transfer of ownership is easier with the corporation because the shares owned by a stockholder can be sold to another party. When ownership of a partnership changes, the partnership must be dissolved and another one formed.

Chapter 1, E 5. 1.

This is not a business transaction because no economic exchange has taken place.

Yes, this is properly an expense of the business.

Yes, this is properly an expense of the business (assuming that Tom intends to repay the loan).

Chapter 1, E 6. 1. 2. 3. 4. 5.

b c a a b

6. c 7. b 8. a 9. c 10. a .

Chapter 1, E 7. Company US.Chip Nanhai Tova Holstein Company US.Chip Nanhai Tova Holstein

2,750,000 5,000,000 350,000,000 3,500,000

1,300,000 2,800,000 290,000,000 3,900,000

× × × ×

Sales 1.000 0.130 0.011 1.430

= = = =

$2,750,000 $ 650,000 $3,850,000 $5,005,000

× × × ×

Assets 1.000 0.130 0.011 1.430

= = = =

$1,300,000 $ 364,000 $3,190,000 $5,577,000

Holstein is the largest in terms of sales and assets due to the high value of the euro. Chapter 1, E 8. 1.

Assets = Liabilities + Stockholders' Equity $760,000 = Liabilities + $310,000 Liabilities = $450,000

Assets = Liabilities + Stockholders' Equity Assets = $130,000 + $159,000 Assets = $289,000

Assets 2/3 Assets Assets Liabilities Beginning:

Change: End:

= 1/3 Assets + $90,000 = $90,000 = $135,000 = 1/3 × $135,000

$620,000 = Liabilities + $300,000 Liabilities = $320,000 $620,000 = $320,000 + $300,000 + 90,000 – 45,000 $710,000 = $275,000 Stockholders' Equity = $435,000

9 .

= $45,000

+ Stockholders' Equity

Chapter 1, E 9. 1.

a. b. c. d. e. f. g.

A L A SE A L A

a. b. c. d. e. f. g.

IS BS IS BS IS BS RE

Chapter 1, E 10. Rojas Services Company Balance Sheet December 31, 2011 Assets Cash

Liabilities $ 25,000

Accounts receivable

62,500

Supplies

12,500

Building

112,500 50,000

Equipment

Accounts payable

$ 50,000

Stockholders' Equity Common stock Retained earnings Total stockholders'

$125,000 87,500 212,500

equity Total liabilities and Total assets

$262,500

stockholders' equity

10 .

$262,500

Chapter 1, E 11. Kaisha Corporation Income Statement For the Year Ended December 31, 2011 Revenue Service revenue

$13,200

Expenses Wages expense Advertising expense

$8,340 1,350

Rent expense Utilities expense Total expenses Income before income taxes

1,200 900 11,790

Income taxes expense

$ 1,410 200

Net income

$ 1,210 Kaisha Corporation Statement of Retained Earnings For the Year Ended December 31, 2011

Retained earnings, December 31, 2010

$1,440 1,210

Net income for the year Subtotal Less dividends

$2,650 700 $1,950

Retained earnings, December 31, 2011 Kaisha Corporation Balance Sheet December 31, 2011 Assets

Liabilities

Cash Accounts receivable

$1,550

Supplies

100 1,000

Land

Total assets

Accounts payable

750 Stockholders' Equity Common stock

$1,000 1,950

Retained earnings Total stockholders' equity Total liabilities and

2,950

stockholders' equity

$3,400

11 .

$ 450

Chapter 1, E 12. 1. Net income is: End: Beginning:

$26,500 Assets $550,000 $360,000

= Liabilities + Stockholders' Equity = $301,000 + $249,000 222,500 = $137,500 + $ 26,500

Net income $81,500 2. Net income is: Change in Stockholders' Equity + Dividends Net income $6,000 3. Net loss is: Change in Stockholders' Equity

$26,500 55,000 $81,500

– Stockholders' investments

$26,500 32,500

Net loss

($ 6,000)

$59,500 4. Net income is: Change in Stockholders' Equity + Dividends

$26,500 58,000

– Stockholders' investments

$84,500 25,000

Net income

$59,500

12 .

Chapter 1, E 13. Primorsk Corporation Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities Net income

$19,000

Adjustments to reconcile net income to net cash flows from operating activities (Increase) in accounts receivable Increase in accounts payable

($ 3,900) 5,850

Net cash flows from operating activities

1,950 $20,950

Cash flows from investing activities ($62,500)

Purchased equipment Net cash flows from investing activities

( 62,500)

Cash flows from financing activities Borrowed from bank

$39,000 ( 9,750)

Paid dividends Net cash flows from financing activities Net increase (decrease) in cash

29,250

Cash at beginning of year

($12,300) 27,950

Cash at end of year

$15,650

Chapter 1, E 14. Mrs. Bell's Pastry, Inc. Statement of Retained Earnings For the Year Ended January 31, 2011 Retained earnings, January 31, 2010

$105,000 54,490

Net income for the year Subtotal Less dividends

$159,490 —

Retained earnings, January 31, 2011

$159,490

Retained earnings represent the equity of the stockholders generated from the income-producing activities of the business and kept for use in the business. The board of directors of Mrs. Bell's Pastry may have decided not to pay any dividends because it wanted to use the funds for other purposes such as to finance the company's growth or pay off debt. 13 .

Chapter 1, E 15. 2011

2010

Net income Total revenues

$ 25,000 $240,000

$ 24,000

Profit Margin

10.42%

12.00%

$200,000

Profit margin has decreased from 12.00 percent to 10.42 percent. The decrease is a result of revenues increasing by 20 percent coupled with a net income increase of less than 5 percent. 2011 Profit Margin Net Income Total Revenues

$25,000 $240,000

0.1042 or 10.42%

0.1200 or 12.00%

2010 Profit Margin Net Income Total Revenues

$24,000 $200,000

14 .

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Chapter 1, P 1. 1. Matching completed IS BS BS IS/RE BS BS IS BS

Utilities expense Building Common stock Net income Land Equipment Revenues Accounts receivable

BS IS RE IS IS BS BS IS

Accounts payable Rent expense Dividends Income taxes expense Fees earned Cash Supplies Wages expense

2. User Insight: Statement associated with profitability identified The income statement is most closely associated with the goal of profitability.

15 .

Chapter 1, P 2. 1. Financial statements completed Set A

Set B

Set C

Income Statement Revenue Expenses

$5,320 4,810

Net income

(m)

(g)

$2,460 2,010

(h)

$ 450

(n)

(i)

$ 200 450 100

(o)

$ 550

(p)

$ 8,600 7,000

$ 510

$ 1,600

Beginning balance Net income Less dividends

$1,780 510 190

(b) (c)

$15,400 1,600 1,000

Ending balance

$2,100

(d)

$16,000

Total assets

$2,700

(e)

$26,000

Liabilities Stockholders’ equity Common stock Retained earnings Total liabilities and

$ 400

(f)

$ 2,000

$1,300

200 2,100

8,000 16,000

(k)

50 550

(q)

stockholders’ equity

$2,700

$26,000

(l)

$1,900

(r)

(a)

Statement of Retained Earnings

Balance Sheet (j)

$1,900

2. User Insight: Income statement discussed The income statement must be prepared first because the amount of net income is necessary to determine the ending balance of retained earnings. The ending balance of retained earnings is necessary for the preparation of the balance sheet.

16 .

Chapter 1, P 3. 1. Financial statements prepared Special Assets, Inc. Income Statement For the Year Ended December 31, 2011 Revenue Commission sales revenue Expenses Commissions expense Marketing expense Office rent expense Supplies expense Telephone and computer expenses Wages expense Total expenses Income before income taxes Income taxes expense

$400,000 $225,000 20,100 36,000 2,600 5,100 32,000 320,800 $ 79,200 27,000 $ 52,200

Net income Special Assets, Inc. Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income for the year Subtotal Less dividends

$ 35,300 52,200 $ 87,500 33,000 $ 54,500

Retained earnings, December 31, 2011 Special Assets, Inc. Balance Sheet December 31, 2011 Assets Cash Accounts receivable Supplies Equipment

Liabilities $ 57,700 4,500 700 59,900

Accounts payable Income taxes payable Commissions payable Total liabilities

$ 3,600 13,000 22,700 $ 39,300

Stockholders' Equity Common stock $29,000 54,500 Retained earnings Total stockholders' equity Total liabilities and Total assets .

$122,800

stockholders' equity 17

83,500 $122,800

Chapter 1, P 3. (Continued) 2. User Insight: Useful statement identified The statement of cash flows is very useful in assessing whether a company's operations are generating sufficient funds to support expansion. The statement tells whether operations are producing enough cash or whether the company will need to obtain outside financing from creditors or owners.

18 .

Chapter 1, P 4. 1. Financial statements prepared Unique Ad, Inc. Income Statement For the Year Ended January 31, 2010 Revenue Advertising service revenue Expenses Equipment rental expense Marketing expense Salaries expense Supplies expense Office rent expense Total expenses Income before income taxes Income taxes expense

$165,200 $37,200 6,800 86,000 19,100 13,500 162,600 $

2,600 560

2,040

Retained earnings, January 31, 2009 Net income for the year Subtotal Less dividends

— 2,040

2,040 —

Retained earnings, January 31, 2010

2,040

Net income Unique Ad, Inc. Statement of Retained Earnings For the Year Ended January 31, 2010

Unique Ad, Inc. Balance Sheet January 31, 2010 Assets Cash Accounts receivable Supplies

Liabilities $

1,800 24,900 1,600

Accounts payable Income taxes payable Salaries payable Total liabilities

$19,400 560 1,300 $21,260

Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and Total assets

$ 28,300

stockholders' equity 19

$ 5,000 2,040 7,040 $ 28,300

Chapter 1, P 4. (Continued) 2. User Insight: Financial challenges identified The company is challenged both in terms of profitability and liquidity. Profitability is low in that it has earned only $2,040 on revenues of $165,200. Liquidity is low because the company has cash of only $1,800 and liabilities of $21,260.

20 .

Chapter 1, P 5. 1.

User Insight: Relationship of financial statements The income statement shows net income of $3,175 earned by the company over a period of time. The amount of net income is necessary for the preparation of the statement of retained earnings. The statement of retained earnings shows the ending balance of $6,250. The ending balance of retained earnings appears in the stockholders' equity section of the balance sheet. The statement of cash flows explains the changes in the cash balance on the balance sheet during the year.

User Insight: Liquidity and profitability The income statement is most closely associated with the goal of profitability, because it shows the earnings of the business. The cash flow statement is most closely associated with the goal of liquidity, because it shows the changes in cash.

User Insight: Company's performance evaluated The company appears to be very profitable because it has earned $3,175 of net income on revenues of $6,100. It has also paid dividends in the amount of $2,400. However, the return on total assets (net income divided by total assets) is only 5.87 percent, or $0.0587 on each dollar of assets invested. Moreover, the company might experience some challenges in its liquidity position in the future because it has liabilities of $13,350 and cash of only $6,700.

User Insight: Role of CPA When deciding whether to make a loan to a company, a banker evaluates the company's ability to pay interest charges and repay the loan at the appropriate time. Accordingly, a banker studies the company's liquidity and cash flows as well as its profitability. That information is represented in financial statements, which are prepared by a company's management and can be falsified for personal gain. To lend credibility to the financial statements, the banker may request an independent CPA audit. The audit would verify that the financial statements present the data fairly and conform to GAAP in all material respects.

21 .

Chapter 1, P 6. 1. Financial statements completed Set A

Set B

Set C

Income Statement Revenue Expenses

$1,200 810

Net income

$ 390

(a)

$ 6,600 (g) 5,000

$240 92

(b)

$ 1,600 (h)

$148

$15,400

$132

(m)

Statement of Retained Earnings Beginning balance Net income

$2,900

Less dividends

390 200

Ending balance

$3,090

(c)

1,600 1,000 (i)

148

(n)

—

(o)

$16,000 (j)

$280

(p)

$30,000

$580

(q) (r)

Balance Sheet Total assets

$6,690

Liabilities

$1,600

$ 5,000

$200

Retained earnings

2,000 3,090

(e)

9,000 16,000 (k)

100 280

Total liabilities and stockholders’ equity

$6,690

(f)

$30,000 (l)

$580

(d)

Stockholders’ equity Common stock

2. User Insight: Financial statement order explained The income statement must be prepared first because the amount of net income is necessary to determine the ending balance of retained earnings. The statement of retained earnings is prepared second because it provides the ending balance of retained earnings for the balance sheet, which is prepared last.

22 .

Chapter 1, P 7. 1. Financial statements prepared Real Deal, Inc. Income Statement For the Year Ended December 31, 2011 Revenue Commission sales revenue Expenses Commissions expense Office rent expense Wages expense Marketing expense Telephone and computer expenses Utilities expense Total expenses Income before income taxes Income taxes expense

$400,000 $225,000 36,000 32,000 20,100 5,100 2,600 320,800 $ 79,200 27,000 $ 52,200

Net income Real Deal, Inc. Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income for the year Subtotal Less dividends

$35,300 52,200 $87,500 33,000 $54,500

Retained earnings, December 31, 2011 Real Deal, Inc. Balance Sheet December 31, 2011 Assets Cash Accounts receivable Supplies Equipment

Liabilities $ 57,700 4,500 700 59,900

Accounts payable Income taxes payable Commissions payable Total liabilities

$ 3,600 13,000 22,700 $ 39,300

Stockholders' Equity Common stock $29,000 54,500 Retained earnings Total stockholders' equity Total liabilities and Total assets

$122,800

stockholders' equity 23

83,500 $122,800

Chapter 1, P 7. (Continued) 2. User Insight: Useful statement identified The statement of cash flows is very useful in assessing whether a company's operations are generating sufficient funds to support expansion. The statement tells whether operations are producing enough cash or whether the company will need to obtain outside financing from creditors or owners.

24 .

Chapter 1, P 8. 1. Financial statements prepared Creative Ads, Inc. Income Statement For the Year Ended January 31, 2011 Revenue Advertising service revenue Expenses Salaries expense Equipment rental expense Utilities expense Office rent expense Marketing expense Total expenses Income before income taxes Income taxes expense

$165,200 $86,000 37,200 19,100 13,500 6,800 162,600

Net income

2,600 560

2,040

Creative Ads, Inc. Statement of Retained Earnings For the Year Ended January 31, 2011 Retained earnings, January 31, 2010 Net income for the year Subtotal Less dividends

$ — 2,040

Retained earnings, January 31, 2011

$2,040

$2,040 —

Creative Ads, Inc. Balance Sheet January 31, 2011 Assets Cash Accounts receivable Supplies

Liabilities $ 1,800 24,900 1,600

Accounts payable $19,400 Income taxes payable 560 1,300 Salaries payable Total liabilities Stockholders' Equity Common stock Retained earnings Total stockholders' equity Total liabilities and

Total assets

$28,300

stockholders' equity 25

$21,260

$ 5,000 2,040 7,040 $28,300

Chapter 1, P 8. (Continued) 2. User Insight: Financial challenges identified Income Taxes Expense is the total expense for the accounting period. Income Taxes Payable is the amount that has not yet been paid to the government. 3. User Insight: Financial challenges identified The company is challenged both in terms of profitability and liquidity. Profitability is low in that the company has earned only $2,040 on revenues of $165,200. Liquidity is low because the company has cash of only $1,800 and liabilities of $21,260.

26 .

Chapter 1, P 9. 1. Financial statements completed Set A

Set B

Set C

Expenses

$1,100 600 (a)

$ 6,900 (g) 5,200

$210 130 (m)

Net income

$ 500 (b)

$ 1,700 (h)

$ 80

$2,700

$11,400

$340

Income Statement Revenue

Statement of Retained Earnings Beginning balance Net income

500 (c) 200

1,700 1,000 (i)

80 (n) 20 (o)

$3,000

$12,100 (j)

$400 (p)

Total assets

$6,400 (d)

$27,600

$880 (q)

Liabilities

$1,500

$ 7,000

$200 (r)

Retained earnings

1,900 3,000 (e)

8,500 12,100 (k)

280 400

Total liabilities and stockholders’ equity

$6,400 (f)

$27,600 (l)

$880

Less dividends Ending balance Balance Sheet

Stockholders’ equity Common stock

27 .

Chapter 1, P 10. 1. Financial statements prepared Bradford Realty, Inc. Income Statement For the Year Ended October 30, 2011 Revenue Commission sales revenue Expenses Commissions expense Office rent expense Wages expense Telephone and computer expenses Utilities expense Total expenses Income before income taxes Income taxes expense

$415,000 $230,000 40,000 29,200 6,300 2,700 308,200 $106,800 35,700 $ 71,100

Net income Bradford Realty, Inc. Statement of Retained Earnings For the Year Ended October 31, 2011 Retained earnings, October 31, 2010 Net income for the year Subtotal Less dividends

$ 15,700 71,100

Retained earnings, October 31, 2011

$ 46,800

$ 86,800 40,000

Bradford Realty, Inc. Balance Sheet October 31, 2011 Assets Cash Accounts receivable Supplies Equipment

Liabilities $ 57,500 12,700 900 44,200

Accounts payable Income taxes payable Commissions payable Total liabilities

3,500 12,500 21,500 $ 37,500

Stockholders' Equity Common stock $ 31,000 46,800 Retained earnings Total stockholders' equity Total liabilities and Total assets

$115,300

stockholders' equity 28

77,800 $115,300

Chapter 1, P 10. (Continued) 2. User Insight: Ability to pay bills evaluated Commissions Expense is the total expense for the accounting period. Commissions Payable is the amount that has not yet been paid. 3. User Insight: Ability to pay bills evaluated The company's ability to pay its bills or its liquidity appears good because it has cash of $57,500 and total liabilities of only $37,500.

29 .

Chapter 1, C 1. The three basic activities Costco will engage in to achieve its goals are financing activities (obtaining adequate funds or capital to operate its business), investing activities (spending the capital it receives so that it will be productive), and operating activities (running its business). Financing activities include obtaining capital from owners and from creditors, such as banks and suppliers. They also include repaying creditors and paying a return to the owners. Investing activities include buying land, buildings, equipment, and other long-lived resources needed in the operation of the business and selling these resources when they are no longer needed by the business. Operating activities include selling merchandise and service to customers; employing managers and workers; buying, producing, and selling goods and services; and paying taxes to the government. Costco's management is the group of people who have overall responsibility for operating the business and for meeting the company's profitability and liquidity goals. The functions management must perform to fulfill its responsibility are obtaining financial resources so the company can continue operating (financial management); investing the financial resources of the business in productive assets that support the company's goals (asset management); developing and producing goods and services (operations management); selling, advertising, and distributing goods and services (marketing management); hiring, evaluating, and compensating employees (human resource management); and capturing, organizing, and communicating data about all aspects of the company's operations (information management). Accounting is covered by the last function. Chapter 1, C 2. Assets are economic resources owned by a business that are expected to benefit future operations. The people in an organization are not assets of the business because they are not owned by the business. Businesses pay their employees on a periodic basis (hourly, weekly, monthly, annually); they do not buy employees. Salaries, wages, and other costs associated with employment are considered expenses and appear on the income statement. Southwest Airlines considers its people to be its most important asset because of the costs of hiring, training, motivating, and compensating high-quality employees who will benefit future operations. Airlines depend on their ability to develop and keep competent and motivated individuals. Their success in attracting and retaining high-quality employees depends on the opportunities and compensation they provide.

30 .

Chapter 1, C 3. Generally accepted accounting principles (GAAP) encompass the conventions, rules, rules, and procedures necessary to define accepted practice at a particular time. When financial statements are prepared in accordance with GAAP and audited by an independent CPA, financial analysts understand the significance of the amounts in the financial statements and can assess a company's performance with confidence.

Some bodies that influence GAAP are as follows: Public Company Accounting Oversight Board (PCAOB): Appoints the FASB to issue rules on accounting practice Financial Accounting Standards Board (FASB): The most important body that issues rules on accounting practice

American Institute of Certified Public Accountants (AICPA): Influences accounting practice through its senior technical committees Governmental Accounting Standards Board (GASB): Sets accounting standards for government entities

International Accounting Standards Board (IASB): Sets international accounting standards Internal Revenue Service (IRS): Influences practice through rules for determining income tax liabilities Chapter 1, C 4. Liquidity was more important than profitability to Lechters' short-term survival because without the ability to pay its debts, the company was forced into bankruptcy. With the $86 million in new financing, which provided additional liquidity, the company was able to return to profitability. Achieving profitability enables a company to survive in the long term because profitability is necessary to attract and keep the investments of stockholders.

31 .

Chapter 1, C 5. 1.

Student A's assumption that an increase in total assets is equal to net income is false. It is true that net income results in an increase in assets, but so do many other transactions. For example, investments by owners and loans from banks also increase assets. Also, assets can be reduced by transactions that do not affect net income—for example, repayment of a loan. Student B's assumption that the change in cash from one year to the next is equal to net income or net loss is also false. All the examples cited above affect cash but not net income. Moreover, revenue can be recorded before cash is received, as when RIM bills a customer for services performed. And expenses can be recorded before cash is paid, as when RIM is billed by a supplier for services already received. Student C is correct. To estimate net income from an examination of the balance sheet, the change in retained earnings must be considered. Net income increases retained earnings. So net income can be estimated by taking the difference in retained earnings from one year to the next (there are no dividends).

Net income for 2009 was $1,892,616. RIM, retained earnings, February 28, 2009 Less RIM, retained earnings, March 1, 2008 Increase in RIM, retained earnings in 2009 Plus dividends paid in 2008 Net income for the year ended February 28, 2009

$3,545,710* 1,653,094 $1,892,616 — $1,892,616**

* All numbers are in thousands. ** Net income is approximate because there may be effects that are not being considered at this point in the course.

32 .

Chapter 1, C 6. 1. The names CVS gives its four basic financial statements are as follows: Consolidated Statements of Operations (Income Statement) Consolidated Balance Sheets Consolidated Statements of Cash Flows Consolidated Statements of Shareholders' Equity; includes data for retained earnings 2. The accounting equation for CVS on December 31, 2009, is as follows: (in millions) Assets $61,641

= =

Liabilities $25,873

+ +

Stockholders' Equity $35,768

3. Total revenues of CVS for the year ended December 31, 2009, were $98,729 million. 4. Yes, the company earned $3,696 million. This was an increase from net earnings of $3,212 million for the year ended December 31, 2008. (Note: Preference diviends are distributions to owners.) 5. No, the company's cash and cash equivalents decreased by $266 million. This number can be found toward the bottom of the statement of cash flows or can be computed by taking the difference of the cash and cash equivalents from the December 31, 2008 and December 31, 2009 balance sheets. 6. Cash flows from operating activities increased from 2008 to 2009. Cash flows used by investing activities were negative but significantly lower in 2009 than in 2008, and cash flows used in financing activities increased from 2008 to 2009. 7. CVS was audited by KPMG LLP. The auditor's report is important because it tells whether the company's financial statements and accompanying information are prepared in accordance with generally accepted accounting principles. If this is so, the reader of the financial statements can rely on them and analyze them. The auditor's report lends credibility to the financial statements.

33 .

Chapter 1, C 7. 1. With sales of $98,729 million and total assets of $61,641 million, CVS is much larger than Southwest, which has revenues of $10,350 million and total assets of $14,269 million. Note that CVS generates 9.5 times as much sales on about 4.3 times the total assets of Southwest. Neither assets nor revenues are better than the other to measure the size of a company. Assets tell how large a company's resources are, and revenues tell how well the company is able to generate revenue. Both are useful measures of a company's size. 2. CVS has net income (earnings) of $3,696 million, which is about 37 times more than Southwest's earnings of $99 million. CVS has had increasing net income over the three years, whereas Southwest's net income has been decreasing over the past three years. 3. In 2009, CVS had profit margin of 3.74 percent ($3,696 ÷ $98,729), and Southwest had profit margin of 0.96 percent ($99 ÷ $10,350). By this measure, CVS is significantly more profitable than Southwest. 4. CVS has cash and cash equivalents of $1,086 million compared to Southwest's cash and cash equivalents of $1,114 million. CVS's cash decreased by $266 million compared to the $254 million decrease by Southwest. CVS had cash flows from operating activities of $4,035 million compared with Southwest's cash flows from operating activities of $985 million. CVS has slightly less cash on hand, but by the measure of cash flows from operating activities, it has a lot more liquidity.

34 .

Chapter 1, C 8. The ethical situations are presented for discussion purposes. Students are likely to have many different viewpoints. 1. The alternative courses of action are to disclose or not to disclose the employee's hourly rate. The information should not be disclosed because of its confidential nature. 2.

The alternative courses of action are to ignore the inappropriate expenses or to report them to the home office. It might also be possible to discuss them with the manager in private. This is a difficult situation because of the possibility of retribution. If the manager does not take appropriate remedial action, the accountant should report his actions—and be prepared to look for another job.

The alternative courses of action are to accept the gift or to return it. To avoid a conflict of interest, the appropriate action would be to return the gift.

This is a common problem faced by young accountants. The alternative courses of action are to do the work and not report it, to do the work and report it, or to talk to a superior as soon as the problem is recognized. The third alternative is the best because there may be some other reason that the job cannot be done in the allotted time. Underreporting hours usually is not tolerated by CPA firms.

The alternative courses of action are to report or not to report the $200 in cash. Accountants must maintain their integrity, which means being honest. The $200 should be reported; it would be illegal not to report it.

The courses of action are to disclose the investment or not to disclose the investment. A CPA must avoid even the appearance of a conflict of interest. To be independent, the CPA should disclose the investment and then sell the stock.

35 .

Chapter 1, C 9. 1. Balance sheets prepared Murphy Lawn Services, Inc. Balance Sheet June 1, 2011 Assets

Liabilities $2,700

Cash

Loan payable

$1,000 Stockholders' Equity 1,700

Common stock Total liabilities and $2,700

Total assets

$2,700

stockholders' equity

Murphy Lawn Services, Inc. Balance Sheet August 31, 2011 Assets Cash

Liabilities $3,520

Accounts payable

$ 525

Accounts receivable

875

Wages payable

Supplies

50 200

Loan payable

100 700

Total liabilities

$1,325

Deposit

Stockholders' Equity Common stock Retained earnings Total stockholders' equity

$1,700 1,620 3,320

Total liabilities and Total assets

$4,645

stockholders' equity

36 .

$4,645

Chapter 1, C 9. (Continued) 2. Memorandum prepared Memorandum Today's date Date: Beth Murphy To: (Student's name) From: Assessment of Performance Re: I have reviewed the balance sheets for Murphy Lawn Services, Inc., at June 1, 2011, and August 31, 2011. With regard to your business goal of profitability, your net income for the summer is $1,620. Because you did not pay any dividends to yourself, the only factors that can affect retained earnings are revenues and expenses. Because retained earnings increased during the period from $0 to $1,620, your net income must have been $1,620. With regard to your business goal of liquidity, you have increased your cash from $2,700 to $3,520, an increase of $820. At the same time, your liabilities increased only $325, from $1,000 to $1,325. Also, you have total assets of $4,645. Finally, I suggest in the future that you also prepare an income statement, which will show details of your revenues and expenses related to profitability, and the statement of cash flows, which will show the details of the changes to your cash balance. Let me know if you have any further questions.

37 .

CHAPTER 2—Solutions ANALYZING BUSINESS TRANSACTIONS

Chapter 2, SE 1. Jan. Feb. Mar.

10 Do not recognize because an order is not a complete transaction. There is no obligation on the part of either party at this point. 15 Recognize the purchase. Delivery has been made; there is an obligation to pay. 1 Recognize the payment. Cash is paid, and the obligation no longer exists.

Chapter 2, SE 2. The concept of recognition is applied by recording the transaction at the recognition point on June 1 when the transaction takes place. Supplies are purchased with cash, and the buyer takes title to the supplies. The concept of valuation is applied by recording the supplies at a cost of $2,000. The classification concept is applied by reducing the asset Cash and increasing the asset Supplies. Supplies are classified as an asset because they have not been used up and will benefit future operations. If they were used up immediately, they could be classified as Supplies Expense. Chapter 2, SE 3. 1. 2. 3. 4.

Liability Asset None (Stockholders' Equity) Revenue

5. 6. 7. 8.

Expense Asset Liability Asset

5. 6. 7. 8.

Debit Debit Credit Debit

Chapter 2, SE 4. 1. 2. 3. 4.

Credit Debit Debit Credit

38 .

Chapter 2, SE 5. Mar.

2 Debit Cash; credit Common Stock 5 Debit Equipment; credit Cash 7 Debit Supplies; credit Accounts Payable 19 Debit Cash; credit Recording Service Revenue 22 Debit Cash; credit Unearned Recording Service Revenue 25 Debit Rent Expense; credit Cash 31 Debit Accounts Receivable; credit Recording Service Revenue

Chapter 2, SE 6. Unearned Recording Service Revenue

Cash Mar.

2 19 22

Bal.

10,000 Mar. 5 1,000 25 1,200 12,200 5,900

5,000 1,300

Mar. 22 Common Stock

6,300

Mar.

500

Mar. 19 31 Bal.

Supplies Mar.

600 Rent Expense Equipment

Mar.

Mar. 25

5,000 Accounts Payable Mar.

600

39 .

10,000

Recording Service Revenue

Accounts Receivable Mar. 31

1,200

1,300

1,000 500 1,500

Chapter 2, SE 7. Smile's Recordings, Inc. Trial Balance March 31, 2011 Cash Accounts Receivable Supplies Equipment Accounts Payable Unearned Recording Service Revenue Common Stock Recording Service Revenue Rent Expense

$ 5,900 500 600 5,000 $

1,300 $13,300

40 .

600 1,200 10,000 1,500

$13,300

Chapter 2, SE 8. May

2 Debit Cash; credit Common Stock 5 Debit Office Equipment; credit Cash 7 Debit Supplies; credit Accounts Payable 19 Debit Cash; credit Programming Service Revenue 22 Debit Cash; credit Unearned Programming Service Revenue 25 Debit Rent Expense; credit Cash 31 Debit Accounts Receivable; credit Programming Service Revenue

Chapter 2, SE 9. Unearned Programming Service Revenue

Cash May

2 19 22

Bal.

5,000 May 500 600 6,100 2,950

5 25

2,500 650

May

3,150

May

250

May

Supplies

Bal.

300 Office Equipment

May

2,500 Accounts Payable May

300

41 .

5,000

Programming Service Revenue

Rent Expense May

600

Common Stock

Accounts Receivable May

650

19 31

500 250 750

Chapter 2, SE 10. Bear's Programming Service, Inc. Trial Balance May 31, 2011 Cash Accounts Receivable Supplies Office Equipment Accounts Payable Unearned Programming Service Revenue Common Stock Programming Service Revenue Rent Expense

42 .

$2,950 250 300 2,500 $ 300 600 5,000 750 650 $6,650

$6,650

Chapter 2, SE 11. General Journal Date Sept.

Description 6 Accounts Receivable Service Revenue Billed customer for services performed 16 Cash Accounts Receivable Recorded receipt of partial payment on account billed September 6

43 .

Page 4 Post. Ref.

Debit 3,800

Credit 3,800

1,800 1,800

Chapter 2, SE 12. Cash Date Sept.

Item 16

Post. Ref. J4

Debit

Credit

1,800

Accounts Receivable Date Sept.

Item 6 16

Post. Ref. J4 J4

Account No. 113 Balance Debit

Credit

3,800 1,800

Service Revenue Date Sept.

Item 6

Post. Ref.

Account No. 111 Balance Debit Credit

Debit

Credit

Debit

Credit

3,800 2,000 Account No. 411 Balance Debit Credit

3,800

Note: At this point, the account numbers would also be posted to the accounts in the general journal in SE 11. Trial Balance September 16 Cash Accounts Receivable Service Revenue

$1,800 2,000 _____ $3,800

44 .

$3,800 $3,800

Chapter 2, SE 13. General Journal Date Description Mar. 2 Cash Common Stock Issued common stock 5 Equipment Cash Purchased equipment for cash 7 Supplies Accounts Payable Purchased supplies on account 19 Cash Recording Service Revenue Performed recording services for cash 22 Cash Unearned Recording Service Revenue Received payment for recording services to be performed 25 Rent Expense Cash Paid the rent for March 31 Accounts Receivable Recording Service Revenue Billed a customer for services performed

45 .

Post. Ref.

Debit 10,000

Credit 10,000

5,000 5,000 600 600 1,000 1,000

1,200 1,200

1,300 1,300 500 500

Chapter 2, SE 14. Jan. 2

Cash 1,200 Jan. 4

700

The transactions of January 2 and 4 have an immediate impact on cash, whereas the transactions of January 8 and 9 will not impact cash until later, when the cash is received or paid.

46 .

Chapter 2, SE 15. Financial ratio calculated Revenues Average Total Assets

Asset Turnover = $29,700 (

$28,000

$26,000 )

$29,700 $27,000

47 .

1.1 times

Chapter 2, E 1. 1. 2.

No issue is more important than another. Each must be resolved satisfactorily for a transaction to be recorded correctly. The most common violation of the recognition concept is when a revenue is recognized before the earnings process is complete. For instance, the recording of an order as revenue before the service is performed or the product is delivered to the customer would overstate revenues. Assets and expenses are closely related because many assets are expenses that have not yet been used. Examples are prepaid assets and plant and equipment. As a result, debits increase assets and expenses, and credits decrease assets and expenses. They appear on opposite sides of the accounting equation. With unearned revenues (a liability), cash is received in advance for a service to be performed later. With prepaid expenses (an asset), cash is paid in advance of receiving a service.

Chapter 2, E 2. 1.

3. 4.

Retained Earnings is the most likely account to have an abnormal balance (debit) because of situations in which expenses exceed revenues (net loss). It is unusual for any other account to have an abnormal balance. All equipment needs normal repairs. These are considered an ongoing cost of business and thus are expenses. However, it may be argued that if the repair is major, such as a major overhaul that is done every five years, the expenditure would benefit future years and thus could be recorded as an asset. To maintain liquidity, it can issue stock, sell long-term investments (e.g., unused equipment), or take out a loan. A retail company selling advertising products would have the following asset account: Merchandise Inventory.

48 .

Chapter 2, E 3. Jan. Feb. Mar. June July

15 Not recorded. An offer is not a completed transaction. 2 Not recorded. Notice of a price increase is not a transaction. 29 Recorded. The utilities expense has been incurred, and the liability for payment exists. 10 Not recorded. An order does not constitute a recognition point. 6 Recorded. Villa Corporation now owns the office equipment, and a liability to pay exists.

Chapter 2, E 4. 1.

Purchases recognized on date shipped Order b c d e

Date Shipped July

10 16 23 27

Date Received July

15 22 30 1

$1,500 900 1,200 1,400

Total July purchases

$5,000

Aug.

Purchases recognized on date received Order a b c d

Date Shipped June 26 July 10 16 23

Date Received July 5 15 22 30

Amount $ 600 1,500 900 1,200

Total July purchases

$4,200

49 .

Amount

Chapter 2, E 5. Assets

Cash

Liabilities

Accounts Payable

1,725

Stockholders' Equity Common Stock Common Stock

600 $1,725 =

$ 600

$1,725 =

$1,725

Retained Earnings Retained Earnings

900

300

+ $1,125

50 .

–

Dividends

Dividends 375

Revenues Service Revenue

–

Expenses Rent Expense

750

450

Chapter 2, E 6. Type of Account Stockholders' Equity

Normal Balance (increases balance)

Retained Earnings Item

Asset

a. b. c. d. e. f. g. h. i. j. k. l. m. n. o. p. q. r. s. t. u. v. w. x. y. z.

Liability

Common Stock

Dividends

Expense

Debit

x x x

x x

Credit

x x

x x x x

x x x x x

x x

x x x

x x

51 .

Revenue

Chapter 2, E 7. a.

The asset account Cash was increased. Increases in assets are recorded by debits. Debit Cash $5,000. A component of stockholders' equity, Common Stock, was increased. Increases in stockholders' equity are recorded by credits. Credit Common Stock $5,000. The asset Prepaid Rent was increased. Increases in assets are recorded by debits. Debit Prepaid Rent $3,360. The asset Cash was decreased. Decreases in assets are recorded by credits. Credit Cash $3,360. The asset Supplies was increased. Increases in assets are recorded by debits. Debit Supplies $240. The liability Accounts Payable was increased. Increases in liabilities are recorded by credits. Credit Accounts Payable $240. The asset Cash was increased. Increases in assets are recorded by debits. Debit Cash $1,400. Stockholders' equity was increased by the fees earned. Increases in stockholders' equity are recorded by credits. Credit Hair Cutting Fees Earned $1,400. The liability Accounts Payable was decreased. Decreases in liabilities are recorded by debits. Debit Accounts Payable $240. The asset Cash was decreased. Decreases in assets are recorded by credits. Credit Cash $240. The stockholders' equity was decreased by the utilities expense. Decreases in stockholders' equity are recorded by debits. Debit Utilities Expense $144. The asset Cash was decreased. Decreases in assets are recorded by credits. Credit Cash $144. The stockholders' equity was decreased when dividends were paid to stockholders. Decreases in stockholders' equity are recorded by debits. Debit Dividends $200. The asset Cash was decreased. Decreases in assets are recorded by credits. Credit Cash $200.

52 .

Chapter 2, E 8. Credit

Paid for supplies purchased on credit last month.

Received cash from customers billed last month.

Made a payment on accounts payable.

Purchased supplies on credit.

Billed a client for lawn services.

Made a rent payment for the current month.

Received cash from customers for current lawn services.

Paid employee wages.

Ordered equipment.

Received and paid for the equipment ordered in i .

No entry

53 .

Debit

Chapter 2, E 9. Cash a. g.

Bal.

8,600 7,440

b. d. e. f. h.

16,040 8,640

Accounts Payable f.

1,600 1,200 1,800 800 2,000 7,400

11,800

2,000 Repair Fees Earned

2,200

Repair Equipment

Salaries Expense

3,200 1,200 4,400

1,800 Rent Expense

54 .

2,200 1,400

Dividends

Repair Supplies

a. d. Bal.

c. Bal.

Common Stock

800

1,600

7,440

Chapter 2, E 10. Change Repair Service, Inc. Trial Balance June 30, 2011 Cash Repair Supplies Repair Equipment Accounts Payable Common Stock Dividends Repair Fees Earned Salaries Expense Rent Expense

$ 8,640 2,200 4,400 $ 1,400 11,800 2,000 7,440 1,800 1,600 $20,640

Chapter 2, E 11. a. b. c. d. e. f. g. h.

Issued common stock for cash, $40,000. Purchased equipment with cash, $15,000. Billed customer for services rendered, $8,000. Purchased equipment on account, $9,000. Paid wages with cash, $3,600. Paid cash on account owed, $4,500. Received cash on account, $1,500. Sold equipment (at cost) for cash, $900.

55 .

$20,640

Chapter 2, E 12. Chapla Corporation Trial Balance March 31, 2011 Cash Accounts Receivable Prepaid Insurance Land Building Equipment Notes Payable Accounts Payable Common Stock Retained Earnings

$10,800 5,600 1,320 6,240 40,800 14,400 $20,000 21,420 * 24,000 13,740 $79,160

* $79,160

– ( $20,000

$24,000

$13,740 ) =

$79,160

$21,420

Chapter 2, E 13. a. b. c. d.

Unequal totals. The total debits would be $27 more than the total credits. Equal balance. However, both Accounts Receivable (an asset account) and Accounts Payable (a liability account) would be overstated by $150. Equal balance. However, both accounts would be incorrect. Cash would be overstated by $378, and Office Supplies would be understated by $378. Equal balance. However, an error has been made by debiting the wrong asset. Therefore, Supplies would be overstated by $450, and Equipment would be understated by $450.

56 .

Chapter 2, E 14. Kilda Services, Inc. Trial Balance July 31, 2011 Cash Accounts Receivable Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Common Stock Retained Earnings Dividends Revenues Salaries Expense Rent Expense Advertising Expense Utilities Expense

$ 8,120 11,560 480 720 14,800 $ 4,800 7,720 6,000 15,120 2,200 11,840 5,200 1,200 680 520 $45,480

57 .

$45,480

Chapter 2, E 15. Revenues from Services 1,500 1,800 3,300

Credit Sale

Cash Sale

Cash 1,500 1,200 2,700 900

1,100 700 1,800

Expenses 1,100 1,300 2,400

Collection on Account

Credit Purchase

Accounts Receivable 1,800 600

Cash Purchase

Payment on Account

1,200

Accounts Payable 700

1,300 600

The cash balance after these transactions is $900. The amount still to be received (the balance of Accounts Receivable) is $600. The amount still to be paid (the balance of Accounts Payable) is $600.

58 .

Chapter 2, E 16. General Journal Date

Post. Ref.

Description a. Cash Repair Equipment Common Stock Issue common stock for cash and repair equipment b. Rent Expense Cash Paid current month's rent c. Repair Supplies Accounts Payable Purchased repair supplies on credit d. Repair Equipment Cash Purchased additional repair equipment for cash e. Salaries Expense Cash Paid salary to a helper f. Accounts Payable Cash Paid $800 of the amount purchased on credit in transaction c g. Cash Repair Fees Earned Accepted cash for repairs completed h. Dividends Cash Declared and paid a dividend

59 .

Debit 8,600 3,200

Credit

11,800

1,600 1,600 2,200 2,200

1,200 1,200

1,800 1,800 800 800

7,440 7,440

2,000 2,000

Chapter 2, E 17. May

1 Merchandise Inventory Accounts Payable Purchased merchandise inventory on account

2,400 2,400

The answer given here assumes the perpetual inventory method because it is most intuitive at this point in the course. The purpose of this exercise is to focus on analytical thinking. 2 Marketable Securities Cash Purchased marketable securities 3 Accounts Payable Merchandise Inventory Returned part of merchandise inventory for full credit 4 Accounts Receivable Sales Sold merchandise inventory

6,000 6,000 500 500

1,600 1,600

(Note to the instructor: A full discussion might be held at this point on what should be done to the Merchandise Inventory account.) 5 Land Building Cash Mortgage Payable Purchased land and building with partial payment in cash 6 Cash Advance Deposit or Unearned Revenue Recorded deposit on services of $24,000 to be provided

60 .

200,000 400,000 120,000 480,000

7,000 7,000

Chapter 2, E 18. General Journal Date Description Dec. 14 Equipment Cash Accounts Payable Purchased equipment; paid onethird in cash 28 Accounts Payable Cash Paid for part of equipment purchased on credit

Page 10 Post. Ref. 144 111 212

212 111

Debit 12,000

Credit 4,000 8,000

6,000 6,000

General Ledger Cash Date Dec.

13 14 28

Item Balance

Post. Ref.

Account No. 111 Balance Debit

 J10 J10

Credit

4,000 6,000

Equipment Date Dec.

Item

Debit

J10

12,000

Credit

Dec.

14 28

Item

Debit

Credit

Account No. 212 Balance Debit

Credit 8,000

J10 J10

6,000

61 .

16,000 12,000 6,000

12,000

Accounts Payable Date

Credit

Account No. 144 Balance

Post. Ref.

Debit

Credit 8,000 2,000

Chapter 2, E 19. Financial ratio calculated Revenue

Asset Turnover =

2012 =

Average Total Assets $88,000 ( $102,000 $88,000

2011 =

+ =

$91,000

$80,000

) ÷ 2

1.0 times

$80,000 (

$80,000 $80,000

+ =

$76,000

$72,000

) ÷ 2

1.1 times

By this measure, the profitability has decreased by 0.1. It is important to use average total assets to make the components of the formula consistent.

62 .

Chapter 2, P 1. Assets

Liabilities

Stockholders' Equity Common Stock Common Stock 15,000

Retained Earnings Retained Earnings 22,000

–

Dividends

Revenues

Expenses

Cash 9,200

Accounts Payable 3,210

Accounts Receivable 39,000

Loans Payable 5,000

Telephone Expense 480

Equipment 24,590

Unearned Revenues 9,000

Wages Expense 62,000

Accounting equation without Equipment: Equipment +

$48,200 = $72,790

Equipment = $24,590 Accounting equation in balance: $72,790 = $17,210

+ $55,580

$72,790 = $72,790

63 .

Dividends 18,000

Design Revenue 105,000

–

Rent Expense 5,940

Chapter 2, P 2.

a. b. c. d. e.

Paid for supplies purchased on credit last month. Billed customers for services performed. Paid the current month's rent. Purchased supplies on credit. Received cash from customers for services performed but not yet billed. f. Purchased equipment on account. g. Received a bill for repairs. h. Returned portion ofequipment the equipment that was Returned apart of the purchased in fpurfor a credit. in f for a credit. chased i. Received payments from customers previously billed. j. Paid the bill received in g . k. Received an order for services to be performed. l. Paid for repairs with cash. m. Made a payment to reduce the principal of the note payable. n. Declared and paid a dividend.

64 .

Debit

Credit

7 2 12 3

1 11 1 7

1 5 13

11 7 7

7 1 7

5 2 1 No entry

6 10

1 1

Chapter 2, P 3. 1. T accounts set up 2. Transactions recorded in the accounts Cash a. j.

5,700

260

1,380

c. h.

190 330

i. k. l. m.

40 90 440 300

7,080 Bal.

Accounts Receivable f.

2,040

2,040 Bal.

1,380

Supplies e.

330

1,380

660

1,650

5,430 Computers

Office Equipment

a. g.

5,000 480

a. g.

3,600 380

Bal.

5,480

Bal.

3,980

Accounts Payable h.

330

e. g.

330

330 860 1,190

Bal. Common Stock a.

14,300

Dividends m.

Salaries Expense l.

440 Repair Expense

No entry

300

90 Advertising Expense

190

65 .

Tuition Revenue f.

Utilities Expense k.

860

Rent Expense b.

260

2,040

Chapter 2, P 3. (Continued) 3. Trial balance prepared Star Secretarial Training, Inc. Trial Balance (Today's Date) Cash Accounts Receivable Supplies Computers Office Equipment Accounts Payable Common Stock Dividends Tuition Revenue Salaries Expense Utilities Expense Rent Expense Repair Expense Advertising Expense

$ 5,430 660 330 5,480 3,980 $

860 14,300

300 2,040 440 90 260 40 190 $17,200

$17,200

4. User Insight: Transactions "f" and "j" examined The revenues were $2,040, and only $1,380 of cash was received from those revenues. The company accepts credit sales to accommodate its students and encourage them to enroll. The company must consider the possibility that it will not receive the cash until later and that some students will not be able to pay.

66 .

Chapter 2, 2, P P 4. 4. Chapter 1.

Transactions entered in journal form

June

2 Cash Common Stock To issue 7,200 shares of $1 par value common stock 3 Supplies Accounts Payable To purchase supplies on account 4 Bicycles Cash Accounts Payable To purchase bicycles; made partial payment and agreed to pay the rest later 5 Shed Cash To purchase shed to store bicycles 8 Shed Cash To install shed 9 No entry 10 Maintenance Expense Cash To pay for cleanup 13 Cash Rental Revenue To record rentals made for cash 17 Accounts Payable Cash To pay for supplies purchased on June 3

67 .

7,200 7,200

150 150 2,500 1,200 1,300

2,900 2,900 400 400

75 75 970 970 150 150

Chapter 2, P 4. (Continued) June

18 Repair Expense Cash To repair bicycles 23 Accounts Receivable Rental Revenue To bill company for rentals 25 Concession Fee Expense Cash To pay monthly concession fee 27 Cash Rental Revenue To record rentals made for cash 29 Wages Expense Cash To pay wages of assistant 30 Dividends Cash To declare and pay a dividend

68 .

55 55 110 110 100 100 960 960 240 240 500 500

Chapter 2, P 4. (Continued) 2. T accounts set up and entries posted from the journal Cash 6/2 6/13 6/27

7,200 970 960

6/4 6/5 6/8 6/10 6/17 6/18 6/25 6/29 6/30

9,130 Bal.

Accounts Receivable 1,200 2,900 400 75 150 55 100 240 500

6/23

110

Supplies 6/3

150

5,620

3,510 Shed

6/5 6/8

2,900 400

Bal.

3,300

Bicycles 6/4

2,500

Accounts Payable 6/17

150

6/3 6/4

150

1,450 Bal.

Common Stock 6/2

Wages Expense 6/29

240

Dividends 7,200

6/30

500

Concession Fee Expense 6/25

100

69 .

1,300

Rental Revenue

Maintenance Expense 6/10

150 1,300

6/13 6/23 6/27

970 110 960

Bal.

2,040

Repair Expense 6/18

Chapter 2, P 4. (Continued) 3.

Trial balance prepared Patel Rentals, Inc. Trial Balance June 30, 2010

Cash Accounts Receivable Supplies Shed Bicycles Accounts Payable Common Stock Dividends Rental Revenue Wages Expense Maintenance Expense Repair Expense Concession Fee Expense

$ 3,510 110 150 3,300 2,500 $ 1,300 7,200 500 2,040 240 75 55 100 $10,540

______ $10,540

User Insight: Recognition and classification discussed

June 3 and 10 are the recognition points for these transactions. June 3 is the recognition point for the purchase of supplies, because it is on June 3 when the title to the supplies passes and there is an obligation to pay. June 10 is the recognition point for the cleaning work because this is when the cleaning is done and there is an obligation to pay for it. Both transactions are recorded at cost, the amount that the company is obligated to pay. The supplies purchased on June 3 are classified as an asset, Supplies, because the supplies are not used immediately but will be used up in the future. The purchase of cleaning work is classified as stockholders' equity, Maintenance Expense, because it is necessary now in the current period for the company to continue running. Also the purchase of supplies is classified as Accounts Payable, a liability, because the supplies are to be paid for in the future. Conversely, the payment to a maintenance person is classified as Cash, an asset, because the cleaning work is paid for on the day of purchase.

70 .

Chapter 2, P 5. 3.

Transactions entered in the general journal (Requirements 1, 2, 4, and 5 follow) General Journal

Date Description 2010 Aug. 2 Rent Expense Cash To pay August rent 3 Cash Accounts Receivable To record receipt of cash on account 7 No entry 10 Accounts Receivable Marketing Fees To bill customers for services 12 Accounts Payable Cash To pay on account 14 Supplies Accounts Payable To purchase supplies on credit 17 Accounts Payable Supplies To return supplies for credit 19 Cash Marketing Fees To record receipt of payment for services 24 Utilities Expense Cash To pay August utility bill 26 Advertising Expense Accounts Payable To record receipt of August advertising bill

71 .

Page 22 Post. Ref.

Debit

512 111

650

111 113

2,300

113 411

2,800

212 111

1,300

115 212

380

212 115

111 411

4,800

513 111

250

515 212

700

Credit

650

2,300

2,800

1,300

380

4,800

250

700

Chapter 2, P 5. (Continued) General Journal Date Description 2010 Aug. 29 Accounts Receivable Marketing Fees To bill customer for services 30 Salaries Expense Cash To pay salaries for August 31 Dividends Cash To declare and pay dividend

72 .

Page 23 Post. Ref.

Debit

113 411

2,700

511 111

3,800

313 111

1,200

Credit

2,700

3,800

1,200

Chapter 2, P 5. (Continued) 1. 2. 4.

Ledger accounts set up Amounts from July trial balance entered Entries from journal posted to ledger accounts

Cash Date 2010 July 31 Aug. 2 3 12 19 24 30 31

Item

Account No. 111 Balance

Post. Ref.

Debit

Credit

Balance J22 J22 J22 J22 J22 J23 J23

650 2,300 1,300 4,800 250 3,800 1,200

Accounts Receivable Date 2010 July 31 Aug. 3 10 29

Item

Post. Ref.

Debit

Credit

Balance J22 J22 J23

Item

2,300 2,800 2,700

10,590 9,940 12,240 10,940 15,740 15,490 11,690 10,490

Debit

Credit

5,500 3,200 6,000 8,700 Account No. 115 Balance

Post. Ref.

Debit

Credit

Balance J22 J22

380 80

73 .

Credit

Account No. 113 Balance

Supplies Date 2010 July 31 Aug. 14 17

Debit

Debit 610 990 910

Credit

Chapter 2, P 5. (Continued) Office Equipment Date 2010 July 31

Item

Account No. 141 Balance

Post. Ref.

Debit

Credit

Balance

Item

Account No. 212 Balance

Post. Ref.

Debit

Credit

J22 J22 J22 J22

Item

380 80 700

Account No. 311 Balance

Post. Ref.

Debit

Credit

Account No. 312 Balance

Post. Ref.

Debit

Credit

Credit 6,300

Account No. 313 Balance

Post. Ref.

Debit

J23

1,200

74 .

Debit

Balance

Item

Credit 12,000

Dividends Date 2010 Aug. 31

Debit

Balance

Item

Credit 2,600 1,300 1,680 1,600 2,300

1,300

Retained Earnings Date 2010 July 31

Debit

Balance

Common Stock Date 2010 July 31

Credit

4,200

Accounts Payable Date 2010 July 31 Aug. 12 14 17 26

Debit

Credit

Debit 1,200

Credit

Chapter 2, P 5. (Continued) Marketing Fees Date 2010 Aug. 10 19 29

Item

Account No. 411 Balance

Post. Ref.

Debit

J22 J22 J23

Credit 2,800 4,800 2,700

Salaries Expense Date 2010 Aug. 30

Item

Post. Ref.

Debit

J23

Item

Credit

3,800

Post. Ref.

Debit

Credit

650

Post. Ref.

Debit

Credit

250

Credit

Debit

Credit

250 Account No. 515 Balance

Post. Ref.

Debit

J22

700

75 .

Debit

Account No. 513 Balance

J22

Item

Credit

650

Advertising Expense Date 2010 Aug. 26

Debit

Account No. 512 Balance

J22

Item

2,800 7,600 10,300

3,800

Utilities Expense Date 2010 Aug. 24

Credit

Account No. 511 Balance

Rent Expense Date 2010 Aug. 2

Debit

Credit

Debit 700

Credit

Chapter 2, P 5. (Continued) 5.

Trial balance prepared Alpha Pro Corporation Trial Balance August 31, 2010

Cash Accounts Receivable Supplies Office Equipment Accounts Payable Common Stock Retained Earnings Dividends Marketing Fees Salaries Expense Rent Expense Utilities Expense Advertising Expense

$10,490 8,700 910 4,200 $ 2,300 12,000 6,300 1,200 10,300 3,800 650 250 700 $30,900

______ $30,900

User Insight: Transactions for August 3, 10, 19, and 29 examined

The revenues were $10,300, and only $4,800 of cash was received from those revenues. Also, the company received $2,300 of cash for services provided in previous months. Not all customers pay on time, and the company has to finance them.

76 .

Chapter 2, P 6. Assets

Liabilities

Accounts Payable

Cash 6,200

Stockholders' Equity Common Stock Common Stock

2,710

Accounts Receivable

Retained Earnings Retained Earnings

15,000

22,000

Loans Payable

35,000

$41,200 = $72,790 Equipment = $31,590

Accounting equation in balance: + $56,080

$72,790 = $72,790

77 .

Design Revenue 103,000

–

Expenses

Rent Expense 6,440

59,000

Accounting equation without Equipment:

$72,790 = $16,710

18,000

Revenues

Wages Expense

9,000

Equipment +

Dividends

480

Unearned Revenue

31,590

Dividends

Telephone Expense

5,000

Equipment

–

Chapter 2, P 7. 1.

Journal entries prepared

June

2 Cash Common Stock Issued 14,400 shares of $1 par value common stock 3 Supplies Accounts Payable Purchased supplies on account 4 Bicycles Cash Accounts Payable Purchased bicycles; made partial payment and agreed to pay the rest later 5 Shed Cash Purchased shed to store bicycles for cash 8 Shed Cash Paid for shed installation 9 No entry 10 Maintenance Expense Cash Paid for cleanup 13 Cash Rental Revenue Recorded rentals made for cash 17 Accounts Payable Cash Paid for supplies purchased on June 3

78 .

14,400 14,400

300 300 5,000 2,400 2,600

5,800 5,800

800 800

150 150 1,940 1,940 300 300

Chapter 2, P 7. (Continued) June

18 Repair Expense Cash Paid for bicycle repairs 23 Accounts Receivable Rental Revenue Billed company for rentals 25 Concession Fee Expense Cash Paid monthly concession fee 27 Cash Rental Revenue Recorded rentals made for cash 29 Wages Expense Cash Paid wages of assistant 30 Dividends Cash Declared and paid a dividend

79 .

110 110 220 220 200 200 1,920 1,920 480 480 1,000 1,000

Chapter 2, P 7. (Continued) 2. T accounts set up and entries posted from the journal Cash 6/2 14,400 6/13 1,940 6/27 1,920

6/4 6/5 6/8 6/10 6/17 6/18 6/25 6/29 6/30

18,260 Bal.

Accounts Receivable 2,400 5,800 800 150 300 110 200 480 1,000

6/23

220

Supplies 6/3

300

11,240

7,020 Shed

6/5 6/8

5,800 800

Bal.

6,600

Bicycles 6/4

5,000

Accounts Payable 6/17

300

6/3 6/4

300

2,900 Bal.

Common Stock 6/2

14,400

Wages Expense 6/29

480

Dividends 6/30

1,000

150

Concession Fee Expense 6/25

200

80 .

2,600

Rental Revenue

Maintenance Expense 6/10

300 2,600

6/13 6/23 6/27

1,940 220 1,920

Bal.

4,080

Repair Expense 6/18

110

Chapter 2, P 7. (Continued) 3.

Trial balance prepared Kluz Rentals, Inc. Trial Balance June 30, 2011

Cash Accounts Receivable Supplies Shed Bicycles Accounts Payable Common Stock Dividends Rental Revenue Wages Expense Maintenance Expense Repair Expense Concession Fee Expense

$ 7,020 220 300 6,600 5,000 $ 2,600 14,400 1,000 4,080 480 150 110 200 $21,080

$21,080

User Insight: Recognition and classification discussed

June 3 and 10 are the recognition points for these transactions. June 3 is the recognition point for the purchase of supplies because it is on June 3 when the title to the supplies passes and there is an obligation to pay. June 10 is the recognition point for the cleaning work because this is when the cleaning is done and there is an obligation to pay for it. Both transactions are recorded at cost, the amount that the company is obligated to pay. The supplies purchased on June 3 are classified as an asset, Supplies, because the supplies are not used immediately but will be used up in the future. The purchase of cleaning work is classified as stockholders' equity, Maintenance Expense, because it is necessary now in the current period for the company to continue running. Also the purchase of supplies is classified as Accounts Payable, a liability, because the supplies are to be paid for in the future. Conversely, the payment to a maintenance person is classified as Cash, an asset, because the cleaning work is paid for on the day of purchase.

81 .

Chapter 2, P 8. 3.

Transactions entered in the general journal (Requirements 1, 2, 4, and 5 follow) General Journal

Date Description 2011 Aug. 2 Rent Expense Cash Paid August rent 3 Cash Accounts Receivable Recorded receipt of cash on account 7 No entry 10 Accounts Receivable Marketing Fees Billed customers for services 12 Accounts Payable Cash Paid on account 14 Supplies Accounts Payable Purchased supplies on credit 17 Accounts Payable Supplies Returned supplies for credit 19 Cash Marketing Fees Recorded receipt of payment for services 24 Utilities Expense Cash Paid August utility bill 26 Advertising Expense Accounts Payable Recorded receipt of August advertising bill

82 .

Page 22 Post. Ref.

Debit

512 111

650

111 113

2,300

113 411

2,800

212 111

1,100

115 212

380

212 115

111 411

4,800

513 111

280

515 212

700

Credit

650

2,300

2,800

1,100

380

4,800

280

700

Chapter 2, P 8. (Continued) General Journal Date Description 2011 Aug. 29 Accounts Receivable Marketing Fees Billed customer for services 30 Salaries Expense Cash Paid salaries for August 31 Dividends Cash Declared and paid dividend

83 .

Page 23 Post. Ref.

Debit

113 411

2,700

511 111

3,800

313 111

1,200

Credit

2,700

3,800

1,200

Chapter 2, P 8. (Continued) 1. 2. 4.

Ledger accounts set up Amounts from July trial balance entered Entries from journal posted to ledger accounts

Cash Date 2011 July 31 Aug. 2 3 12 19 24 30 31

Item

Account No. 111 Balance

Post. Ref.

Debit

Credit

Balance J22 J22 J22 J22 J22 J23 J23

650 2,300 1,100 4,800 280 3,800 1,200

Accounts Receivable Date 2011 July 31 Aug. 3 10 29

Item

Post. Ref.

Debit

Credit

Balance J22 J22 J23

Item

2,300 2,800 2,700

10,200 9,550 11,850 10,750 15,550 15,270 11,470 10,270

Debit

Credit

5,500 3,200 6,000 8,700 Account No. 115 Balance

Post. Ref.

Debit

Credit

Balance J22 J22

380 80

84 .

Credit

Account No. 113 Balance

Supplies Date 2011 July 31 Aug. 14 17

Debit

Debit 610 990 910

Credit

Chapter 2, P 8. (Continued) Office Equipment Date 2011 July 31

Item

Account No. 141 Balance

Post. Ref.

Debit

Credit

Balance

Item

Account No. 212 Balance

Post. Ref.

Debit

Credit

J22 J22 J22 J22

Item

380 80 700

Account No. 311 Balance

Post. Ref.

Debit

Credit

Account No. 312 Balance

Post. Ref.

Debit

Credit

Credit 5,910

Account No. 313 Balance

Post. Ref.

Debit

J23

1,200

85 .

Debit

Balance

Item

Credit 12,000

Dividends Date 2011 Aug. 31

Debit

Balance

Item

Credit 2,600 1,500 1,880 1,800 2,500

1,100

Retained Earnings Date 2011 July 31

Debit

Balance

Common Stock Date 2011 July 31

Credit

4,200

Accounts Payable Date 2011 July 31 Aug. 12 14 17 26

Debit

Credit

Debit 1,200

Credit

Chapter 2, P 8. (Continued) Marketing Fees Date 2011 Aug. 10 19 29

Item

Account No. 411 Balance

Post. Ref.

Debit

J22 J22 J23

Credit 2,800 4,800 2,700

Salaries Expense Date 2011 Aug. 30

Item

Post. Ref.

Debit

J23

Item

Credit

3,800

Post. Ref.

Debit

Credit

650

Post. Ref.

Debit

Credit

280

Credit

Debit

Credit

280 Account No. 515 Balance

Post. Ref.

Debit

J22

700

86 .

Debit

Account No. 513 Balance

J22

Item

Credit

650

Advertising Expense Date 2011 Aug. 26

Debit

Account No. 512 Balance

J22

Item

2,800 7,600 10,300

3,800

Utilities Expense Date 2011 Aug. 24

Credit

Account No. 511 Balance

Rent Expense Date 2011 Aug. 2

Debit

Credit

Debit 700

Credit

Chapter 2, P 8. (Continued) 5.

Trial balance prepared Brilliant Ads Corporation Trial Balance August 31, 2011

Cash Accounts Receivable Supplies Office Equipment Accounts Payable Common Stock Retained Earnings Dividends Marketing Fees Salaries Expense Rent Expense Utilities Expense Advertising Expense

$10,270 8,700 910 4,200 $ 2,500 12,000 5,910 1,200 10,300 3,800 650 280 700 $30,710

______ $30,710

User Insight: Transactions for August 3, 10, 19, and 29 examined

87 .

Chapter 2, P 9.

a. b. c. d. e.

Paid for supplies purchased on credit last month. Billed customers for services performed. Paid the current month's rent. Purchased supplies with cash. Received cash from customers for services performed but not yet billed. f. Purchased equipment on account. g. Received a bill for repairs. h. Returned portion ofequipment the equipment that was Returned apart of the purchased in fpurfor a credit. in f for a credit. chased i. Received payments from customers previously billed. j. Paid the bill received in g . k. Received an order for services to be performed. l. Paid for repairs with cash. m. Made a payment to reduce the principal of the note payable. n. Declared and paid a dividend.

88 .

Debit

Credit

7 2 12 3

1 11 1 1

1 5 13

11 7 7

7 1 7

5 2 1 No entry

6 10

1 1

Chapter 2, P 10. 1. T accounts set up 2. Transactions recorded in the accounts Cash a. j.

6,100

700

1,060

c. h.

220 270

i. k. l. m.

80 110 530 250

7,160 Bal.

Accounts Receivable f.

1,910

1,910 Bal.

1,060

Supplies e.

270

1,060

850

2,160

5,000 Computers

Office Equipment

a. g.

4,300 499

a. g.

5,400 425

Bal.

4,799

Bal.

5,825

Accounts Payable h.

270

e. g.

270

270 924 1,194

Bal. Common Stock a.

15,800

Dividends m.

Salaries Expense l.

530 Repair Expense

No entry

250

110 Advertising Expense

220

89 .

Tuition Revenue f.

Utilities Expense k.

924

Rent Expense b.

700

1,910

Chapter 2, P 10. (Continued) 3. Trial balance prepared Creative Training, Inc. Trial Balance (Today's Date) Cash Accounts Receivable Supplies Computers Office Equipment Accounts Payable Common Stock Dividends Tuition Revenue Rent Expense Salaries Expense Advertising Expense Utilities Expense Repair Expense

$ 5,000 850 270 4,799 5,825 $

924 15,800

250 1,910 700 530 220 110 80 $18,634

$18,634

4. User Insight: Transactions f and j examined The revenues were $1,910, and only $1,060 of cash was received from those revenues. The company accepts credit sales to accommodate its students and encourage them to enroll. The company must consider the possibility that it will not receive the cash until later and that some students will not be able to pay.

90 .

Chapter 2, C 1. Memorandum Date: Today's date To: Owners From: Student's name Re: Accounting Policy for Delivery Trucks You have asked me to record our newly purchased delivery trucks at current market value. However, to do this will not be in accord with the cost principle. This principle holds that assets should be recorded initially at cost because it is a verifiable amount. Market values are more subjective and thus are not as reliable and do not represent the actual cost that we have incurred. The entry to record the purchase should be made as follows: Delivery Trucks Cash

xxx xxx

Note that the delivery trucks are an asset on our balance sheet because they will benefit future periods. The fact that we made a bargain purchase will be reflected in increased profits as we allocate a lower expense over the life of the asset. Chapter 2, C 2. This case raises classification issues. Rebates, as the SEC says, should not be classified as revenues. They should be classified as a reduction of costs and expenses. Think of it this way: if you bought a product for $100 with a mail-in rebate of $30, you would consider its cost to be $70, not a cost of $100 and revenue of $30. The latter would not affect your income, but you would be overstating costs and revenues by the same amount. The same situation applies to the companies. The SEC does not want them to overstate revenues through incorrect classification.

91 .

Chapter 2, C 3. 1.

Accounts classified

Cash and Due from Banks Loans to Customers Securities Available for Sale Deposits by Customers 2.

Asset Asset Asset Liability

T accounts set up and transactions recorded Cash and Due from Banks (b)

2,000

(a) (c)

2,000 5,000

Securities Available for Sale (a)

2,000 Loans to Customers

(c)

5,000 Deposits by Customers (b)

2,000

Chapter 2, C 4. Financial statements are prepared on the accrual basis, which differs from cash flows. In this case, it appears that the company is making sales on credit, which increases accounts receivable and delays the receipt of cash. The company is also paying off accounts payable, which uses cash. The company could make more of an effort to collect its accounts receivable and possibly change its credit policies to encourage more cash sales and faster payments. With regard to accounts payable, the company could work with its suppliers to get better terms. Although it cannot be determined from the facts, the company may be increasing inventory or investing in long-term assets, both of which use cash.

92 .

Chapter 2, C 5. 1. 2. 3.

CVS's notes to the financial statements state that "Advertising costs are expensed when the related advertising takes place." CVS's notes to the financial statements state that "Inventories are stated at the lower of cost or market . . . ." CVS's notes to the financial statements state that "Cash and cash equivalents consist of cash and temporary investments with maturities of three months or less when purchased."

93 .

Chapter 2, C 6. Financial ratio calculated Revenues

Asset Turnover =

Average Total Assets

CVS 2009 =

$98,729 (

$98,729.0

2008 =

$61,641

$61,301.0

+ =

$60,960

) ÷ 2

1.6 times

$87,472 (

$60,960 $87,472

$57,841

+ =

$54,722

) ÷ 2

1.5 times

Southwest 2009 =

$10,350 (

$10,350

2008 =

$14,269

$14,169

+ =

$14,068

) ÷ 2

0.7 times

$11,023 (

$14,068 $11,023 $15,420.0

+ =

$16,772

) ÷ 2

0.7 times

Asset turnover increased for both companies from 2008 to 2009. CVS was producing more revenues on each dollar invested in assets than Southwest was. The trend is the same for both years examined.

94 .

Chapter 2, C 7. In a normal sale, which this appears to be, title passes when the sale is made. So the transaction was recorded properly as a sale when shipment was made on December 31. But Shah undoubtedly was taking advantage of the company's accounting policy. In some companies, a very liberal return policy is offered to encourage customers to buy. Other companies limit returns, especially of commodities like copier paper, to a small percentage of a sale. We do not know the company's policy in this case, but it is unlikely that an office supply firm would routinely accept such a large return. If a company is in a business in which substantial returns are usual—publishing, for example—it is appropriate to estimate returns in the financial statements. Opinions will vary about the ethics of Shah's action. Most students will argue that his behavior was not ethical. Others may insist that the action fell within the company's rules and that the conversation with the buyer was simply an aggressive sales tactic. They may claim that the purchaser might very well have kept the large order. However, if both transactions stand, Quality Office Supplies Corporation loses in two ways: first, it must pay Shah a bonus that he did not earn; second, it incurs the costs associated with the return (possibly shipping, insurance, handling, and even damage).

95 .

Chapter 2, C 8. 1.

March transactions recorded in journal form

Cash Common Stock Issued 575 shares of $25 par value common stock Legal Expense Cash Paid attorney Cash Loan Payable Recorded receipt of loan from bank Loan Payable Interest Expense Cash Made payment on bank loan, including interest Truck Cash Truck Loan Payable Purchased truck, making $3,125 down payment Prepaid Rent Cash Paid three months' rent in advance Office Equipment Accounts Payable Purchased office equipment; payment due April 10 Material Handling Equipment Accounts Payable Purchased material handling equipment; payment due April 10

96 .

14,375 14,375

875 875 6,250 6,250 250 75 325

12,375 3,125 9,250

1,125 1,125 1,000 1,000

625 625

Chapter 2, C 8. (Continued) Cash Accounts Receivable Delivery Revenue Recorded delivery revenues for March j. Cash Accounts Receivable Recorded receipt of payments on accounts k. Wages Expense Cash Paid wages for March l. Utilities Expense Accounts Payable Recorded receipt of utility bill for March m. Cash Unearned Revenue Recorded receipt of payment in advance for a delivery order i.

97 .

500 1,125 1,625 375 375 562 562 93 93 62 62

Chapter 2, C 8. (Continued) 2 and 3. Entries set up in T accounts and balances determined Cash a. c. i. j. m.

14,375

875

1,125

6,250 500 375 62

d. e. f. k.

325 3,125 1,125 562

Bal.

750

21,562 Bal.

Accounts Receivable

Office Equipment

12,375

1,125

1,000

h. l.

625 93

Bal.

1,718

1,000

9,250

875

250

6,250

Bal.

6,000

Delivery Revenue 14,375

i. Interest Expense d.

Legal Expense

Utilities Expense l.

625 Loan Payable

Common Stock

Wages Expense 562

Material Handling Equipment

Unearned Revenue

Truck Loan Payable

15,550

Accounts Payable

375

6,012

Truck e.

Prepaid Rent

1,625

Chapter 2, C 8. (Continued) 4.

Trial balance prepared Takla Delivery Service Corporation Trial Balance March 31, 2011

Cash Accounts Receivable Prepaid Rent Truck Office Equipment Material Handling Equipment Accounts Payable Unearned Revenue Loan Payable Truck Loan Payable Common Stock Delivery Revenue Legal Expense Wages Expense Utilities Expense Interest Expense

$15,550 750 1,125 12,375 1,000 625 $ 1,718 62 6,000 9,250 14,375 1,625 875 562 93 75 $33,030

$33,030

Information in trial balance evaluated

The activity of the Cash account is important because a business needs to maintain enough cash to operate and to pay its bills. However, the balance in the Cash account is a poor indicator of whether a company is profitable. There are several reasons. One is that cash can be used to purchase assets that benefit future periods. For example, the company purchased a truck and other assets that will benefit future periods. A second reason is that some cash received may may not be revenue. The bank loan to the company is an example. A third reason is that expenses can be incurred that have not yet been paid. The utility bill that has not been paid is an example. A fourth reason is that revenues may be forthcoming from customers who have bought on credit but not yet paid their outstanding balances. There is a $750 balance in Accounts Receivable at the end of March, for which revenues have already been recognized and recorded but not collected.

99 .

Chapter 2, C 8. (Continued) To determine if a company is making a profit, the accountant must look beyond the Cash account. Some indication of profitability can be obtained by examining the revenues and expenses listed in the trial balance. But this approach has limitations, too. For example, the expenses may be incomplete. In the Takla Delivery case, an examination of the trial balance shows revenues of $1,625 and expenses of $1,605 ($562 + $93 + $75 + $875), but there is no account yet for rent expense. Part of the amount in Prepaid Rent has now been used up; it should be treated as an expense. If we add one month's rent, $375, to the expenses, total expenses are $1,980, which exceeds the revenues. Other assets also may be partially "used up" by the end of the month. The trial balance proves only that the accounts are in balance. It does not prove that a company has made a profit over the period. 6.

Ethical implications identified

It would be unethical to record an order as revenue. An order does not meet the criteria for revenue recognition under generally accepted accounting principles. It does not represent an obligation to pay, and delivery has not taken place.

100 .

CHAPTER 3—Solutions MEASURING BUSINESS INCOME

Chapter 3, SE 1. 1. 2. 3. 4.

c b d a

Chapter 3, SE 2. Dec.

31 Insurance Expense Prepaid Insurance To record insurance expired during the year $460 + $1,040 – $700 = $800

800 800

Chapter 3, SE 3. Dec.

31 Supplies Expense Supplies To record supplies used during the year $380 + $980 – $440 = $920

920 920

Chapter 3, SE 4. Mar.

31 Depreciation Expense—Office Equipment Accumulated Depreciation—Office Equipment To record depreciation for the month

Balance Sheet Presentation: Office equipment Less accumulated depreciation

100 100

$1,900 300

$1,600

Chapter 3, SE 5. June 30 Wages Expense Wages Payable To record wages accrued at the end of June ( $1,380 ÷ 6 ) × 1 = $230

101 .

230 230

Chapter 3, SE 6. Aug. 31 Unearned Service Revenue Service Revenue To record service revenue earned during August on which advance deposits had been received

760 760

Chapter 3, SE 7. Shimura Company Income Statement For the Month Ended December 31, 2011 Revenue Service revenue Expenses Wages expense Rent expense Income taxes expense Utilities expense Telephone expense Total expenses

$1,300 $450 200 175 100 25 950 $ 350

Net income Shimura Company Statement of Retained Earnings For the Month Ended December 31, 2011 Retained earnings, November 30, 2011 Net income Subtotal Less dividends Retained earnings, December 31, 2011

102 .

$4,300 350 $4,650 175 $4,475

Chapter 3, SE 8. Closing entries prepared Dec. 31 Service Revenue Income Summary To close the revenue account Income Summary Wages Expense Rent Expense Income Taxes Expense Utilities Expense Telephone Expense To close the expense accounts Income Summary Retained Earnings To close the Income Summary account Retained Earnings Dividends To close the Dividends account

103 .

1,300 1,300 950 450 200 175 100 25 350 350 175 175

Chapter 3, SE 9. Cloud Company Income Statement For the Month Ended October 31, 2011 Revenue Service revenue Expenses Wages expense Rent expense Income taxes expense Utilities expense Telephone expense Total expenses

$1,950 $675 300 263 150 38 1,426 $ 524

Net income Cloud Company Statement of Retained Earnings For the Month Ended October 31, 2011 Retained earnings, September 30, 2011 Net income Subtotal Less dividends Retained earnings, October 31, 2011

104 .

$6,450 524 $6,974 263 $6,711

Chapter 3, SE 10. Closing entries prepared Dec. 31 Service Revenue Income Summary To close the revenue account Income Summary Wages Expense Rent Expense Income Taxes Expense Utilities Expense Telephone Expense To close the expense accounts Income Summary Retained Earnings To close the Income Summary account Retained Earnings Dividends To close the Dividends account

105 .

1,950 1,950 1,426 675 300 263 150 38 524 524 263 263

Chapter 3, SE 11. Unearned Revenue at December 31 Service Revenue earned during December Potential receipts from services provided during December Less Unearned Revenue at November 30

$ 450 2,550

Cash received during December for services to be provided

$2,350

$3,000 650

Chapter 3, SE 12. Financial ratio calculated: Cash Flow Yield =

Cash Flow from Operations Net Income

106 .

$8,750 $7,000

1.3

times

Chapter 3, E 1. 1. 2.

When a company has net income, its stockholders' equity increases, but there is also an increase in assets and/or decrease in liabilities. To measure a company's performance (net income) accurately, each expense (in this case, guaranty or warranty expense) must be matched with the related revenue in the year in which the product or service was sold. Otherwise, net income will be overstated, and the related liability will be understated. Accrual accounting is more closely related to profitability because the purpose of accrual accounting is to measure net income. Cash accounting is more closely related to the goal of liquidity. No, the carrying value will equal the market value of the asset only by coincidence because the goal of recording depreciation is to allocate the cost of the asset over its life, not to determine its market value.

Chapter 3, E 2. 1.

Retained Earnings is not listed because it begins with a zero balance in the first month of operation. It does not yet reflect the amounts of revenues, expenses, and dividends for the year, which are listed in the adjusted trial balance. You would expect to find the amount expended in cash on the debit side of the Supplies T account. The amount expended in cash to purchase supplies represents an asset increase and is recorded by a debit to Supplies. The amount expensed during the period represents an asset decrease and is recorded by a credit to Supplies. Cash flow yield is a good measure of liquidity and is closely related to the goal of liquidity. It tells how much cash is generated by the company's operations in relation to its net income.

Chapter 3, E 3. (Note to the instructor: Because more than one concept may apply to a particular action, which concept is most applicable is a matter of judgment. This exercise is intended to generate discussion.) 1. 2. 3.

b d e

4. 5. 6.

a f c

107 .

Chapter 3, E 4. 1. 2. 3. 4.

Services have not been rendered. Persuasive evidence of an arrangement does not exist. Collectibility is not reasonably assured. The seller's price to the buyer is not fixed or determinable.

Chapter 3, E 5. 2011 Dec.

31 Magazine Subscriptions Received in Advance Magazine Subscriptions Revenue To recognize revenue for subscriptions expired during 2011

87,500 87,500

Chapter 3, E 6. 1.

Insurance Expense Prepaid Insurance To record expired insurance $33,690 – $16,540 = $17,150 Insurance Expense Prepaid Insurance To record expired insurance

17,150 17,150

4,300 4,300

108 .

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Chapter 3, E 7. 1. Amounts indicated by the question marks are in italics a b Supplies on hand at July 1 $264 $ 217 Supplies purchased during 52 1,191 the month

c $196

d $ 822

174

1,928

Total supplies available Supplies consumed during the month

$316

$1,408

$370

$2,750

194

972

314

1,632

Supplies on hand at July 31

$122

$ 436

$ 56

$1,118

2. Adjusting entry for column a July 31 Supplies Expense Supplies To record adjustment for supplies used

194 194

Chapter 3, E 8. 1. May

31 Salaries Expense Salaries Payable To accrue salaries owed but not paid at month end $70,000 ÷ 5 = $14,000 per day × 2 work days (Monday and Tuesday) incurred = $28,000 2. June 3 Salaries Expense Salaries Payable Cash To pay weekly salaries

109 .

28,000 28,000

42,000 28,000 70,000

Chapter 3, E 9. 1. Royalty expense and royalty income calculated January to June 2011 (payment on November 1) July to December 2011 ( $430,000 × 15 percent)

$20,000 64,500

2011 royalty expense and royalty income

$84,500

Note: The $12,000 paid on May 1 relates to 2010. 2. Adjusting entries recorded In Bit Comp, Inc.'s records: 2011 Dec. 31 Royalty Expense Royalty Payable To record royalties owed for the last half of 2011, to be paid on May 1, 2011 In Regina Company's records: 2011 Dec. 31 Royalty Receivable Royalty Income To record royalties earned for the last half of 2011, to be received on May 1, 2011

110 .

64,500 64,500

Chapter 3, E 10. Spark Cleaning Company, Inc. Income Statement For the Month Ended August 31, 2011 Revenue Janitorial revenue Expenses Wages expense Supplies expense Rent expense Income taxes expense Depreciation expense—truck Gas, oil, and other truck expenses Insurance expense Depreciation expense—cleaning equipment Total expenses

$5,680 2,920 1,200 800 720 580 380 320 12,600

Net income

$ 2,020

Spark Cleaning Company, Inc. Statement of Retained Earnings For the Month Ended August 31, 2011 Retained earnings, July 31, 2011 Net income Subtotal Less dividends Retained earnings, August 31, 2011

$11,034 2,020

111 .

$14,620

$13,054 2,000 $11,054

Chapter 3, E 10. (Continued) Spark Cleaning Company, Inc. Balance Sheet August 31, 2011 Assets Cash Accounts receivable Prepaid insurance Prepaid rent Cleaning supplies Cleaning equipment Less accumulated depreciation Truck Less accumulated depreciation

$ 4,590 2,592 380 200 152 $ 3,200 320

2,880

$ 7,200 720

6,480 $17,274

Total assets Liabilities Accounts payable Wages payable Unearned janitorial revenue Income taxes payable

420 80 920 800

Total liabilities

$ 2,220 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$ 4,000 11,054 15,054 $17,274

Total liabilities and stockholders' equity

112 .

Chapter 3, E 11. Closing entries recorded Aug. 31 Janitorial Revenue Income Summary To close the revenue account Income Summary Wages Expense Supplies Expense Rent Expense Income Taxes Expense Depreciation Expense—Truck Gas, Oil, and Other Truck Expenses Insurance Expense Depreciation Expense—Cleaning Equipment To close the expense accounts 31 Income Summary Retained Earnings To close the Income Summary account 31 Retained Earnings Dividends To close the Dividends account

113 .

14,620 14,620 12,600 5,680 2,920 1,200 800 720 580 380 320 2,020 2,020 2,000 2,000

Chapter 3, E 12. 1. Office Supplies Expense Office Supplies To record supplies consumed during the year Beginning balance $168 830 + Purchases = Total available – Ending balance Supplies consumed

428

$998 570 $428

2. Depreciation Expense—Office Equipment Accumulated Depreciation—Office Equipment To record depreciation allocated to the year 3. Property Taxes Expense Property Taxes Payable To record property taxes applicable to the sixmonth period 4. Interest Receivable Interest Income To record interest accrued during the period 5. Unearned Revenue Service Revenue To record revenue earned for services for which payment had been received in advance 6. Accounts Receivable Service Revenue To record service revenue earned but not billed

114 .

428

1,065 1,065 900 900

425 425 375 375

400 400

Chapter 3, E 13. 1.

Entries recorded

Oct.

Dec.

1 Cash Unearned Legal Fees To record legal fees received in advance 31 Unearned Legal Fees Legal Fees Earned To recognize three months' fees earned ( $42,000 ÷ 12 months ) × 3 months = $10,500

42,000 42,000 10,500 10,500

2. Revenue on the income statement includes the $10,500 in legal fees that have been earned. Unearned Legal Fees is a liability of $31,500 on the balance sheet. Chapter 3, E 14. Closing entries recorded Dec.

31 Consulting Fees Earned Income Summary To close the revenue account 31 Income Summary Office Salaries Expense Income Taxes Expense Rent Expense Advertising Expense Telephone Expense To close the expense accounts 31 Income Summary Retained Earnings To close the Income Summary account 31 Retained Earnings Dividends To close the Dividends account

115 .

31,700 31,700 23,275 13,500 3,000 2,650 2,525 1,600 8,425 8,425 7,000 7,000

Chapter 3, E 15. Statement of retained earnings prepared Cindy's Beauty Salon, Inc. Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends

$52,000 44,000

Retained earnings, December 31, 2011

$77,000

$96,000 19,000

Chapter 3, E 16. Prepaid Insurance at end of 2011 Insurance Expense during 2011 Potential payments for insurance during 2011 Less Prepaid Insurance at end of 2010 Cash payments for insurance during 2011

$ 1,200 1,900

Wages Payable at end of 2010 Wages Expense during 2011 Potential payments for wages during 2011 Less Wages Payable at end of 2011 Cash payments for wages during 2011

$ 1,100 9,750

Unearned Revenue at end of 2011 Fees Earned during 2011 Potential receipts from fees during 2011 Less Unearned Revenue at end of 2010 Cash receipts from fees during 2011

$ 2,100 4,450

$ 1,650

$10,850 600 $10,250

$ 6,550 950 $ 5,600

116 .

$ 3,100 1,450

Chapter 3, E 17. 1. Cash paid for rent during the year: Ending balance Rent Expense Potential cash paid for rent Less beginning balance

$152,700 $

$ 152,700 — $ 152,700

Cash paid during the year 2. Cash paid for interest during the year: Beginning balance Interest Expense Potential cash paid for interest Less ending balance

$26,400 $ 3,000 23,400 $26,400 — $26,400

Cash paid during the year 3. Cash paid for salaries during the year: Beginning balance Salaries Expense Potential cash paid for salaries Less ending balance

$229,000 $ 15,000 242,000 $257,000 28,000 $229,000

Cash paid during the year Chapter 3, E 18. Financial ratios calculated Cash Flow Yield =

2011 =

2010 =

Cash Flows from Operating Activities Net Income $6,000 $5,000 $5,500 $4,300

117 .

2,700 150,000

1.2 or

1.2 times

1.3 or

1.3 times

Chapter 3, P 1. Amount of Adjustment (+ or –)

Balance Sheet Account Office Supplies

–

$ 783

Prepaid Rent

–

600

Accumulated Depreciation— Equipment

416

Unearned Answering Service Revenue

–

Wages Payable

Income Taxes Payable

Balance Income after Statement Account Adjustment Office Supplies Expense $ 150 Rent Expense 200

Balance after Adjustment $ 783

$ 783

600

416

Depreciation Expense— Equipment

416

148

740

Answering Service Revenue

148

9,250

105

Wages Expense

105

2,005

1,110

Income Taxes Expense

1,110

118 .

Amount of Adjustment (+ or –)

Chapter 3, P 2. 1.

Adjusting entries recorded

Nov.

30 Supplies Expense Supplies To record supplies used $2,350 + $4,218 – $1,397 = $5,171 30 Insurance Expense Prepaid Insurance To record expired insurance $4,720 1,750 [ ( $4,200  12 months ) x 5 months ] 404 [ ( $7,272  36 months ) x 2 months ] $6,874

5,171

30 Depreciation Expense—Buildings Depreciation Expense—Equipment Accumulated Depreciation—Buildings Accumulated Depreciation—Equipment To record annual depreciation 30 Unearned Service Revenue Service Revenue To record service revenue earned on services collected in advance ( $18,600  12 months ) x 3 months = $4,650 30 Accounts Receivable Service Revenue To record service revenue earned on a contract to be billed in January 30 Interest Expense Interest Payable To record accrued interest on note payable

16,000 40,000

5,171

6,874 6,874

16,000 40,000 4,650 4,650

7,000 7,000

18,000 18,000

119 .

Chapter 3, P 2. (Continued) g. Nov. 30 Salaries Expense Salaries Payable To record accrued salaries ( $15,000  6 days ) x 4 days = $10,000 No entry h. i. 30 Income Taxes Expense Income Taxes Payable To accrue estimated income taxes for the year 2.

10,000 10,000

23,000 23,000

User Insight: Revenue recognition discussed

In transaction "e," $7,000 has to be recognized as revenue because services have already been provided and there is an obligation to pay for them. In transaction "h," November 29 is not a recognition point because no services have been provided and there is no obligation to pay for them.

120 .

Chapter 3, P 3. 1. 2.

T accounts set up and balances entered Adjusting entries posted to the accounts

Bal.

Cash 13,786

Bal. Bal.

Prepaid Rent 1,400 (b) 900

Accounts Receivable Bal. Bal.

Bal. 24,840 (g) 915 Bal. 25,755

500

Office Equipment Bal. 7,300

Office Supplies 991 (a) 894 97

Accumulated Depreciation— Office Equipment Bal. (c) Bal.

2,600 720 3,320

Accounts Payable Bal. 1,820

Notes Payable Bal. 10,000

Interest Payable (d) 600

Salaries Payable (e) 230

Unearned Service Revenue (f) 1,450 Bal. 2,860 Bal. 1,410

Income Taxes Payable (h) 2,780

Common Stock Bal. 11,000

Retained Earnings Bal. 19,387

Service Revenue Bal. 58,500 (f) 1,450 (g) 915 Bal. 60,865

Salaries Expense Bal. 33,400 (e) 230 Bal. 33,630

Bal. (b) Bal.

Rent Expense 7,700 500 8,200

Office Supplies Expense (a) 894

(d)

Interest Expense 600

Income Taxes Expense (h) 2,780

Dividends Bal. 15,000 Utilities Expense Bal. 1,750

Depreciation Expense— Office Equipment (c) 720

121 .

Chapter 3, P 3. (Continued) 3.

Adjusted trial balance prepared Prima Consultants Corporation Adjusted Trial Balance December 31, 2010

Cash Accounts Receivable Office Supplies Prepaid Rent Office Equipment Accumulated Depreciation—Office Equipment Accounts Payable Notes Payable Interest Payable Salaries Payable Unearned Service Revenue Income Taxes Payable Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Utilities Expense Rent Expense Office Supplies Expense Depreciation Expense—Office Equipment Interest Expense Income Taxes Expense

$ 13,786 25,755 97 900 7,300 $

15,000 60,865 33,630 1,750 8,200 894 720 600 2,780 $111,412

122 .

3,320 1,820 10,000 600 230 1,410 2,780 11,000 19,387

_______ $111,412

Chapter 3, P 3. (Continued) 4. User Insight: The following financial statements are affected by the adjustments: a. b. c. d. e.

Balance sheet, income statement, statement of retained earnings

g. Balance sheet, income statement, statement of retained earnings h. Balance sheet, income statement, statement of retained earnings The statement of cash flows is not affected by the adjustments.

123 .

Chapter 3, P 4. 1. 2.

T accounts set up and balances entered Adjusting entries posted to the accounts Cash

Bal.

Accounts Receivable

3,700

Bal.

Office Supplies Bal.

780

Bal.

225

(a)

555

Bal.

Bal. (d)

635 21

Bal.

656

(e)

Bal.

100

7,100

219

Bal.

219

Bal.

—

Retained Earnings Bal. 3,439

(b)

140

Bal. (c)

770 795

Bal.

1,565

Income Taxes Payable (f)

Bal.

2,430

Dividends 6,000

Tax Fees Revenue Bal. 21,926 (e) 219 Bal. 22,145

Office Salaries Expense Bal. 8,300

Advertising Expense Bal. 650

Rent Expense 2,400

Telephone Expense Bal. 220 (d) 21 Bal. 241

Insurance Expense (b) 140

Depreciation Expense— Office Equipment

Office Supplies Expense 555

(c)

795

124 .

240

Unearned Tax Fees Revenue

Common Stock Bal. 3,500

(a)

Bal.

Accumulated Depreciation— Office Equipment

Office Equipment

Accounts Payable

Bal.

1,099

Prepaid Insurance

Income Taxes Expense (f)

2,430

Chapter 3, P 4. (Continued) 3.

Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared Ortega Tax Service, Inc. Adjusted Trial Balance December 31, 2010

Cash Accounts Receivable Prepaid Insurance Office Supplies Office Equipment Accumulated Depreciation—Office Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings Dividends Tax Fees Revenue Office Salaries Expense Advertising Expense Rent Expense Telephone Expense Insurance Expense Office Supplies Expense Depreciation Expense—Office Equipment Income Taxes Expense

$ 3,700 1,099 100 225 7,100 $ 1,565 656 2,430 3,500 3,439 6,000 22,145 8,300 650 2,400 241 140 555 795 2,430 $33,735

______ $33,735

Note: Unearned Tax Fees Revenue does not appear on the adjusted trial balance because it now has a zero balance.

125 .

Chapter 3, P 4. (Continued) Ortega Tax Service, Inc. Income Statement For the Year Ended December 31, 2010 Revenue Tax fees revenue Expenses Office salaries expense Advertising expense Rent expense Telephone expense Insurance expense Office supplies expense Depreciation expense—office equipment Income taxes expense Total expenses

$8,300 650 2,400 241 140 555 795 2,430 15,511

Net income

$ 6,634

Ortega Tax Service, Inc. Statement of Retained Earnings For the Year Ended December 31, 2010 Retained earnings, December 31, 2009 Net income Subtotal Less dividends

$ 3,439 6,634

Retained earnings, December 31, 2010

$ 4,073

126 .

$22,145

$10,073 6,000

Chapter 3, P 4. (Continued) Ortega Tax Service, Inc. Balance Sheet December 31, 2010 Assets Cash Accounts receivable Prepaid insurance Office supplies Office equipment Less accumulated depreciation

$ 3,700 1,099 100 225 $7,100 1,565

5,535 $10,659

Total assets Liabilities Accounts payable Income taxes payable

$ 656 2,430

Total liabilities

$ 3,086 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$3,500 4,073 7,573 $10,659

Total liabilities and stockholders' equity 4.

User Insight: The effect of adjusting entries discussed

By definition, adjusting entries cannot include a debit or a credit to Cash. Because adjusting entries never involve the cash account, they never affect cash flows. That is why it is not necessary to show the effects of adjusting entries on the statement of cash flows.

127 .

Chapter 3, P 5. 1.

Adjusting entries recorded in the general journal General Journal

Date Description 2010 June 30 Rent Expense Prepaid Rent To expense one year's rent paid in advance 30 Insurance Expense Prepaid Insurance To record insurance that expired during the year 30 Maintenance Expense Prepaid Maintenance To record amount of deposit used during the year 30 Spare Parts Expense Spare Parts To record spare parts used during the year $11,310 – $2,016 = $9,294 30 Depreciation Expense—Limousines Accumulated Depreciation—Limousines To record depreciation on the limousines for the year $220,000 x 12.5% = $27,500 30 Interest Expense Interest Payable To record accrued interest 30 Unearned Passenger Service Revenue Passenger Service Revenue To recognize passenger service revenue earned $30,000 – $17,815 = $12,185 30 Income Taxes Expense Income Taxes Payable To accrue estimated income taxes for the year

128 .

Page 14 Post. Ref.

Debit

514 117

12,000

515 118

1,800

518 119

10,944

516 141

9,294

517 143

27,500

519 213

11,300

212 411

12,185

520 214

13,250

Credit

12,000

1,800

10,944

9,294

27,500

11,300

12,185

13,250

Chapter 3, P 5. (Continued) 2. 3.

Ledger accounts opened and balances recorded Adjusting entries posted from the general journal

Cash Date 2010 June 30

Item

Post. Ref.

Debit

Credit

Balance

9,812

Accounts Receivable Date 2010 June 30

Item

Post. Ref.

Debit

Credit

Balance

Item

Post. Ref.

Balance Adjustment

J14

Debit

Credit

Account No. 117 Balance Debit Credit

12,000

12,000 —

Credit

Account No. 118 Balance Debit Credit

Prepaid Insurance Date 2010 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

1,800

Prepaid Maintenance Date 2010 June 30 30

Item Balance Adjustment

Account No. 112 Balance Debit Credit 14,227

Prepaid Rent Date 2010 June 30 30

Account No. 111 Balance Debit Credit

Post. Ref.

Debit

J14

4,900 3,100

Credit

Account No. 119 Balance Debit Credit

10,944

12,000 1,056

129 .

Chapter 3, P 5. (Continued) Spare Parts Date 2010 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

9,294

Limousines Date 2010 June 30

Item

Post. Ref.

Debit

Credit

Balance

Item Balance Adjustment

Item

Post. Ref.

Debit

J14

Credit

27,500

35,000 62,500

Credit

Account No. 211 Balance Debit Credit

Post. Ref.

Debit

Balance

45,000

Unearned Passenger Service Revenue Date 2010 June 30 30

Item Balance Adjustment

Post. Ref.

J14

Debit

Credit

Item

Post. Ref.

12,185

Adjustment

J14

130 .

Debit

Account No. 212 Balance Debit Credit 30,000 17,815

Interest Payable Date 2010 June 30

Account No. 142 Balance Debit Credit

Account No. 143 Balance Debit Credit

Notes Payable Date 2010 June 30

11,310 2,016

220,000

Accumulated Depreciation—Limousines Date 2010 June 30 30

Account No. 141 Balance Debit Credit

Credit

Account No. 213 Balance Debit Credit

11,300

Chapter 3, P 5. (Continued) Income Taxes Payable Date 2010 June 30

Item

Post. Ref.

Adjustment

J14

Debit

Credit

Account No. 214 Balance Debit Credit

13,250

Credit

Account No. 311 Balance Debit Credit

Common Stock Date 2010 June 30

Item

Post. Ref.

Debit

Balance

40,000

Retained Earnings Date 2010 June 30

Item

Post. Ref.

Debit

Credit

Balance

48,211

Item

Account No. 313 Balance Debit Credit

Dividends Date 2010 June 30

Post. Ref.

Debit

Credit

Balance

20,000

Passenger Service Revenue Date 2010 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

Account No. 411 Balance Debit Credit

12,185

428,498 440,683

Credit

Account No. 511 Balance Debit Credit

Gas and Oil Expense Date 2010 June 30

Account No. 312 Balance Debit Credit

Item

Post. Ref.

Debit

Balance

89,300

131 .

Chapter 3, P 5. (Continued) Salaries Expense Date 2010 June 30

Item

Post. Ref.

Debit

Credit

Balance

206,360

Advertising Expense Date 2010 June 30

Item

Post. Ref.

Debit

Credit

Balance

Post. Ref.

Debit

Adjustment

J14

12,000

Debit

Account No. 515 Balance Debit Credit

Credit

Item

Post. Ref.

Adjustment

J14

Credit

1,800

Spare Parts Expense Date 2010 June 30

Item

Post. Ref.

Adjustment

J14

Debit

Credit

9,294

Item

Post. Ref.

Debit

Adjustment

J14

27,500

132 .

Account No. 516 Balance Debit Credit 9,294

Depreciation Expense—Limousines Date 2010 June 30

Account No. 514 Balance Debit Credit

Item

Insurance Expense Date 2010 June 30

Account No. 513 Balance Debit Credit 26,800

Rent Expense Date 2010 June 30

Account No. 512 Balance Debit Credit

Credit

Account No. 517 Balance Debit Credit 27,500

Chapter 3, P 5. (Continued) Maintenance Expense Date 2010 June 30

Item

Post. Ref.

Debit

Adjustment

J14

10,944

Item

Post. Ref.

Debit

Account No. 519 Balance Debit Credit

Adjustment

J14

11,300

11,300 Account No. 520 Balance Debit Credit

Credit

Interest Expense Date 2010 June 30

Credit

Income Taxes Expense Date 2010 June 30

Item

Post. Ref.

Debit

Adjustment

J14

13,250

133 .

Account No. 518 Balance Debit Credit

Credit

13,250

Chapter 3, P 5. (Continued) 4.

Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared VIP Limo Service, Inc. Adjusted Trial Balance June 30, 2010

Cash Accounts Receivable Prepaid Insurance Prepaid Maintenance Spare Parts Limousines Accumulated Depreciation—Limousines Notes Payable Unearned Passenger Service Revenue Interest Payable Income Taxes Payable Common Stock Retained Earnings Dividends Passenger Service Revenue Gas and Oil Expense Salaries Expense Advertising Expense Rent Expense Insurance Expense Spare Parts Expense Depreciation Expense—Limousines Maintenance Expense Interest Expense Income Taxes Expense

9,812 14,227 3,100 1,056 2,016 220,000 $ 62,500 45,000 17,815 11,300 13,250 40,000 48,211 20,000 440,683 89,300 206,360 26,800 12,000 1,800 9,294 27,500 10,944 11,300 13,250

$678,759

_______ $678,759

Note: Prepaid Rent does not appear on the adjusted trial balance because it now has a zero balance.

134 .

Chapter 3, P 5. (Continued) VIP Limo Service, Inc. Income Statement For the Year Ended June 30, 2010 Revenue Passenger service revenue Expenses Gas and oil expense Salaries expense Advertising expense Rent expense Insurance expense Spare parts expense Depreciation expense—limousines Maintenance expense Interest expense Income taxes expense Total expenses

$440,683 $ 89,300 206,360 26,800 12,000 1,800 9,294 27,500 10,944 11,300 13,250 408,548

Net income

$ 32,135

VIP Limo Service, Inc. Statement of Retained Earnings For the Year Ended June 30, 2010 Retained earnings, June 30, 2009 Net income Subtotal Less dividends

$ 48,211 32,135

Retained earnings, June 30, 2010

$ 60,346

$ 80,346 20,000

135 .

Chapter 3, P 5. (Continued) VIP Limo Service, Inc. Balance Sheet June 30, 2010 Assets Cash Accounts receivable Prepaid insurance Prepaid maintenance Spare parts Limousines Less accumulated depreciation

$220,000 62,500

9,812 14,227 3,100 1,056 2,016 157,500

$187,711

Total assets Liabilities Notes payable Unearned passenger service revenue Interest payable Income taxes payable

$ 45,000 17,815 11,300 13,250

Total liabilities

$ 87,365 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$ 40,000 60,346

Total liabilities and stockholders' equity 5.

100,346 $187,711

User Insight: The effect of adjustments discussed

Adjusting entries affect net income on the income statement, and therefore they affect the profit margin. Adjusting entries can also affect revenues. After the adjustments have been posted in the previous parts of the problem, the profit margin for the year has decreased because the additional expenses recorded exceed the additional revenues.

136 .

Chapter 3, P 6.

a. b. c. d. e. f.

Amount of Adjustment (+ or –)

Balance Sheet Account Office Supplies

–

$ 783

Prepaid Rent

–

600

Accumulated Depreciation— Equipment Unearned Answering Service Revenue Wages Payable Income Taxes Payable

Balance Income after Statement Account Adjustment Office Supplies Expense $ 150 Rent Expense 200

416

–

148 105

740 105

1,110

+ +

137 .

Amount of Adjustment (+ or –)

Balance after Adjustment $ 783

$ 783

600

Depreciation Expense— Equipment

416

Answering Service Revenue

Wages Expense Income Taxes Expense

+ +

148 105

9,250 2,005

1,110

Chapter 3, P 7. 1. Adjusting entries recorded a. Nov.

30 Supplies Expense Supplies To record supplies used $2,350 + $4,218 – $1,397 = $5,171 30 Insurance Expense Prepaid Insurance To record expired insurance $4,720 1,750 [ ( $4,200 ÷ 12 months ) × 5 months ] 404 [ ( $7,272 ÷ 36 months ) × 2 months ] $6,874

5,171

30 Depreciation Expense—Buildings Depreciation Expense—Equipment Accumulated Depreciation—Buildings Accumulated Depreciation—Equipment To record annual depreciation 30 Unearned Service Revenue Service Revenue To record service revenue earned on services collected in advance ( $18,600 ÷ 12 months ) × 3 months = $4,650 30 Accounts Receivable Service Revenue To record service revenue earned on a contract to be billed in January 30 Interest Expense Interest Payable To record accrued interest on note payable

16,000 40,000

138 .

5,171

6,874 6,874

16,000 40,000 4,650 4,650

7,000 7,000

18,000 18,000

Chapter 3, P 7. (Continued) g. Nov. 30 Salaries Expense Salaries Payable To record accrued salaries ( $15,000 ÷ 6 days ) × 4 days = $10,000 No entry h. i. 30 Income Taxes Expense Income Taxes Payable To accrue estimated income taxes for the year

10,000 10,000

23,000 23,000

2. User Insight: Revenue recognition discussed In transaction e , $7,000 has to be recognized as revenue because services have already been provided and there is an obligation to pay for them. In transaction h , November 29 is not a recognition point because no services have been provided and there is no obligation to pay for them.

139 .

Chapter 3, P 8. 1. T accounts set up and balances entered 2. Adjusting entries posted to the accounts

Bal.

Cash 13,786

Accounts Receivable Bal. Bal.

Bal. 24,840 (g) 915 Bal. 25,755

Office Supplies 991 (a) 894 97

Accumulated Depreciation—

Bal. Bal.

Prepaid Rent 1,400 (b) 900

500

Office Equipment Bal. 7,300

Office Equipment Bal. (c) Bal.

2,600 720 3,320

Accounts Payable Bal. 1,820

Notes Payable Bal. 10,000

Interest Payable (d) 600

Salaries Payable (e) 230

Unearned Service Revenue (f) 1,450 Bal. 2,860 Bal. 1,410

Income Taxes Payable (h) 2,780

Common Stock Bal. 11,000

Retained Earnings Bal. 19,387

Service Revenue Bal. 58,500 (f) 1,450 (g) 915 Bal. 60,865

Salaries Expense Bal. 33,400 (e) 230 Bal. 33,630

Bal. (b) Bal.

Rent Expense 7,700 500 8,200

Office Supplies Expense (a) 894

(d)

Interest Expense 600

Income Taxes Expense (h) 2,780

140 .

Dividends Bal. 15,000 Utilities Expense Bal. 1,750

Depreciation Expense— Office Equipment (c) 720

Chapter 3, P 8. (Continued) 3. Adjusted trial balance prepared Sigma Consultants Corporation Adjusted Trial Balance December 31, 2011 Cash Accounts Receivable Office Supplies Prepaid Rent Office Equipment Accumulated Depreciation—Office Equipment Accounts Payable Notes Payable Interest Payable Salaries Payable Unearned Service Revenue Income Taxes Payable Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Utilities Expense Rent Expense Office Supplies Expense Depreciation Expense—Office Equipment Interest Expense Income Taxes Expense

141 .

$ 13,786 25,755 97 900 7,300 $

3,320 1,820 10,000 600 230 1,410 2,780 11,000 19,387

15,000 60,865 33,630 1,750 8,200 894 720 600 2,780 $111,412

$111,412

Chapter 3, P 8. (Continued) 4. User Insight: The following financial statements are affected by the adjustments: a. b. c. d. e. f. g. h.

Balance sheet, income statement, statement of retained earnings Balance sheet, income statement, statement of retained earnings Balance sheet, income statement, statement of retained earnings Balance sheet, income statement, statement of retained earnings Balance sheet, income statement, statement of retained earnings Balance sheet, income statement, statement of retained earnings Balance sheet, income statement, statement of retained earnings Balance sheet, income statement, statement of retained earnings

The statement of cash flows is not affected by the adjustments.

142 .

Chapter 3, P 9. 1. T accounts set up and balances entered 2. Adjusting entries posted to the accounts Cash Bal.

Accounts Receivable

3,650

Bal.

Office Supplies Bal. Bal.

610 180

(a)

Bal.

590 45 635

6,800

315

130

Bal. (c)

670 650

Bal.

1,320

Income Taxes Payable

315

(f)

2,385

—

Retained Earnings Bal. 3,117

Travel Fees Revenue Bal. 20,079 (e) 315 Bal. 20,394

Office Salaries Expense Bal. 8,300

Advertising Expense Bal. 585

Rent Expense 2,350

Telephone Expense Bal. 411 (d) 45 Bal. 456

Insurance Expense (b) 130

Office Supplies Expense 430

Bal.

Depreciation Expense— Office Equipment (c)

650

143 .

Bal. Bal.

(b)

Common Stock Bal. 3,300

Bal.

(a)

(e)

195 65

Accumulated Depreciation— Office Equipment

Unearned Travel Fees Revenue

Accounts Payable Bal. (d) Bal.

Bal. Bal.

970

Office Equipment 430

Prepaid Insurance

Dividends 4,200

Income Taxes Expense (f)

2,385

Chapter 3, P 9. (Continued) 3.

Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared Angel Travel, Inc. Adjusted Trial Balance December 31, 2011

Cash Accounts Receivable Prepaid Insurance Office Supplies Office Equipment Accumulated Depreciation—Office Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings Dividends Travel Fees Revenue Office Salaries Expense Advertising Expense Rent Expense Telephone Expense Insurance Expense Office Supplies Expense Depreciation Expense—Office Equipment Income Taxes Expense

$ 3,650 970 65 180 6,800 $ 1,320 635 2,385 3,300 3,117 4,200 20,394 8,300 585 2,350 456 130 430 650 2,385 $31,151

$31,151

Note: Unearned Travel Fees Revenue does not appear on the adjusted trial balance because it now has a zero balance.

144 .

Chapter 3, P 9. (Continued) Angel Travel, Inc. Income Statement For the Year Ended December 31, 2011 Revenue Travel fees revenue Expenses Office salaries expense Income taxes expense Rent expense Depreciation expense—office equipment Advertising expense Telephone expense Office supplies expense Insurance expense Total expenses

$8,300 2,385 2,350 650 585 456 430 130 15,286

Net income

$ 5,108

Angel Travel, Inc. Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends

$3,117 5,108

Retained earnings, December 31, 2011

$4,025

145 .

$20,394

$8,225 4,200

Chapter 3, P 9. (Continued) Angel Travel, Inc. Balance Sheet December 31, 2011 Assets Cash Accounts receivable Prepaid insurance Office supplies Office equipment Less accumulated depreciation

$ 3,650 970 65 180 $6,800 1,320

5,480 $10,345

Total assets Liabilities Accounts payable Income taxes payable

$ 635 2,385

Total liabilities

$ 3,020 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$3,300 4,025 7,325 $10,345

Total liabilities and stockholders' equity 4. User Insight: The effect of adjusting entries discussed

By definition, adjusting entries cannot include a debit or a credit to Cash. Because adjusting entries never involve the Cash account, they never affect cash flows. That is why it is not necessary to show the effects of adjusting entries on the statement of cash flows.

146 .

Chapter 3, P 10. 1. Adjusting entries recorded in the general journal General Journal

Date Description 2011 June 30 Rent Expense Prepaid Rent To expense one year's rent paid in advance 30 Insurance Expense Prepaid Insurance To record insurance that expired during the year 30 Maintenance Expense Prepaid Maintenance To record amount of deposit used during the year 30 Spare Parts Expense Spare Parts To record spare parts used during the year $15,100 – $2,580 = $12,520 30 Depreciation Expense—Vehicles Accumulated Depreciation—Vehicles To record depreciation on the vehicles for the year $190,000 × 12.5% = $23,750 30 Interest Expense Interest Payable To record accrued interest 30 Unearned Service Revenue Service Revenue To recognize service revenue earned $29,500 – $13,535 = $15,965 30 Income Taxes Expense Income Taxes Payable To accrue estimated income taxes for the year

147 .

Page 14 Post. Ref.

Debit

514 117

11,000

515 118

1,400

518 119

9,879

516 141

12,520

517 143

23,750

519 213

11,800

212 411

15,965

520 214

12,980

Credit

11,000

1,400

9,879

12,520

23,750

11,800

15,965

12,980

Chapter 3, P 10. (Continued) 2. Ledger accounts opened and balances recorded 3. Adjusting entries posted from the general journal Cash Date 2011 June 30

Item

Post. Ref.

Debit

Credit

Balance

8,120

Accounts Receivable Date 2011 June 30

Item

Post. Ref.

Debit

Credit

Balance

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

Account No. 117 Balance Debit Credit

11,000

11,000 —

Credit

Account No. 118 Balance Debit Credit

Prepaid Insurance Date 2011 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

1,400

Prepaid Maintenance Date 2011 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

9,879

148 .

Account No. 112 Balance Debit Credit 13,270

Prepaid Rent Date 2011 June 30 30

Account No. 111 Balance Debit Credit

3,700 2,300 Account No. 119 Balance Debit Credit 11,000 1,121

Chapter 3, P 10. (Continued) Spare Parts Date 2011 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

Account No. 141 Balance Debit Credit

12,520

15,100 2,580

Credit

Account No. 142 Balance Debit Credit

Vehicles Date 2011 June 30

Item

Post. Ref.

Debit

Balance

190,000

Accumulated Depreciation—Vehicles Date 2011 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

Account No. 143 Balance Debit Credit

23,750

25,000 48,750

Credit

Account No. 211 Balance Debit Credit

Notes Payable Date 2011 June 30

Item

Post. Ref.

Debit

Balance

48,000

Unearned Service Revenue Date 2011 June 30 30

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

29,500 13,535

15,965

Interest Payable Date 2011 June 30

Item

Post. Ref.

Adjustment

J14

Debit

149 .

Account No. 212 Balance Debit Credit

Credit

Account No. 213 Balance Debit Credit

11,800

Chapter 3, P 10. (Continued) Income Taxes Payable Date 2011 June 30

Item

Post. Ref.

Adjustment

J14

Debit

Credit

Account No. 214 Balance Debit Credit

12,980

Credit

Account No. 311 Balance Debit Credit

Common Stock Date 2011 June 30

Item

Post. Ref.

Debit

Balance

27,000

Retained Earnings Date 2011 June 30

Item

Post. Ref.

Debit

Credit

Balance

53,650

Dividends Date 2011 June 30

Item

Post. Ref.

Debit

Credit

Balance

Item Balance Adjustment

Post. Ref.

Debit

J14

Credit

Account No. 411 Balance Debit Credit

15,965

419,160 435,125

Credit

Account No. 511 Balance Debit Credit

Gas and Oil Expense Date 2011 June 30

Item

Post. Ref.

Debit

Balance

95,600

150 .

Account No. 313 Balance Debit Credit 19,000

Service Revenue Date 2011 June 30 30

Account No. 312 Balance Debit Credit

Chapter 3, P 10. (Continued) Salaries Expense Date 2011 June 30

Item

Post. Ref.

Debit

Credit

Balance

214,320

Advertising Expense Date 2011 June 30

Item

Post. Ref.

Debit

Credit

Balance

Item

Debit

Adjustment

J14

11,000

Debit

Account No. 515 Balance Debit Credit

Credit

Item

Post. Ref.

Adjustment

J14

Credit

1,400

Spare Parts Expense Date 2011 June 30

Item

Debit

Adjustment

J14

12,520

12,520 Account No. 517 Balance Debit Credit

Item

Post. Ref.

Debit

Adjustment

J14

23,750

151 .

Account No. 516 Balance Debit Credit

Post. Ref.

Credit

Depreciation Expense—Vehicles Date 2011 June 30

Account No. 514 Balance Debit Credit

Post. Ref.

Insurance Expense Date 2011 June 30

Account No. 513 Balance Debit Credit 21,200

Rent Expense Date 2011 June 30

Account No. 512 Balance Debit Credit

Credit

23,750

Chapter 3, P 10. (Continued) Maintenance Expense Date 2011 June 30

Item

Post. Ref.

Adjustment

J14

Debit

Credit

9,879

Interest Expense Date 2011 June 30

Post. Ref.

Debit

Adjustment

J14

11,800

Item

Post. Ref.

Debit

Account No. 520 Balance Debit Credit

Adjustment

J14

12,980

152 .

Account No. 519 Balance Debit Credit

Item

Credit

Income Taxes Expense Date 2011 June 30

Account No. 518 Balance Debit Credit

Credit

12,980

Chapter 3, P 10. (Continued) 4.

Adjusted trial balance, income statement, statement of retained earnings, and balance sheet prepared Ray Heating & Cooling, Inc. Adjusted Trial Balance June 30, 2011

Cash Accounts Receivable Prepaid Insurance Prepaid Maintenance Spare Parts Vehicles Accumulated Depreciation—Vehicles Notes Payable Unearned Service Revenue Interest Payable Income Taxes Payable Common Stock Retained Earnings Dividends Service Revenue Gas and Oil Expense Salaries Expense Advertising Expense Rent Expense Insurance Expense Spare Parts Expense Depreciation Expense—Vehicles Maintenance Expense Interest Expense Income Taxes Expense

8,120 13,270 2,300 1,121 2,580 190,000 $ 48,750 48,000 13,535 11,800 12,980 27,000 53,650 19,000 435,125

95,600 214,320 21,200 11,000 1,400 12,520 23,750 9,879 11,800 12,980 $650,840

$650,840

Note: Prepaid Rent does not appear on the adjusted trial balance because it now has a zero balance.

153 .

Chapter 3, P 10. (Continued) Ray Heating & Cooling, Inc. Income Statement For the Year Ended June 30, 2011 Revenue Service revenue Expenses Salaries expense Gas and oil expense Depreciation expense—vehicles Advertising expense Income taxes expense Spare parts expense Interest expense Rent expense Maintenance expense Insurance expense Total expenses

$435,125 $214,320 95,600 23,750 21,200 12,980 12,520 11,800 11,000 9,879 1,400 414,449

Net income

$ 20,676

Ray Heating & Cooling, Inc. Statement of Retained Earnings For the Year Ended June 30, 2011 Retained earnings, June 30, 2010 Net income Subtotal Less dividends

$ 53,650 20,676

Retained earnings, June 30, 2011

$ 55,326

154 .

$ 74,326 19,000

Chapter 3, P 10. (Continued) Ray Heating & Cooling, Inc. Balance Sheet June 30, 2011 Assets Cash Accounts receivable Prepaid insurance Prepaid maintenance Spare parts Vehicles Less accumulated depreciation

$190,000 48,750

8,120 13,270 2,300 1,121 2,580

141,250 $168,641

Total assets Liabilities Notes payable Unearned service revenue Interest payable Income taxes payable

$ 48,000 13,535 11,800 12,980

Total liabilities

$ 86,315 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$ 27,000 55,326 82,326

Total liabilities and stockholders' equity

$168,641

5. User Insight: The effect of adjustments discussed Adjusting entries affect net income on the income statement, and therefore they affect the cash flow yield. After the adjustments have been posted in the previous parts of the problem, the cash flow yield for the year has increased because the additional expenses recorded exceed the additional revenues, decreasing net income and thus increasing cash flow yield.

155 .

Chapter 3, C 1. According to the concepts of accrual accounting and the matching rule, the accountant must estimate and record (accrue) the expenses associated with a sale even though cash may not be paid out until future years. This procedure enables management to tell whether a company is earning an income and to make informed decisions. In other words, whenever Never Flake sold a rust-prevention coating, there was an associated warranty expense that the company could expect to pay in future years. If warranty expenses had been estimated correctly in the years in which sales were made, Never Flake's management would have realized that it was either charging too little for the rust-prevention service or being too generous in the period covered by the warranty. The failure to properly estimate the warranty expense undoubtedly led to poor management decisions and, eventually, to the company's bankruptcy. Chapter 3, C 2. a. b.

c. d.

Lucent Technologies recognized revenue. However, collectibility was not reasonably assured. Therefore, Lucent Technologies violated the matching rule. America Online (AOL) recognized advertising as an asset. However, advertising services had already been used to produce revenue in that accounting period. Therefore, AOL violated the matching rule. Future benefits are uncertain. Eclipsys recognized revenue, although it had not yet rendered the services. Therefore, Eclipsys violated the matching rule. Xerox violated the guidelines for recognition by overstating revenues. It should record revenues from the leases over the periods during which the leases are earned rather than at the date of signing. Therefore, Xerox violated the matching rule. KnowledgeWare recognized revenue, although the delivery did not occur and there was no obligation to pay. Therefore, KnowledgeWare violated the matching rule.

Chapter 3, C 3. Deferred production costs result from expenditures for scenery, costumes, and stage properties that are specifically related to future productions. These costs are recorded are recorded as assets in the year in which the expenditures are made and should be expensed through an adjusting entry in the year in which the production is shown. Deferred ticket revenue (unearned revenue) relates to ticket sales for the following opera season. This amount is taken into revenue through an adjusting entry in the year in which the production is performed. These accounting policies applying policies apply accrual accounting and the matching rule to the preparation of financial statements. This enables Lyric Opera's management to assess the financial success of each year's operations and to make year-to-year comparisons of operating results.

156 .

Chapter 3, C 4. 1. Film and television costs defined Film and television costs consist of the cost of producing films and television programs less the amount that has been expensed. They are classified as an asset because they are the net amount associated with films and television programs that are expected to produce revenues in future years. 2. T accounts set up to record the amount spent (in millions) Cash

Film and Television Costs

$3,421

3. T accounts set up to record the amount expensed (in millions) Film and Television Expense (amortization)

Film and Television Costs

$3,486

4. Matching rule discussed The matching rule attempts to allocate the costs of films and television programs to the accounting periods in which the revenues associated with the costs are recognized. For example, a common way of determining the amount to expense in a given period is to multiply the cost of films and television programs times the revenues received in the current period divided by the total revenues expected to be received over the life of the films and television programs.

157 .

Chapter 3, C 5. 1.

All current assets except cash can be affected by adjusting entries. Similarly, long-term assets like property and equipment can require adjustments to allocate cost to the life of the assets. Adjusting entries serve to allocate prepaid expenses that have been used in the current period and accrue revenue that has been earned. The note on property and equipment lists the various types of the company's assets and discloses their estimated useful lives. Depreciation and amortization expense appears on the CVS statement of cash flows in the lower portion of the statement where net income is reconciled to cash from operating activities. Because depreciation and amortization are operating expenses, they would also be included in operating expenses on the income statement. CVS states that its financial statements are prepared in accordance with generally accepted accounting principles (GAAP). This means that management has to make estimates and assumptions. For instance, determining the amount of depreciation expense depends on several estimates, such as the estimated lives of the assets.

Chapter 3, C 6. CVS (dollars in millions): Cash Flow Yield =

Cash Flows from Operating Activities Net Income

2009 =

$4,035.0 = $3,696.0

1.1

or 1.1 times

2008 =

$3,947.0 = $3,212.0

1.2

or 1.2 times

Southwest (dollars in millions): Cash Flow Yield =

Cash Flows from Operating Activities Net Income

2009 =

$985 $99

9.9

or 9.9 times

2008 =

-$1,521 = $178

-8.5

or -8.5 times

CVS is steadier even though its cash flow yield decreased in 2009 and was less than that of Southwest in 2009. CVS is steady even though less in 2009.

158 .

Chapter 3, C 7. It is not appropriate to record the cash received for the service contracts as revenues in the current year because policy coverage does not begin until the second year of ownership. This would overstate net income in the first year when cash is received. The expenses associated with these receipts will not be incurred for one year or more from the date of receipt. This would cause the net income to be understated in the two years the policy actually covered—years 2 and 3 of ownership. To give management a clear view of how the business is doing, accrual accounting and the matching rule should be applied. This can be done by recording the cash received as deferred revenue (a liability) until the period in which the service is actually provided, which is after the regular warranty period expires. At that time, an entry would be made to debit the Unearned Service Revenue account and to credit the Service Contract Revenue account for one year's worth or a portion of a year's worth of the service contract. The remaining amount would be adjusted the following year. Students may suggest an alternative method: immediately recording the cash received as revenue, but recording the estimated cost as an expense through an adjusting entry. This method does not work as well because the service is provided in the years in which the service contract applies, not in the year in which the cash is received, and because it is difficult to estimate the amount of the future expense. To apply accrual accounting, the accountant must assume that it is possible to divide the life of the business into time periods (periodicity) and that the business will be a going concern long enough for the transactions and service contracts to be resolved. This question raises the issue of whether it would be unethical not to follow good accounting practice. In answering this question, one must recognize who benefits and who is harmed when good practices are not followed. If management's recommendation is accepted, earnings will be overstated in 2011. Perhaps this overstatement will hurt no one. But the likelihood is that various people with stakes in the company will be hurt. For example, stockholders and creditors, such as banks, may receive an incorrect view of the company's progress and pay too high a price for stock or lend too much money to the company. One must also ask what management's stake is in this issue. Is compensation tied to net income? Could managers possibly lose their jobs if the financial results are not positive? The goal of accounting is to provide useful information based on the substance of business activities. Accounting practice should not be manipulated to achieve personal goals. If people would be hurt or unfairly rewarded because good accounting practice is not followed, it would be unethical to accept management's recommendation.

159 .

Chapter 3, C 8. 1. Adjusting entries prepared a.

Printing Supplies Expense Printing Supplies To record supplies used $17,500 = $22,500 $40,000 – Depreciation Expense—Equipment Accumulated Depreciation—Equipment To record depreciation on equipment Wages Expense Wages Payable To record accrued wages Income Taxes Expense Income Taxes Payable To record estimated income taxes Unearned Subscriptions Revenue Subscriptions Revenue To recognize subscriptions fulfilled $20,250 × 1 / 3 = $6,750

160 .

22,500 22,500

25,000 25,000 11,750 11,750 13,500 13,500 6,750 6,750

Chapter 3, C 8. (Continued) 2. Financial statement amounts recast

Revenues Expenses

Net income Total assets Liabilities Stockholders' equity

Before $432,500 352,500

Adjustments (e) (a) (b) (c) (d)

6,750

22,500 25,000 11,750 13,500

425,250 $ 14,000

$ 80,000 $215,000 $ 60,000 155,000

(e)

6,750

After $439,250

(a)

22,500

(b)

25,000

11,750 13,500

$167,500 $ 78,500 89,000 *

Total liabilities and stockholders' equity

$215,000

$167,500

* Total assets – liabilities ($167,500 – $78,500); also equals stockholders' equity before adjustment less decrease in net income ($155,000 – $66,000). 3. Results discussed The performance of the company is much less favorable than Rak's original figures suggest. As a result of the adjustments, net income is $66,000 ($80,000 – $14,000) less than Rak's initial determination. The lower net income means that stockholders' equity is only $89,000 ($155,000 – $66,000). Instead of earning 18.5 percent on revenues ($80,000 ÷ $432,500) and 37.2 percent on assets ($80,000 ÷ $215,000), the firm earned only 3.2 percent on revenues ($14,000 ÷ $439,250) and 8.4 percent on assets ($14,000 ÷ $167,500). Rak's plan to issue a $62,500 dividend is probably ill-advised because it exceeds earnings by over four times and it would reduce stockholders' equity to $26,500 ($89,000 – $62,500).

161 .

162 .

Supplement to CHAPTER 3 CLOSING ENTRIES AND THE WORK SHEET Answers to Review Questions 1. No, the work sheet cannot be used as a substitute for the financial statements. It is a tool used in preparing financial statements. Work sheets and financial statements serve different purposes. The work sheet is simply an internal working paper for the accountant. Financial statements are formal reports, required by law and by GAAP, for external as well as internal distribution. 2. The Adjusted Trial Balance columns should be totaled before the adjusted amounts are carried to the Income Statement and Balance Sheet columns to prove the balance. The Income Statement and Balance Sheet columns cannot be correct unless the Adjusted Trial Balance columns balance. If the adjusted trial balance columns were not totaled before amounts were carried to the Income Statement and Balance Sheet problems, any error would carry through and the financial statements could be misstated. If the error were discovered at a later time, more numbers would need to be corrected. 3. The amounts should be extended line by line to the proper debit or credit column of the Income Statement or Balance Sheet columns, beginning with the first line. This procedure avoids overlooking an account. 4. Not usually. The difference is the amount of net income or loss for the period. Net income and net loss would equal each other in case the company exactly broke even, with zero profit and zero loss. 5. The totals do not usually agree. Included in the Balance Sheet credit column are accumulated depreciation accounts, for example, which appear on the balance sheet as deductions from the associated asset accounts. Also, dividends are included with the debits in the Balance Sheet columns, whereas they are deducted from the Retained Earnings account balance in the statement of retained earnings before the balance sheet is prepared. 6. The adjusting entries are posted before the closing entries; otherwise, the closing entries would not set temporary, or nominal, accounts to zero balances. Also, adjusting entries should be made first so that the temporary accounts reflect actual revenues and expenses for the period. Furthermore, after all adjusting entries have been made, closing entries can be determined from the adjusted ledger balances. 7. The posting of adjusting entries to the ledger often follows the preparation of the work sheet because the necessary adjustments are determined on the work sheet.

163 .

Chapter 3S, E 1. 2011 Dec. 31 Repair Revenue Income Summary To close the credit balance account 31 Income Summary Wages Expense Rent Expense Supplies Expense Insurance Expense Depreciation Expense—Repair Equipment Income Taxes Expense To close the debit balance accounts 31 Income Summary Retained Earnings To close the Income Summary account 31 Retained Earnings Dividends To close the Dividends account

164 .

25,620 25,620 16,830 8,110 1,200 4,260 915 1,345 1,000 8,790 8,790 5,000 5,000

Chapter 3S, E 2. 1. 2.

Trial balance amounts entered on the work sheet Work sheet completed

Account Name Cash Accounts Receivable Prepaid Insurance Supplies Office Equipment Accumulated Depreciation— Office Equipment Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Utilities Expense Wages Expense Insurance Expense Depreciation Expense— Office Equipment Wages Payable Supplies Expense Income Taxes Expense Income Taxes Payable

Work Sheet For the Month Ended October 31, 2011 Adjusted Trial Balance Adjustments Trial Balance Debit Credit Debit Credit Debit Credit 4 4 7 7 2 (a) 1 1 4 3 1 (e) 8 8 1 4 3 (b) 5 7

(c)

(b)

2 10 43

6 25

(d)

2 11

(a)

(c)

1 (d)

(e) (f)

3 * 1

1 1

3 1 (f)

9 Net Income *$4 – $1 = $3 165 .

2 4 1 5 7

6 23

Balance Sheet Debit Credit 4 7 1 1 8

2 4 1 5 7

Income Statement Debit Credit

1 9

1 3 1

1 46

19 6 25

1 21 6 27

Chapter 3S, P 1. 1. 2.

T accounts opened and balances entered Closing entries entered in T accounts

(d)

June

Dividends 54,000 (d) June —

Bal. Bal. (b) (c)

(a)

Retained Earnings 54,000 Bal. (c) June Bal.

June

30 30

Income Summary 604,550 (a) June 83,150 Bal.

54,000

687,700 —

Revenue from Court Fees 678,100 Bal. Bal.

678,100 —

Revenue from Locker Fees 9,600 Bal. Bal.

9,600 —

Bal. Bal.

Wages Expense 351,000 (b) June —

351,000

Bal. Bal.

Maintenance Expense 51,600 (b) June —

51,600

Bal. Bal.

Advertising Expense 39,750 (b) June —

39,750

Bal. Bal.

Utilities Expense 64,800 (b) June —

64,800

Bal. Bal.

Supplies Expense 6,000 (b) June —

6,000

166 .

271,150 83,150 300,300

Chapter 3S, P 1. (Continued)

Bal. Bal.

Depreciation Expense—Building 30,000 (b) June 30 —

30,000

Bal. Bal.

Depreciation Expense—Equipment 12,000 (b) June 30 —

12,000

Bal. Bal.

Property Taxes Expense 22,500 (b) June 30 —

22,500

Bal. Bal.

Miscellaneous Expense 6,900 (b) June —

6,900

Bal. Bal.

Income Taxes Expense 20,000 (b) June —

20,000

167 .

Chapter 3S, P 1. (Continued) 3.

Income statement, statement of retained earnings, and balance sheet prepared Settles Tennis Club, Inc. Income Statement For the Year Ended June 30, 2011

Revenues Revenue from court fees Revenue from locker fees Total revenues Expenses Wages expense Utilities expense Maintenance expense Advertising expense Depreciation expense—building Property taxes expense Income taxes expense Depreciation expense—equipment Miscellaneous expense Supplies expense Total expenses

$678,100 9,600 $687,700 $351,000 64,800 51,600 39,750 30,000 22,500 20,000 12,000 6,900 6,000 604,550 $ 83,150

Net income Settles Tennis Club, Inc. Statement of Retained Earnings For the Year Ended June 30, 2011 Retained earnings, June 30, 2010 Net income Subtotal Less dividends Retained earnings, June 30, 2011

168 .

$271,150 83,150 $354,300 54,000 $300,300

Chapter 3S, P 1. (Continued) Settles Tennis Club, Inc. Balance Sheet June 30, 2011 Assets Cash Prepaid advertising Supplies Land Building Less accumulated depreciation Equipment Less accumulated depreciation

$ 26,200 9,600 1,200 100,000 $645,200 260,000

385,200

$156,000 50,400

105,600 $627,800

Total assets Liabilities Accounts payable Wages payable Property taxes payable Unearned revenue—locker fees Income taxes payable

$ 73,000 9,000 22,500 3,000 20,000

Total liabilities

$127,500 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$200,000 300,300 500,300

Total liabilities and stockholdlers' equity 4.

$627,800

Reason for closing entries explained

Closing entries are journal entries made at the end of the accounting period to accomplish two purposes: (1) to set the stage for the next accounting period by clearing the temporary accounts (income statement accounts and Dividends) of their balances and transferring them to retained earnings and (2) to summarize revenues and expenses.

169 .

Chapter 3S, P 2. 1. 3. 6.

Entries for May prepared Adjusting entries for May prepared Closing entries for May prepared General Journal

Date Description 2011 May 1 Cash Common Stock To issue stock 1 Store Rent Expense Cash To pay one month's rent 1 Prepaid Insurance Cash To purchase one-year policy 2 Repair Equipment Cash Accounts Payable To purchase repair equipment, oneseventh down 5 Repair Supplies Accounts Payable To purchase repair supplies on credit from AWD Company 8 Advertising Expense Cash To purchase newspaper advertisement 15 Cash Repair Revenue To record receipt of revenue for the first half of the month 21 Accounts Payable Cash To make payment on account to AWD Company

170 .

Page 1 Post. Ref.

Debit

111 311

5,000

511 111

425

117 111

480

144 111 212

4,200

119 212

468

512 111

111 411

400

212 111

225

Credit

5,000

425

480

600 3,600

468

400

225

Chapter 3S, P 2. (Continued) General Journal Date Description 2011 May 31 Cash Repair Revenue To record receipt of revenue for the last half of the month 31 Dividends Cash To declare and pay dividend Adjusting entries: May 31 Insurance Expense Prepaid Insurance To record one month's expired insurance $480 ÷ 12 = $40 31 Repair Supplies Expense Repair Supplies To record supplies used during May $468 – $169 = $299 31 Depreciation Expense—Repair Equipment Accumulated Depreciation—Repair Equipment To record depreciation for one month 31 Income Taxes Expense Income Taxes Payable To record one month's estimated income taxes

171 .

Page 2 Post. Ref.

Debit

111 411

975

313 111

300

513 117

514 119

299

515

975

300

299

145

516 213

Credit

50 50

Chapter 3S, P 2. (Continued) General Journal Date

Page 3 Post. Ref.

Description

Debit

Credit

Closing entries: 2011 May 31 Repair Revenue Income Summary To close the credit balance account 31 Income Summary Store Rent Expense Advertising Expense Insurance Expense Repair Supplies Expense Depreciation Expense—Repair Equipment Income Taxes Expense To close the debit balance accounts 31 Income Summary Retained Earnings To close the Income Summary account 31 Retained Earnings Dividends To close the Dividends account

172 .

411 314

1,375

314 511 512 513 514

944

1,375

425 60 40 299

515 516

70 50

314 312

431

312 313

300

431

300

Chapter 3S, P 2. (Continued) 4.

May adjusted trial balance prepared Javier's Repair Service, Inc. Adjusted Trial Balance May 31, 2011

Cash Prepaid Insurance Repair Supplies Repair Equipment Accumulated Depreciation—Repair Equipment Accounts Payable Income Taxes Payable Common Stock Dividends Repair Revenue Store Rent Expense Advertising Expense Insurance Expense Repair Supplies Expense Depreciation Expense—Repair Equipment Income Taxes Expense

173 .

$ 4,285 440 169 4,200 $

70 3,843 50 5,000

300 1,375 425 60 40 299 70 50 $10,338

$10,338

Chapter 3S, P 2. (Continued) 5.

May income statement, statement of retained earnings, and balance sheet prepared Javier's Repair Service, Inc. Income Statement For the Month Ended May 31, 2011

Revenue Repair revenue Expenses Store rent expense Repair supplies expense Depreciation expense—repair equipment Advertising expense Income taxes expense Insurance expense Total expenses

$1,375 $425 299 70 60 50 40 944

Net income

$ 431

Javier's Repair Service, Inc. Statement of Retained Earnings For the Month Ended May 31, 2011 Retained earnings, May 1, 2011 Net income Subtotal Less dividends

$ — 431

Retained earnings, May 31, 2011

$ 131

174 .

$ 431 300

Chapter 3S, P 2. (Continued) Javier's Repair Service, Inc. Balance Sheet May 31, 2011 Assets Cash Prepaid insurance Repair supplies Repair equipment Less accumulated depreciation

$4,285 440 169 $4,200 70

Total assets

4,130 $9,024

Liabilities Accounts payable Income taxes payable

$3,843 50

Total liabilities

$3,893 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$5,000 131 5,131 $9,024

Total liabilities and stockholders' equity 7. May post-closing trial balance prepared Javier's Repair Service, Inc. Post-Closing Trial Balance May 31, 2011 Cash Prepaid Insurance Repair Supplies Repair Equipment Accumulated Depreciation—Repair Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings

$4,285 440 169 4,200 $

$9,094

175 .

70 3,843 50 5,000 131 $9,094

Chapter 3S, P 2. (Continued) 8. Journal entries for June prepared 9. Adjusting entries for June prepared 12. Closing entries for June prepared General Journal Date 2011 June

Post. Ref.

Description

1 Store Rent Expense Cash To pay one month's rent 1 Accounts Payable Cash To make monthly payment to Motley Company 6 Repair Supplies Accounts Payable To purchase repair supplies on credit from AWD Company 15 Cash Repair Revenue To record receipt of revenue for the first half of the month 20 Advertising Expense Cash To purchase additional advertisement 23 Accounts Payable Cash To make payment on account to AWD Company 30 Cash Repair Revenue To record receipt of revenue for the last half of the month 30 Dividends Cash To declare and pay dividend

176 .

Page 4 Debit

511 111

425

212 111

300

119 212

863

111 411

914

512 111

212 111

600

111 411

817

313 111

300

Credit

425

300

863

914

600

817

300

Chapter 3S, P 2. (Continued) General Journal Date

Post. Ref.

Description Adjusting entries:

2011 June 30 Insurance Expense Prepaid Insurance To record one month's expired insurance 30 Repair Supplies Expense Repair Supplies To record supplies used during June $1,032 – $413 = $619 30 Depreciation Expense—Repair Equipment Accumulated Depreciation—Repair Equipment To record depreciation for one month 30 Income Taxes Expense Income Taxes Payable To record one month's estimated income taxes Closing entries: 30 Repair Revenue Income Summary To close the credit balance account 30 Income Summary Store Rent Expense Advertising Expense Insurance Expense Repair Supplies Expense Depreciation Expense—Repair Equipment Income Taxes Expense To close the debit balance accounts

177 .

Page 5 Debit

513 117

514 119

619

515

619

145

516 213

411 314

1,731

314 511 512 513 514

1,264

515 516

Credit

1,731

425 60 40 619 70 50

Chapter 3S, P 2. (Continued) General Journal Date Description 2011 June 30 Income Summary Retained Earnings To close the Income Summary account 30 Retained Earnings Dividends To close the Dividends account

178 .

Page 6 Post. Ref.

Debit

314 312

467

312 313

300

Credit

467

300

Chapter 3S, P 2. (Continued) Cash Date 2011 May

June

Item 1 1 1 2 8 15 21 31 31 1 1 15 20 23 30 30

Post. Ref. J1 J1 J1 J1 J1 J1 J1 J2 J2 J4 J4 J4 J4 J4 J4 J4

Debit

Credit

5,000 425 480 600 60 400 225 975 300 425 300 914 60 600 817 300

Prepaid Insurance Date 2011 May June

Item 1 31 30

Adjustment Adjustment

Post. Ref. J1 J2 J5

179 .

Debit

Credit

480 40 40

Account No. 111 Balance Debit Credit 5,000 4,575 4,095 3,495 3,435 3,835 3,610 4,585 4,285 3,860 3,560 4,474 4,414 3,814 4,631 4,331 Account No. 117 Balance Debit Credit 480 440 400

Chapter 3S, P 2. (Continued) Repair Supplies Date 2011 May

Item

5 31 6 30

June

Adjustment Adjustment

Post. Ref.

Debit

J1 J2 J4 J5

Credit

468 299 863 619

Repair Equipment Date 2011 May

Item 2

2011 May June

31 30

Item Adjustment Adjustment

2011 May

2 5 21 1 6 23

June

Item

4,200

Debit

Credit

Account No. 145 Balance Debit Credit

70 70

70 140

Credit

Account No. 212 Balance Debit Credit

Post. Ref. J2 J5

Post. Ref.

Debit

J1 J1 J1 J4 J4 J4

Credit

3,600 468 225 300 863 600

180 .

Account No. 144 Balance Debit Credit

Debit

Accounts Payable Date

468 169 1,032 413

Post. Ref.

Accumulated Depreciation—Repair Equipment Date

Account No. 119 Balance Debit Credit

3,600 4,068 3,843 3,543 4,406 3,806

Chapter 3S, P 2. (Continued) Income Taxes Payable Date 2011 May June

Item

31 30

Adjustment Adjustment

Post. Ref.

Debit

J2 J5

Credit

Account No. 213 Balance Debit Credit

50 50

50 100

Credit

Account No. 311 Balance Debit Credit

5,000

Credit

Account No. 312 Balance Debit Credit

Common Stock Date 2011 May

Item 1

Post. Ref.

Debit

Retained Earnings Date 2011 May June

31 31 30 30

Item

Post. Ref.

Closing entry Closing entry Closing entry Closing entry

J3 J3 J6 J6

Debit

431

300

431 131 598 298

Debit

Account No. 313 Balance Debit Credit

300 467

Dividends Date 2011 May June

31 31 30 30

Item

Closing entry Closing entry

Post. Ref. J2 J3 J4 J6

181 .

Credit

300 300 300 300

300 — 300 —

Chapter 3S, P 2. (Continued) Income Summary Item

Post. Ref.

Closing entry Closing entry Closing entry Closing entry Closing entry Closing entry

J3 J3 J3 J5 J5 J6

Date 2011 May

31 31 31 30 30 30

June

Debit

Credit 1,375

1,264 467

1,375 431 — 1,731 467 —

Debit

Account No. 411 Balance Debit Credit

944 431 1,731

Repair Revenue Date 2011 May

15 31 31 15 30 30

June

Item

Closing entry

Post. Ref. J1 J2 J3 J4 J4 J5

Credit 400 975

1,731

400 1,375 — 914 1,731 —

Debit

Account No. 511 Balance Debit Credit

1,375 914 817

Store Rent Expense Date 2011 May

1 31 1 30

June

Item

Closing entry Closing entry

Post. Ref. J1 J3 J4 J5

Credit

425 425 425 425

182 .

Account No. 314 Balance Debit Credit

425 — 425 —

Chapter 3S, P 2. (Continued) Advertising Expense Date 2011 May June

8 31 20 30

Item

Closing entry Closing entry

Post. Ref. J1 J3 J4 J5

Debit

Credit

60 60

Date 2011 May June

31 31 30 30

Item Adjustment Closing entry Adjustment Closing entry

J2 J3 J5 J5

60 60

Debit

Credit

Date 2011 May June

31 31 30 30

Item Adjustment Closing entry Adjustment Closing entry

J2 J3 J5 J5

Date 2011 May June

31 31 30 30

Item Adjustment Closing entry Adjustment Closing entry

J2 J3 J5 J5

183 .

Account No. 513 Balance Debit Credit 40

—

40 40

Debit

Credit

299 299 619 619

Depreciation Expense—Repair Equipment Post. Ref.

—

Repair Supplies Expense Post. Ref.

—

Insurance Expense Post. Ref.

Account No. 512 Balance Debit Credit

Debit

Credit

— Account No. 514 Balance Debit Credit 299 — 619 — Account No. 515 Balance Debit Credit

70 70

—

70 70

—

Chapter 3S, P 2. (Continued) Income Taxes Expense Date 2011 May

31 31 30 30

June

Item

Post. Ref.

Adjustment Closing entry Adjustment Closing entry

J2 J3 J5 J5

Debit 50

50 50

—

50 50

184 .

Credit

Account No. 516 Balance Debit Credit

—

Chapter 3S, P 2. (Continued) 10.

June adjusted trial balance prepared Javier's Repair Service, Inc. Adjusted Trial Balance June 30, 2011

Cash Prepaid Insurance Repair Supplies Repair Equipment Accumulated Depreciation—Repair Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings Dividends Repair Revenue Store Rent Expense Advertising Expense Insurance Expense Repair Supplies Expense Depreciation Expense—Repair Equipment Income Taxes Expense

$ 4,331 400 413 4,200 $

300 1,731 425 60 40 619 70 50 $10,908

185 .

140 3,806 100 5,000 131

$10,908

Chapter 3S, P 2. (Continued) 11. June income statement, statement of retained earnings, and balance sheet prepared Javier's Repair Service, Inc. Income Statement For the Month Ended June 30, 2011 Revenue Repair revenue Expenses Repair supplies expense Store rent expense Depreciation expense—repair equipment Advertising expense Income taxes expense Insurance expense Total expenses

$1,731 $619 425 70 60 50 40 1,264

Net income

$ 467

Javier's Repair Service, Inc. Statement of Retained Earnings For the Month Ended June 30, 2011 Retained earnings, May 31, 2011 Net income Subtotal Less dividends

$ 131 467

Retained earnings, June 30, 2011

$ 298

186 .

$ 598 300

Chapter 3S, P 2. (Continued) Javier's Repair Service, Inc. Balance Sheet June 30, 2011 Assets Cash Prepaid insurance Repair supplies Repair equipment Less accumulated depreciation

$4,331 400 413 $4,200 140

4,060 $9,204

Total assets Liabilities Accounts payable Income taxes payable

$3,806 100

Total liabilities

$3,906 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$5,000 298 5,298 $9,204

Total liabilities and stockholders' equity 13.

June post-closing trial balance prepared Javier's Repair Service, Inc. Post-Closing Trial Balance June 30, 2011

Cash Prepaid Insurance Repair Supplies Repair Equipment Accumulated Depreciation—Repair Equipment Accounts Payable Income Taxes Payable Common Stock Retained Earnings

$4,331 400 413 4,200

$9,344

187 .

$ 140 3,806 100 5,000 298 $9,344

Chapter 3S, P 3. 1. Work sheet completed Beauchamp Theater Corporation Work Sheet For the Year Ended June 30, 2011

Account Name Cash Accounts Receivable Prepaid Insurance Office Supplies Cleaning Supplies Land Building Accumulated Depreciation—Building Theater Furnishings Accumulated Depreciation—Theater Furnishings Office Equipment Accumulated Depreciation—Office Equipment Accounts Payable Gift Books Liability Mortgage Payable Common Stock Retained Earnings Dividends Ticket Sales Revenue Theater Rental Revenue Usher Wages Expense Office Wages Expense Utilities Expense Interest Expense Insurance Expense Office Supplies Expense Cleaning Supplies Expense Depreciation Expense—Building Depreciation Expense—Theater Furnishings Depreciation Expense—Office Equipment Wages Payable Income Taxes Expense Income Taxes Payable

Trial Balance Adjustments Debit Credit Debit Credit 31,800 18,544 19,600 (a) 17,400 780 536 (b) 3,590 (c) 3,122 20,000 400,000 39,400 (d) 14,000 370,000 65,000 (e) 36,000 31,600 15,560 (f) 3,160 45,506 41,900 (g) 37,800 300,000 200,000 112,648 60,000 411,400 (g) 37,800 45,200 157,000 (h) 860 24,000 112,700 27,000 1,276,614 1,276,614 (a) 17,400 (b) 536 (c) 3,122 (d) 14,000 (e) 36,000 (f) 3,160 (h) 860 (i) 20,000 (i) 20,000 132,878 132,878

Net Income

188 .

Adjusted Trial Balance Debit Credit 31,800 18,544 2,200 244 468 20,000 400,000 53,400 370,000 101,000 31,600 18,720 45,506 4,100 300,000 200,000 112,648 60,000 449,200 45,200 157,860 24,000 112,700 27,000 17,400 536 3,122 14,000 36,000 3,160

Income Statement Debit Credit

Balance Sheet Debit Credit 31,800 18,544 2,200 244 468 20,000 400,000 53,400 370,000 101,000 31,600 18,720 45,506 4,100 300,000 200,000 112,648 60,000

449,200 45,200 157,860 24,000 112,700 27,000 17,400 536 3,122 14,000 36,000 3,160

860 20,000 1,350,634

860 20,000

20,000 1,350,634

415,778 78,622 494,400

494,400

934,856

494,400

934,856

20,000 856,234 78,622 934,856

Chapter 3S, P 3. (Continued) 2.

Income statement, statement of retained earnings, and balance sheet prepared Beauchamp Theater Corporation Income Statement For the Year Ended June 30, 2011

Revenues Ticket sales revenue Theater rental revenue Total revenues Expenses Usher wages expense Utilities expense Depreciation expense—theater furnishings Interest expense Office wages expense Income taxes expense Insurance expense Depreciation expense—building Depreciation expense—office equipment Cleaning supplies expense Office supplies expense Total expenses Net income Beauchamp Theater Corporation Statement of Retained Earnings For the Year Ended June 30, 2011 Retained earnings, June 30, 2010 Net income Subtotal Less dividends Retained earnings, June 30, 2011

189 .

$449,200 45,200 $494,400 $157,860 112,700 36,000 27,000 24,000 20,000 17,400 14,000 3,160 3,122 536 415,778 $ 78,622

$112,648 78,622 $191,270 60,000 $131,270

Chapter 3S, P 3. (Continued) Beauchamp Theater Corporation Balance Sheet June 30, 2011 Assets Cash Accounts receivable Prepaid insurance Office supplies Cleaning supplies Land Building Less accumulated depreciation Theater furnishings Less accumulated depreciation Office equipment Less accumulated depreciation

$ 31,800 18,544 2,200 244 468 20,000 $400,000 53,400

346,600

$370,000 101,000

269,000

$ 31,600 18,720

Total assets

12,880 $701,736

Liabilities Accounts payable Gift books liability Wages payable Income taxes payable Mortgage payable Total liabilities

$ 45,506 4,100 860 20,000 300,000 $370,466 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$200,000 131,270 331,270 $701,736

Total liabilities and stockholders' equity

190 .

Chapter 3S, P 3. (Continued) 3.

Adjusting and closing entries prepared General Journal Description

Date

Debit

Credit

Adjusting entries: 2011 June

30 Insurance Expense Prepaid Insurance To record expired insurance 30 Office Supplies Expense Office Supplies To record office supplies used $780 – $244 = $536 30 Cleaning Supplies Expense Cleaning Supplies To record cleaning supplies used $3,590 – $468 = $3,122 30 Depreciation Expense—Building Accumulated Depreciation—Building To record depreciation on building for the year 30 Depreciation Expense—Theater Furnishings Accumulated Depreciation—Theater Furnishings To record depreciation on theater furnishings for the year 30 Depreciation Expense—Office Equipment Accumulated Depreciation—Office Equipment To record depreciation on office equipment for the year 30 Gift Books Liability Ticket Sales Revenue To record gift books redeemed 30 Usher Wages Expense Wages Payable To record accrued wages at the end of the period

191 .

17,400 17,400 536 536

3,122 3,122

14,000 14,000

36,000 36,000

3,160 3,160

37,800 37,800 860 860

Chapter 3S, P 3. (Continued) General Journal Description

Date 2011 June 30 Income Taxes Expense Income Taxes Payable To record estimated income taxes Closing entries: June 30 Ticket Sales Revenue Theater Rental Revenue Income Summary To close the credit balance accounts 30 Income Summary Usher Wages Expense Office Wages Expense Utilities Expense Interest Expense Insurance Expense Office Supplies Expense Cleaning Supplies Expense Depreciation Expense—Building Depreciation Expense—Theater Furnishings Depreciation Expense—Office Equipment Income Taxes Expense To close the debit balance accounts 30 Income Summary Retained Earnings To close the Income Summary account 30 Retained Earnings Dividends To close the Dividends account

192 .

Debit

Credit

20,000 20,000

449,200 45,200 494,400 415,778 157,860 24,000 112,700 27,000 17,400 536 3,122 14,000 36,000 3,160 20,000 78,622 78,622 60,000 60,000

CHAPTER 4—Solutions FINANCIAL REPORTING AND ANALYSIS

Chapter 4, SE 1. 1. 2. 3. 4. 5.

O Q O Q O

Chapter 4, SE 2. 1. 2. 3. 4. 5.

Full disclosure Materiality Cost-benefit Conservatism Consistency

Chapter 4, SE 3. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Property, plant, and equipment Current liability Current liability Not on the balance sheet Stockholders' equity Current asset Intangible asset Current asset Current liability Investment

193 .

Chapter 4, SE 4. Balance Sheet May 31, 2011 Assets Current assets Cash Accounts receivable Merchandise inventory Total current assets Investments Property, plant, and equipment Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Franchise

$ 200 1,100 600 $1,900 500 $3,000 700 2,300 200 $4,900

Total assets Liabilities Current liabilities Accounts payable Wages payable Total current liabilities Long-term liabilities Notes payable

$ 800 100 $ 900 400

Total liabilities

$1,300 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$1,000 2,600* 3,600 $4,900

Total liabilities and stockholders' equity *Balancing amount ( $4,900

–

$1,300

–

$1,000 )

194 .

Chapter 4, SE 5. Balance Sheet July 31, 2011 Assets Current assets Cash Accounts receivable Merchandise inventory Total current assets Investments Property, plant, and equipment Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Franchise

$ 300 1,650 900 $2,850 750 $4,500 1,050 3,450 300 $7,350

Total assets Liabilities Current liabilities Accounts payable Wages payable Total current liabilities Long-term liabilities Notes payable

$1,200 150 $1,350 600

Total liabilities

$1,950 Stockholders' Equity

Common stock Retained earnings Total stockholders' equity

$1,500 3,900 * 5,400 $7,350

Total liabilities and stockholders' equity *Balancing amount ( $7,350

–

$1,950

195 .

–

$1,500 )

Chapter 4, SE 6. 1. 2. 3. 4. 5. 6. 7.

Operating expenses Other revenues and expenses Not on the income statement Net sales Operating expenses Other revenues and expenses Not on the income statement

Chapter 4, SE 7. Income Statement For the Year Ended May 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses General expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$2,400 90 $2,490 $840 555 450 210 2,055 $ 435 105 $ 330

Net income

196 .

Chapter 4, SE 8. Income Statement For the Year Ended May 31, 2011 Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$1,560 $555 450 1,005 $ 555 $ 90 210 120 $ 435 105 $ 330

Net income

197 .

$2,400 840

Chapter 4, SE 9. Income Statement For the Year Ended July 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses General expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$3,600 135 $3,735 $1,260 833 675 315 3,083 $ 652 158 $ 494

Net income

198 .

Chapter 4, SE 10. Income Statement For the Year Ended July 31, 2011 Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$2,340 $833 675 1,508 $ 832 $135 315 180 $ 652 158 $ 494

Net income

199 .

$3,600 1,260

Chapter 4, SE 11. Financial ratios computed 1.

Profit Margin = * $260,000

–

Cash Flow Yield =

Debt to = Equity Ratio

5. Return on Assets =

Cash Return on Assets =

Return on Equity =

* ( $180,000

–

$80,000

Net Sales Average Total Assets

$200,000 ) ÷ 2

Net Sales

$140,000

Asset Turnover = * ( $240,000

Net Income

Net Income Total Liabilities Total Stockholders' Equity Net Income Average Total Assets Cash Flows from Operating Activities Average Total Assets Net Income Average Total Stockholders' Equity =

= 11.5%

–

$10,000

$260,000 = 1.2 times $220,000*

$30,000 $30,000 $60,000 $180,000

$30,000 $220,000

$30,000 $220,000 $30,000 $160,000 *

$160,000

200 .

$260,000

$30,000

$220,000

Cash Flows from Operating Activities

$140,000 ) ÷ 2

$30,000*

= 1.0

= 33.3%

= 13.6%

= 18.8%

Chapter 4, SE 12. Profit Margin 8.0%

Asset Turnover 2.1 times

× ×

= Return on Assets = 16.8%

If the debt to equity ratio equals 50 percent, then stockholders' equity is two-thirds of total assets. Show why this is true, using numbers. Return on Assets 16.8%

÷ ÷

2 2

× ×

3 3

201 .

= =

Return on Equity 25.2%

Chapter 4, E 1. 1. The balance sheet provides information about a company's resources (assets) and claims to those resources (liabilities and stockholders' equity). The income statement, statement of cash flows, and statement of retained earnings provide information about changes in resources and claims to them. 2. To record depreciation expense, it is necessary to estimate the useful life of the asset. To record the amount of unearned revenue that is now earned or the amount of accrued revenue on a project, it is necessary to estimate the amount of revenue earned. 3. Consistency in accounting applies only to the use of the accounting principles for presenting the financial information. It does not apply to the conditions that are represented in the financial statements. For example, changes in business operations or the economy may make financial information incomparable from year to year, even though the same accounting policies have been followed. 4. Illegal acts, such as stealing $1,000, are important to management even though for a multimillion-dollar business, it might not be important to the auditors. It would not be material to the overall fairness of the financial statements.

202 .

Chapter 4, E 2. 1.

They are classified as investments because doing so helps users of financial statements assess the performance of the company using such measures as return on assets. Also, the investment category gives users some idea of resources the company may be able to draw on without disturbing the current business operations. Neither measure is better than the other because both measure different aspects of profitability. Income from operations measures the income from a company's ongoing operations before considering issues of financing (interest expense), nonoperating revenues, and income taxes. Net income measures whether a business has been operating successfully. When calculating ratios to measure performance, analysts need benchmarks to measure whether the performance was good or bad. Past performance of the company is one measure, but a better measure is the financial performance of similar companies. This is done by examining industry averages. The statement is false because neither measure is better than the other. However, the return on assets ratio is a more comprehensive measure of profitability because it reflects both profit margin and asset turnover.

203 .

Chapter 4, E 3. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

g f h g f d g f b g g

12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

c b d a f e d a f f c

Chapter 4, E 4. 1. 2. 3. 4. 5.

Cost-benefit Comparability and consistency Full disclosure Materiality Conservatism

Chapter 4, E 5. 1. 2. 3. 4. 5. 6. 7. 8.

d a a e f c b a

9. 10. 11. 12. 13. 14. 15. 16.

a h a h e a c g

204 .

Chapter 4, E 6. Mamba, Inc. Balance Sheet December 31, 2011 Assets Current assets Cash Short-term investments Accounts receivable Inventory Prepaid rent Total current assets Investments Investment in corporate securities Property, plant, and equipment Land Building Less accumulated depreciation Equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Copyright

$12,480 6,560 15,200 16,000 480 $ 50,720 8,000 $ 3,200 $28,000 5,600

22,400

$60,800 6,800

54,000 79,600 2,480 $140,800

Total assets

(continued)

205 .

Chapter 4, E 6. (Continued) Liabilities Current liabilities Accounts payable Revenue received in advance Total current liabilities Long-term liabilities Bonds payable

$20,400 1,120 $ 21,520 24,000

Total liabilities

$ 45,520 Stockholders' Equity

Contributed capital Common stock, $10 par, 4,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity

$40,000 20,000 $60,000 35,280 95,280 $140,800

Total liabilities and stockholders' equity Chapter 4, E 7. 1. 2. 3. 4. 5. 6. 7.

a b e c d c f

8. fc and/or d 9. c 10. c and/or d 11. c 12. f 13. e

206 .

Chapter 4, E 8. 1.

Single-step income statement prepared

Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses General and administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$408,000 $220,000 90,000 60,000 4,000 374,000

Net income

$ 34,000 7,500 $ 26,500

Earnings per share

1.06

Multistep income statement prepared

Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$405,000 220,000 $185,000 $90,000 60,000 150,000 $ 35,000 $ 3,000 4,000 1,000 $ 34,000 7,500

Net income

$ 26,500

Earnings per share

207 .

$405,000 3,000

1.06

Chapter 4, E 9. Pasica, Inc. Income Statement For the Year Ended December 31, 2011 Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

$1,197,132 777,080 $ 420,052 $203,740 100,688 304,428 $ 115,624 $

5,720 13,560 7,840 $ 107,784 24,000

Net income

83,784

Earnings per share

8.38

The multistep income statement lists the gross margin from sales and separates income from operations from other revenues and expenses. In this way, it is possible to evaluate separately the company's ability to sell its products at a satisfactory price and its ability to operate efficiently. Also, its current operations are evaluated separately from financing activities.

208 .

Chapter 4, E 10. Financial ratios computed 1.

= * $195,500 2.

–

Net Sales $23,500 *

* $106,500

–

$47,000

$8,500

(

$106,500

$195,500 $87,750 * ) ÷ 2 +

$195,500

$97,125 =

2.0 times

$87,750 Net Income

Average Total Assets $23,500 $97,125

= 24.2%

209 .

–

Average Total Assets

$18,750

Return on = Assets

–

Net Sales

Asset Turnover =

= 12.0%

$195,500

$116,500

Net Income

Profit Margin =

$23,500

Chapter 4, E 10. (Continued) 4.

Cash Flow Yield =

Cash Flows from Operating Activities Net Income $35,000

= 1.5

$23,500

Cash Flows from Operating Activities Cash Return = on Assets Average Total Assets

$35,000

= 36.0%

$97,125 6.

Total Liabilities

Debt to Equity Ratio

Total Stockholders' Equity $43,000

= 7.

Net Income

Return on = Equity =

= $63,500

–

= 67.7%

$63,500 *

Average Stockholders' Equity $23,500 $63,500

(

$23,500 $56,750

$23,500

$50,000

+ = 41.4% $10,000

210 .

) ÷ 2

$50,000

Chapter 4, E 11. Profitability measures computed 1.

Profit Margin =

Asset Turnover =

Net Income Net Sales

$830,000

= 7.2%

Net Sales Average Total Assets $830,000 (

$460,000

$830,000 $410,000

$360,000

)

Net Income $60,000 Return = = on Assets Average Total Assets $410,000

Cash Flow Yield =

Cash Flows from Operating Activities Net Income

Cash Return on Assets =

Debt to = Equity Ratio

Return = on Equity

= 2.0 times

Cash Flows from Operating Activities Average Total Assets Total Liabilities Total Stockholders' Equity

$72,000 $60,000

$72,000 $410,000 $110,000 $350,000

= 14.6%

= 1.2

= 17.6%

= 31.4%

Net Income Average Stockholders' Equity $60,000 (

$350,000 $60,000

$315,000

= 19.0%

211 .

$60,000

$280,000

)

Chapter 4, P 1. User Insight: Accounting convention explained 1.

The change in depreciation methods is a violation of the comparability and consistency convention. However, management can change its accounting methods if it complies with the convention of full disclosure by reporting the change in the notes to its financial statements. This is an acceptable application of the cost-benefit convention if management has determined that the benefits of the new classification system outweigh the costs. This is an unacceptable application of the materiality convention because illegal actions by a company's personnel—whatever the amount involved—are inherently important to the users of financial statements. Full disclosure would require that this kind of illegal activity be disclosed. This is an unacceptable application of the conservatism convention because conservatism can be used only when two equally acceptable accounting methods are available. Expensing an item of property, plant, and equipment—and that's what the addition is—is not an acceptable method. Uncertainties are always present. The going concern assumption requires that the addition be recorded as property, plant, and equipment and be depreciated over a number of years. The failure to disclose the inventory method is a violation of the full disclosure convention. To interpret the statements, users of financial statements must know which method is used, even though the method used has not changed in a number of years.

212 .

Chapter 4, P 2. 1. Multistep income statements prepared Doug's Hardware Corporation Income Statements For the Years Ended July 31, 2011 and 2010 2011 % Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

2010

$464,200 243,880 $220,320

100.0% $388,466 52.5% 198,788 47.5% $189,678

100.0% 51.2% 48.8%

$ 95,160 90,840 $186,000 $ 34,320

20.5% $ 55,644 19.6% 49,286 40.1% $104,930 7.4% $ 84,748

14.3% 12.7% 27.0% 21.8%

1,420 5,600

0.3% $ 1.2%

750 1,100

0.2% 0.3%

4,180

0.9% $

350

0.1%

6.5% $ 84,398 1.7% 21,250 4.8% $ 63,148

21.7% 5.5% 16.3%*

Net income

$ 30,140 8,000 $ 22,140

Earnings per share

2.21

6.31

*Rounded. 2. User Insight: Income from operations discussed Income from operations decreased from 2010 to 2011 in absolute amount by $50,428 ($84,748 – $34,320) and decreased in percentage from 21.8 percent to 7.4 percent of net sales despite an increase in net sales. There were two reasons for the decrease in income from operations. First, although gross margin increased in absolute amount by $30,642 ($220,320 – $189,678), it decreased in percentage from 48.8 percent of net sales to 47.5 percent. Second and more important, operating expenses increased as a percentage of net sales from 27.0 percent to 40.1 percent. Increases in both selling expenses and general and administrative expenses contributed to this large increase. Management must examine its selling expenses and the company's overhead (general and administrative expenses) to improve its profitability.

213 .

Chapter 4, P 2. (Continued) 3.

User Insight: Income before income taxes discussed

Income before income taxes also decreased from 2010 to 2011. The primary reason for this decline was the decrease in operating income. However, the decrease in income before income taxes ($54,258) is greater than the decrease in operating income ($50,428) primarily because of the 409 percent increase in interest expense from 2010 to 2011. This means that management took on additional debt to finance the business operations.

214 .

Chapter 4, P 3. Bissel Hardware Corporation Balance Sheet June 30, 2011 Assets Current assets Cash Short-term investments Notes receivable Accounts receivable Merchandise inventory Prepaid rent Prepaid insurance Sales supplies Office supplies Deposit for future advertising Total current assets Investments Building, not in use Property, plant, and equipment Land Delivery equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Trademark

$ 64,000 66,000 20,000 552,000 290,000 3,200 9,600 2,560 880 7,360 $1,015,600 99,200 $ 46,800 $82,400 56,800

25,600 72,400 8,000 $1,195,200

Total assets

(continued)

215 .

Chapter 4, P 3. (Continued) Liabilities Current liabilities Accounts payable Salaries payable Interest payable Total current liabilities Long-term liabilities Notes payable

$229,200 10,400 3,680 $ 243,280 160,000

Total liabilities

$ 403,280 Stockholders' Equity

Contributed capital Common stock, $1.10 par value, 40,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

216 .

$ 44,000 320,000 $364,000 427,920 791,920 $1,195,200

Chapter 4, P 3. (Continued) 2.

User Insight: Ratio discussed

A user of the classified balance sheet would want to know the debt to equity ratio because it shows the proportion of the company financed by creditors in comparison with that financed by stockholders. This measure is very important to liquidity analysis because it is related to debt and its repayment. It is also relevant to profitability analysis because the amount of debt affects the amount of interest expense and the stockholders' return on investments.

217 .

Chapter 4, P 4. 1. Profitability measures computed Profit Margin =

$51,000

(

Return on Assets =

2010:

Average Total Assets

$580,000

$435,000

$1,150,000

÷ 2

)

÷ 2

= 2.3 times

$507,500

$435,000 $870,000 $387,500

$340,000

= 2.2 times

Net Income Average Total Assets $75,000 $507,500 $51,000 $387,500

= 14.8%

= 13.2%

218 .

)

$870,000

2011:

Net Sales

$1,150,000

= 5.9%

$870,000

Asset Turnover =

2010:

= 6.5%

$1,150,000

2010:

2011:

Net Sales $75,000

2011:

Net Income

Chapter 4, P 4. (Continued) d.

Cash Flow Yield =

2011:

2010:

$82,500 $75,000 $67,500 $51,000

Cash Return on Assets =

2011:

2010:

= 1.3

Average Total Assets

$507,500 $67,500 $387,500

= 16.3%

= 17.4%

Total Liabilities Total Stockholders' Equity

$245,000 $335,000 $175,000 $260,000

219 .

= 1.1

Cash Flow from Operating Activities

$82,500

Debt to Equity Ratio =

2011:

Cash Flows from Operating Activities Net Income

= 73.1%

= 67.3%

Chapter 4, P 4. (Continued) g.

Return on Equity =

2011:

Average Stockholders' Equity $75,000

( =

2010:

Net Income

$335,000 $75,000 $297,500

$260,000

)

÷ 2

)

÷ 2

= 25.2% $51,000

( =

$260,000 $51,000 $235,000

$210,000

= 21.7%

2. User Insight There was an increase in both profit margin and asset turnover from 2010 to 2011, which resulted in an increase in return on assets. Note that return on assets is more than twice as large as profit margin because of the asset turnover being greater than 2.0 times. The debt to equity ratio in both years exceeds 50 percent and leads to a strong return on equity. Note that all factors combine to produce a very satisfactory return on equity.

220 .

Chapter 4, P 5. 1a. Single-step income statement prepared Surosa Corporation Income Statement For the Year Ended December 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses Administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$357,195 1,400 $358,595 $175,210 110,100 40,400 11,320 337,030 $ 21,565 3,500

Net income

$ 18,065

Earnings per share

1.81

1b. Statement of retained earnings prepared Surosa Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends Retained earnings, December 31, 2011

221 .

$141,585 18,065 $159,650 30,000 $129,650

Chapter 4, P 5. (Continued) 1c. Classified balance sheet prepared Surosa Corporation Balance Sheet December 31, 2011 Assets Current assets Cash Investment in U.S. government securities Accounts receivable Inventory Prepaid expenses Total current assets Investments Investment in securities Property, plant, and equipment Store fixtures Less accumulated depreciation Delivery equipment Less accumulated depreciation Total property, plant, and equipment

$14,200 19,800 52,400 68,270 2,880 $157,550 28,000 $70,810 21,110

$49,700

$44,250 8,550

35,700 85,400 $270,950

Total assets

(continued)

222 .

Chapter 4, P 5. (Continued) Liabilities Current liabilities Notes payable Accounts payable Total current liabilities Long-term liabilities Notes payable Total liabilities

$ 25,000 16,300 $ 41,300 50,000 $ 91,300 Stockholders' Equity

Contributed capital Common stock, $0.50 par value, 10,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

223 .

5,000 45,000

$ 50,000 129,650 179,650 $270,950

Chapter 4, P 5. (Continued) 2.

Profitability measures computed (a) Profit Margin =

Net Income Net Sales

$357,195

Average Total Assets $357,195 (

$270,950 $357,195 $266,575

$262,200 ) ÷ 2

= 1.3 times

Cash Flows from Operating Activities Net Income $20,000 $18,065

= 1.1

Total Liabilities Total Stockholders' Equity Net Income Average Total Assets $18,065 $266,575

= 6.8%

224 .

= 5.1%

Net Sales

(b) Asset Turnover =

$18,065

$91,300 $179,650

= 50.8%

Chapter 4, P 5. (Continued) Cash Flows from Operating Activities Average Total Assets

(f) Cash Return = on Assets =

$20,000 $266,575

Net Income

(g) Return on Equity =

= 7.5%

Average Stockholders' Equity $18,065 (

$179,650 $18,065

$185,618

= 9.7%

225 .

$191,585

) ÷ 2

Chapter 4, P 5. (Continued) User Insight: Financial ratios discussed 3.

The corporation's profit margin of 5.1 percent exceeds the industry average of 2.3 percent, but its asset turnover ratio of 1.3 is much lower than the industry average of 2.0. Thus, its return on assets of 6.8 percent is higher than the industry average of 4.6 percent. Further, it has a debt to equity ratio of only 50.8 percent compared with the industry average of 108.9 percent. Thus, its return on equity is only 9.7 percent compared with an industry average of 9.4 percent. Since the industry average is 9.4 percent for ROE and Surosa's exceeds that even with relatively more equity.

226 .

Chapter 4, P 6. User Insight: Accounting convention explained 1.

Valuing inventory at lower of cost or market is a generally accepted application of the conservatism convention. This method of valuing inventory is less likely to overstate assets and income than the cost method, especially if inventory costs are decreasing or inventory faces obsolescence. Charging items of small unit value as an expense rather than incurring the cost of capitalizing and depreciating them is an acceptable application of the materiality convention. The fact that several chairs are purchased during the year does not affect the decision unless such a substantial quantity is purchased that a distortion of the financial position results. Not disclosing the fire loss in a note to the 2009 financial statements is a violation of the full disclosure convention. Although the fire loss did not affect 2009 operations, it will have a significant or material effect on 2010, which means that knowledge of it is important to users of the financial statements. This is an acceptable application of the cost-benefit convention if management has determined that the benefits of the new reporting system outweigh the costs. The change in inventory methods is a violation of the consistency convention. If a company changes its method of accounting for inventory, it must disclose the change, the effect of the change on net income, and why the newly adopted accounting principle is preferable in the notes to its financial statements so that the reader will be aware of the inconsistency.

227 .

Chapter 4, P 7. 1. Multistep income statements prepared Oak Nursery Corporation Income Statements For the Years Ended April 30, 2010 and 2009 2010 % Net sales Cost of goods sold Gross margin Operating expenses Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses Interest income Less interest expense Excess of other expenses over other revenues Income before income taxes Income taxes

2009

$525,932 234,948 $290,984

100.0% $475,264 44.7% 171,850 55.3% $303,414

100.0% 36.2% 63.8%

$161,692 62,866 $224,558 $ 66,426

30.7% $150,700 12.0% 42,086 42.7% $192,786 12.6% $110,628

31.7% 8.9% 40.6% 23.3% *

1,800 3,600

0.3% $ 0.7%

850 1,700

0.2% 0.4%

1,800

0.3% $

850

0.2% *

12.3% $109,778 3.0% 28,600 9.2% $ 81,178

23.1% * 6.0% 17.1%

Net income

$ 64,626 16,000 $ 48,626

Earnings per share

2.43

4.06

*Rounded. 2. User Insight: Income from operations discussed Income from operations decreased from 2009 to 2010 in absolute amount by $44,202 ($110,628 – $66,426) and decreased in percentage from 23.3 percent to 12.6 percent of net sales despite an increase in net sales. There were two reasons for these decreases. First, gross margin decreased from 63.8 percent of net sales to 55.3 percent. This large decrease resulted in a lower absolute amount of gross margin. Second, operating expenses increased from 40.6 percent of net sales to 42.7 percent. The primary reason for this increase was that general and administrative expenses increased from 8.9 percent of net sales to 12.0 percent. Selling expenses actually decreased as a percentage of net sales. Management must examine its cost of goods sold and the company's overhead (general and administrative expenses).

228 .

Chapter 4, P 7. (Continued) 3.

User Insight: Income before income taxes discussed

Income before income taxes also decreased from 2009 to 2010. The primary reason for this decline was the decrease in operating income. However, the decrease in income before income taxes ($45,152) is greater than the decrease in operating income ($44,202) because of the 111.8 percent increase in interest expense from 2009 to 2010. This means that management took on additional debt to finance the business operations.

229 .

Chapter 4, P 8. 1. Profitability measures computed a.

2011:

2010:

Net Sales $8,000

$131,000 $5,500 $100,000

2010:

= 5.5%

$131,000 (

$72,500

$55,000

$131,000 $63,750

2.1 times

( =

= 6.1%

Net Sales Average Total Assets

Asset Turnover =

2011:

Net Income

Profit Margin =

Cash Flow Yield =

$100,000 $55,000 + $45,000 $100,000 $50,000

2.0 times

Net Income

$12,000 $8,000

= 1.5

2010:

$7,500 $5,500

= 1.4

Total Liabilities Total Stockholders' Equity

2011:

$20,000 $52,500

= 38.1%

2010:

$5,000 $50,000

= 10.0%

230 .

) ÷ 2

Cash flow from Operating Activities

2011:

Debt to Equity Ratio =

) ÷ 2

Chapter 4, P 8. (Continued) e.

Return on Assets =

Net Income Average Total Assets

2011:

$8,000 $63,750

= 12.5%

2010:

$5,500 $50,000

= 11.0%

Cash Return = on Assets

Cash Flow from Operating Activities Average Total Assets

2011:

$12,000 $63,750

= 18.8%

2010:

$7,500 $50,000

= 15.0%

Return on Equity = 2011:

(

Net Income Average Stockholders' Equity $52,500 =

2010:

(

$8,000 $51,250

$50,000 =

$8,000 + $50,000 = 15.6%

$5,500 + $40,000

$5,500 $45,000

= 12.2%

231 .

) ÷ 2

Chapter 4, P 8. (Continued) 2. User Insight Both profit margin and asset turnover increased from 2010 to 2011, causing return on assets to increase by 1.5 percent. Return on equity increased by 3.4 percent because the company increased its debt to equity ratio. It used more assets to produce income by increasing its debt proportionally more than it increased stockholders' equity. Although management may view the level of profitability as disappointing, the company has shown improvement in the key performance measures of return on assets and return on equity.

232 .

Chapter 4, P 9. Beauty Supplies Corporation Balance Sheet June 30, 2011 Assets Current assets Cash Short-term investments Notes receivable Accounts receivable Merchandise inventory Prepaid rent Prepaid insurance Sales supplies Office supplies Deposit for future advertising Total current assets Investments Building, not in use Property, plant, and equipment Land Delivery equipment Less accumulated depreciation Total property, plant, and equipment Intangible assets Trademark Total assets

$ 16,000 16,500 5,000 138,000 72,500 800 2,400 640 220 1,840 $253,900 24,800 $ 11,700 $20,600 14,200

6,400 18,100 2,000 $298,800 (continued)

233 .

Chapter 4, P 9. (Continued) Liabilities Current liabilities Accounts payable Salaries payable Interest payable Total current liabilities Long-term liabilities Notes payable

$ 57,300 2,600 920 $ 60,820 40,000

Total liabilities

$100,820 Stockholders' Equity

Contributed capital Common stock, $1.10 par value, 10,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

$ 11,000 80,000 $ 91,000 106,980 197,980 $298,800

2. User Insight In addition to considering the key elements of the balance sheet, such as total assets, liabilities, and equity, it's also important to consider Net Revenue and Net Income from the income statement and Cash Flows from Operating Activities from the statement of cash flows. The elements from these three statements are used to compute important financial ratios.

234 .

Chapter 4, P 10. 1a. Single-step income statement prepared Cubicle Corporation Income Statement For the Year Ended December 31, 2011 Revenues Net sales Interest income Total revenues Costs and expenses Cost of goods sold Selling expenses Administrative expenses Interest expense Total costs and expenses Income before income taxes Income taxes

$1,428,780 5,600 $1,434,380 $700,840 440,400 161,600 45,280 1,348,120 $

86,260 14,000

Net income

72,260

Earnings per share

3.61

1b. Statement of retained earnings prepared Cubicle Corporation Statement of Retained Earnings For the Year Ended December 31, 2011 Retained earnings, December 31, 2010 Net income Subtotal Less dividends Retained earnings, December 31, 2011

235 .

$566,340 72,260 $638,600 120,000 $518,600

Chapter 4, P 10. (Continued) 1c. Classified balance sheet prepared Cubicle Corporation Balance Sheet December 31, 2011 Assets Current assets Cash Investment in U.S. government securities Accounts receivable Inventory Prepaid expenses Total current assets Investments Investment in securities Property, plant, and equipment Store fixtures Less accumulated depreciation Delivery equipment Less accumulated depreciation Total property, plant, and equipment

$ 56,800 79,200 209,600 273,080 11,520 $ 630,200 112,000 $283,240 84,440

$198,800

$177,000 34,200

142,800 341,600 $1,083,800

Total assets

(continued)

236 .

Chapter 4, P 10. (Continued) Liabilities Current liabilities Notes payable Accounts payable Total current liabilities Long-term liabilities Notes payable Total liabilities

$100,000 65,200 $ 165,200 200,000 $ 365,200 Stockholders' Equity

Contributed capital Common stock, $1.00 par value, 20,000 shares authorized, issued, and outstanding Paid-in capital in excess of par value Total contributed capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

237 .

$ 20,000 180,000 $200,000 518,600 718,600 $1,083,800

Chapter 4, P 10. (Continued) 2.

Profitability measures computed (a) Profit Margin =

(b) Asset Turnover =

(d) Debt to Equity = Ratio (e) Return on Assets =

(f) Cash Return = on Assets

Net Income Net Sales

$72,260

$1,428,780

Net Sales Average Total Assets $1,428,780 ( $1,083,800 $1,428,780 $1,066,300

+ =

$1,048,800 ) ÷ 2 1.3 times

Cash Flow from Operating Activities Net Income

Total Liabilities Total Stockholders' Equity Net Income Average Total Assets $72,260 $1,066,300

= 6.8%

Cash Flow from Operating Activities Average Total Assets $60,000 $1,066,300

= 5.6%

238 .

= 5.1%

$60,000 $72,260 =

= 0.8

$365,200 $718,600

= 50.8%

Chapter 4, P 10. (Continued) Net Income

(g) Return on Equity =

Average Stockholders' Equity $72,260 (

$718,600 $72,260

$742,470

$766,340

) ÷ 2

= 9.7%

3. User Insight: Financial ratios discussed Cubicle Corporation's profit margin of 5.1 percent exceeds the industry average of 3.6 percent, but its asset turnover ratio of 1.3 is much lower than the industry average of 1.9. Thus, its return on assets of 6.8 percent is equal to the industry average of 6.8 percent. Further, it has a debt to equity ratio of only 50.8 percent compared with the industry average of 160.4 percent. Thus, its return on equity is only 9.7 percent compared with an industry average of 14.5 percent. Cubicle needs to consider increasing its debt financing as one method of increasing return on equity.

239 .

Chapter 4, C 1. Consistency requires that an accounting procedure, once adopted by a company, remain in use from one accounting period to another unless management decides that a new procedure is preferable and discloses information about the change in its financial statements. Such consistency ensures the comparability of financial results from one period to another. In this case, a change from the cash method to the accrual method would violate the consistency convention if the change was not disclosed in the financial statements. Full disclosure requires that financial statements and accompanying notes present all information relevant to the user's understanding of the statements. In this case, the notes should disclose the nature of the change, the justification for making it, and its probable effect on net income. Thus, readers of the financial statements will know that a change has been made and can assess its effects. Materiality refers to the relative importance of an item or event. In general, an item is material if there is a reasonable expectation that knowledge of it would influence the decisions of users of financial statements. In this case, the change from the cash to the accrual method would have a 5 percent ($62,500 ÷ $1,250,000) effect on net income. Many people consider 5 percent to be the point at which an amount starts to matter to decision makers. So this is a material effect, and the change in accounting method should be disclosed. (An adjustment may also be made at the beginning of the year, which could mitigate the year-end effect on the financial statements.) Chapter 4, C 2. Materiality refers to the relative importance of an item or event. In general, an item is material if there is a reasonable expectation that knowledge of it would influence the decisions of users of financial statements. The $120,000 inventory loss represents 4 percent of net income ($120,000 ÷ $3,000,000). Whether or not this loss is material depends on who is using the financial statements. To management, it represents a loss of income that impairs the company's ability to improve operations and results. To the auditors, the loss is reflected in the financial statements and thus is not misstated. In most retail operations, some inventory loss is expected. It is unlikely that external users of financial statements would change their decisions because of an item that represents only 4 percent of net income. The auditors may become concerned if the loss is greater in the future or if management does not take action to try to reduce it.

240 .

Chapter 4, C 3. 1. Profitability ratios computed (in millions) and discussed Supervalu

A&P

Net Income (Loss)

($2,855)

($140)

Net Sales Profit Margin

$44,564 -6.4%

$9,516 -1.5%

Net Sales

$44,564

$9,516

Average Total Assets Asset Turnover

( $17,604 +

$21,062 ) ÷ 2 = $19,333 2.3 times

( $3,546 + $3,644 ) ÷ 2 = $3,595 2.6 times

Net Income

($2,855)

($140)

Average Total Assets (from above)

Debt to Equity Ratio

$19,333 582.1%

$3,595 1,223.1%

Return on Assets

-14.8%

-3.9%

Total Liabilities

$15,023

$3,278

Total Stockholders' Equity

$2,581

$268

Net Income

($2,855)

($140)

Average Stockholders' Equity Return on Equity

(

$2,581

+ $5,953 ) -66.9%

2 = $4,267

(

$268 + $418 ) -40.8%

2 = $343

From these figures, it is clear that A&P was the more profitable company for the period analyzed. Its profit margin, return on assets, and return on equity were superior to the same measures for Supervalu because A&P has a smaller net loss.

241 .

Chapter 4, C 3. (Continued) 2. Return on assets discussed Return on assets is a combination of profit margin and asset turnover. The grocery industry has low profit margins. The profit margins of the two companies are -6.4 and -1.5 percent. The industry tries to overcome its low profit margin by turning over its assets many times during the year. A&P has an asset turnover of 2.6 times, which exceeds that of Supervalu of 2.3. The relationships of the two companies' ratios and the industry ratios are as follows:

Supervalu A&P Industry*

Profit Margin -6.4% -1.5% 2.2%

× × × ×

Asset Turnover 2.3 times 2.6 times 5.5 times

= = = =

Return on Assets -14.8% -3.9% * 12.1%

*Industry graphs are provided on pages 218–222, page 224, and page 225 of the text. The higher negative profit margin at Supervalu makes it less profitable than A&P in spite of its lower turnover. However, both companies are less profitable than the industry in terms of asset turnover and return on assets. 3. Debt financing discussed Despite low profit margins, grocery stores tend to have high debt because they are very stable businesses. Both companies use this method to increase their return on equity over what they earn on assets. Both companies have more debt than equity; the debt to equity ratio was 1,223.1 percent for A&P, which is considerably higher than the industry average, and 582.1 percent for Supervalu. When debt is excessive, a company can be in a risky situation. In the case of Supervalu and A&B, the large and A&P, the large amount of debt in relation to equity may put these companies in a vulnerable situation. A&P, with the higher debt to equity ratio, helps its return on equity, but it is still in a more risky situation due to its low profit margin.

242 .

Chapter 4, C 4. 1. To evaluate profitability, the profit margin and return on assets must be computed as follows: Net Income

Profit Margin =

Net Sales $89,512

2011:

$1,222,600 $82,912

2010:

$1,386,400

Average Total Assets $89,512 ( $1,536,910 =

2010:

= 6.0%

Net Income

Return on Assets =

2011:

= 7.3%

$89,512 $1,461,860

$1,386,810 ) ÷ 2

= 6.1% $82,912

( $1,386,810 =

$82,912 $1,316,795

$1,246,780 ) ÷ 2

= 6.3%

Wish Linens, Inc.'s profit margin did improve, from 6.0 percent to 7.3 percent, because of the increase in prices; however, return on assets, which is the broadest measure of profitability, fell from 6.3 percent to 6.1 percent. The reason is that assets are growing at a faster rate than revenues, causing asset turnover to drop, as shown next.

243 .

Chapter 4, C 4. (Continued) 2.

In her evaluation of profitability, Wish is focusing only on the profit margin, failing to take into account that the overall profitability must be evaluated in terms of total investment in assets and the amount of sales generated by those assets. Net Sales Asset Turnover = Average Total Assets 2011:

2010:

$1,222,600 $1,461,860 $1,386,400 $1,316,795

= 0.8

times

= 1.1

times

The asset turnover has decreased from 1.1 times in 2010 to 0.8 times in 2011 because of the decrease in sales (due to higher prices) and the increase in average total assets. This decrease in asset turnover has an adverse affect on profitability as measured by return on assets: Asset Return on Profit × = Margin Turnover Assets 0.8 5.8% 2011: 7.3% × = 1.1 6.6% 2010: 6.0% × =

244 .

Chapter 4, C 5. 1.

Consolidated balance sheets ($ amounts in millions)

Yes, CVS uses a classified balance sheet. It shows different categories of assets like contra assets, property and equipment, goodwill, intangible assets, and other assets. It further divides current assets into six subcategories.

Yes, the debt to equity ratio decreased from 76.3 percent in 2008 to 72.3 percent in 2009. Debt to Equity Ratio =

2009: c.

$25,873 $35,768

Total Liabilities Total Stockholders' Equity = 72.3%

2008:

$34,574

= 76.3%

Contributed capital for 2009 was $27,214 million ($16 + $27,198). (Note: In 2008, CVS had two types of stock: preference and common; in 2009, just common.) Also, capital surplus is the same as additional paid-in capital. Retained earnings were $16,355 million, or about 60 percent as great as contributed capital.

245 .

$26,386

Chapter 4, C 5. (Continued) 2.

Consolidated statements of operations

a. b.

CVS uses a multistep form of income statement. Yes, it is a comparative statement because it presents more than one year of data for comparison. There was an increase in net earnings from $2,623 million in 2007 to $3,198 million in 2008 to $3,696 million in 2009. (Note: The preference dividends are distributions to stockholders, not a part of net earnings.) Income taxes were $2,205 million in 2009 compared with pretax income of $5,913 million, or 37.3 percent. Income taxes were $2,193 million in 2008 compared with pretax earnings of $5,537 million, or 39.6 percent.

246 .

Chapter 4, C 6. (Continued) 1. Liquidity and profitability calculated Profit Margin Net Income (Loss) Net Sales or Total Operating Revenue

Profit Margin = CVS 2009:

$3,696 $98,729

= 3.7%

times 2008:

$3,198 $87,472

= 3.7%

$99 $10,350

= 1.0%

times 2008:

$178 $11,023

= 1.6%

Southwest 2009: Asset Turnover Asset Turnover =

Net Sales Average Total Assets

CVS 2009:

$98,729 ( =

2008:

( =

$61,641 $98,729 $61,301

$60,960 $87,472 $57,841

$60,960

+ =

1.6 times

$87,472 $54,722 + =

)

1.5 times

Southwest 2009:

( =

2008:

( =

$14,269 $10,350 $14,169 $14,068 $11,023 $15,420

$10,350 $14,068 + =

0.7 times

$11,023 $16,772 + =

)

0.7 times

247 .

Chapter 4, C 6. (Continued) Cash Flow Yield Cash Flow Yield =

Cash Flows from Operating Activities Net Income

CVS 2009:

$4,035 $3,696

= 1.1

2008:

$3,947 $3,198

= 1.2

2009:

$985 $99

= 9.9

2008:

($1,521) $178

= -8.5

Southwest

Debt to Equity Ratio Debt to Equity Ratio =

Total Liabilities Total Stockholders' Equity

CVS 2009:

$25,873 $35,768

= 72.3%

2008:

= 161.1%

2008:

$26,386 $34,574

= 76.3%

Southwest 2009:

$8,803 $5,466

248 .

$9,115 $4,953

= 184.0%

Chapter 4, C 6. (Continued) Return on Assets Return on Assets =

Net Income Average Total Assets

CVS 2009:

2008:

$3,696 $60,960

(

$61,641

$3,696 $61,301

= 6.0%

)

$3,198 $54,722

(

$60,960

$3,198 $57,841

= 5.5%

Southwest 2009:

2008:

(

$14,269

$99 $14,169

( =

$14,068 $178 $15,420

$99 $14,068 + = 0.7% $178 $16,772 + = 1.2%

249 .

Chapter 4, C 6. (Continued) Return on Equity Return on Equity =

Net Income Average Stockholders' Equity

CVS 2009:

2008:

(

$35,768

$3,696 $35,171

(

$34,574

$3,198 $32,948

$3,696 $34,574 +

)

= 10.5% $3,198 $31,322 + = 9.7%

Southwest 2009:

2008:

(

$5,466

$99 $5,210

(

$4,953

$178 $5,947

$99 $4,953 + = 1.9% $178 $6,941 + = 3.0%

2. Performance discussed In general, CVS's peformance exceeds the performance of Southwest, both in respect to liquidity and profitability. CVS's profitability measures, especially return on assets and return on equity, are much better than those of Southwest. Also, CVS has a higher profit margin than Southwest does, and it has a much higher asset turnover ratio. CVS also had lower debt to equity ratios for both years: 72.3 percent in 2009, a decrease from 76.3 percent in 2008. Southwest's ratio also decreased in 2009, from 184.0 percent to 161.1 percent. In terms of cash flow yield, CVS is a lot more stable with yield of slightly stable with yield of slightly more than 1, which means that for every dollar of net income, CVS generated one dollar of cash. On the other hand, Southwest's cash flow yield fluctuated greatly from 2008 to 2009, from negative 8.5 to about positive 10.

250 .

Chapter 4, C 7. This situation is framed so that the difference between 75 percent and 90 percent is material but also falls within the range of judgment. Thus, one can take either side of the issue. Some students may say that the first report is tentative and that a reevaluation may legitimately result in an estimate of 90 percent completion. Others may argue that the action is unethical, particularly in view of the bonuses that are tied to revenue, and there is no indication that the customer has approved or accepted the work performed to date. Discussion of whether a student, in assuming the position of the controller, would prepare the report may center on the conflict between the controller's duty to top management and his or her personal ethics. The proper action would be to reexamine the preliminary report to see whether new estimates are justified under the circumstances. If the preliminary report turns out to be the best estimate, then the controller should try to convince top management that changing the report would be unethical and perhaps fraudulent. If top management persists, the controller should not prepare the report and may have to decide whether he or she wants to continue working for the company.

251 .

CHAPTER 5—Solutions THE OPERATING CYCLE AND MERCHANDISING OPERATIONS Chapter 5, SE 1. 1. 2. 3. 4.

d c a b

Chapter 5, SE 2. Financial ratios computed Current Assets =

$ 5,000

$14,000

Working Capital =

$2,000

Current Assets

$14,000

$7,500

Current Ratio =

–

$1,000

+ $6,000

– Current Liabilities

$6,500

Current Assets Current Liabilities

$14,000 $6,500

= 2.15

Chapter 5, SE 3. Days to sell inventory Add days to collect for the sale Less creditors' payment terms

40 25 (33)

Financing period

252 .

Chapter 5, SE 4. List price Less 40 percent trade discount Dealer price Shipping cost Cost of tooling machine Less sales discount ( $7,200 ×

$12,000 4,800 $ 7,200 700 2%

$ 7,900 144

)

$ 7,756

Net cost of tooling machine Chapter 5, SE 5. Merchandise value:

$2,500

Discount: Payment:

$2,075 $2,075

– × –

$425 2% $41.50

= = =

$2,075 $41.50 $2,033.50

Chapter 5, SE 6. T accounts set up and entries posted Cash

Accounts Payable

Freight-In

8/10

970 * 8/7

180

8/2

1,150

8/3

105

Bal.**

970

8/3

105

Bal.

105

8/10

1,150

1,255 Bal.

105

Merchandise Inventory 8/2

1,150 1,150

Bal.

8/7

180 180

970

* $1,150 – $180 = $970 ** The balance of Cash is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account.

253 .

Chapter 5, SE 7. T accounts set up and entries posted Cash

Accounts Payable

Freight-In

8/10

970 * 8/7

180

8/2

1,150

8/3

105

Bal.**

970

8/3

105

Bal.

105

8/10

1,150

1,255 Bal.

105

Purchases Returns and Allowances

Purchases 8/2

1,150

8/7

180

Bal.

1,150

Bal.

180

* $1,150 – $180 = $970 ** The balance of Cash is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account. Chapter 5, SE 8. T accounts set up and entries posted Cash

Accounts Payable

5/10

1,455 * 5/7

Bal.**

1,455

5/10

Freight-In

270

5/2

1,725

5/3

158

1,455 1,725

5/3

158 1,883

Bal.

158

Bal.

158

Merchandise Inventory 5/2 1,725 5/7 270 1,725 270 Bal. 1,455 * $1,725 – $270 = $1,455 ** The balance of Cash is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account.

254 .

Chapter 5, SE 9. T accounts set up and entries posted Cash

Accounts Payable

5/10

1,455* 5/7

Bal.**

1,455

5/10

270

5/2

1,725

5/3

158

1,455

5/3

158

Bal.

158

1,725

1,883 Bal.

Purchases

Freight-In

158

Purchases Returns and Allowances

5/2

1,725

5/7

270

Bal.

1,725

Bal.

270

* $1,725 – $270 = $1,455 ** The balance of Cash is a credit because there are no data about the beginning balance and only one entry has been posted to the credit side of the account. Chapter 5, SE 10. Purchases: $282,900 ($273,700 + $50,600 – $13,800 + $10,350 – $37,950) Cost of goods sold $ 37,950

Merchandise inventory, September 30, 2011

Purchases Less purchases returns and allowances Net purchases

$282,900 10,350 $272,550 13,800

Freight-in Net cost of purchases

286,350

Cost of goods available for sale

$324,300

Less merchandise inventory, 50,600

October 31, 2011

$273,700

Cost of goods sold

255 .

Chapter 5, SE 11. T accounts set up and entries posted Sales

Accounts Receivable

8/4

2,520

Bal.

2,520

8/4

2,520

8/9

735

8/5

231

9/3

1,785

Bal.

231

2,520

2,520 Bal.

9/3

Cash 1,785* 8/5

Bal.

1,554

Sales Returns and Allowances 231

8/9

735

Bal.

735

* $2,520 – $735 = $1,785 Chapter 5, SE 12. 1. 2. 3. 4. 5. 6. 7.

f d g e a c b

Chapter 5, SE 13. 1. 2. 3. 4.

d b a c

256 .

Delivery Expense

—

Chapter 5, E 1. 1.

Yes, a company can have a negative financing period if its merchandise is held for a very short time, if its sales are mostly for cash, or if it has long terms to pay its suppliers.

Because the exchange rate for the dollar is declining as it relates to the euro, the dollar can buy more euros. Therefore, you would want the eventual payment to be made in dollars.

Management has the ultimate responsibility for safeguarding a company’s assets with a system of internal control.

You would want the terms to be FOB destination because the loss of merchandise would be the responsibility of the shipper. If the terms were FOB shipping point, the merchandise would belong to you when it left the shipper and would be your loss.

Chapter 5, E 2. 1.

The balance would be wrong if an error were made in updating the account or if merchandise had been lost or stolen.

Under the periodic inventory system, a physical inventory is needed to determine the cost of goods sold and the resulting amount of ending inventory. Under the perpetual inventory system, a physical inventory is required to verify the inventory as shown in the accounting records.

Merchandise Inventory would be assigned a higher level of risk because there is a greater risk of human error in recording the large number of transactions involved and because there is a greater risk of theft.

It is important because until there is a written record of the cash, there is no accountability. This is why some stores offer a reward to customers who report having made a purchase without receiving a receipt.

Chapter 5, E 3. 1. 2. 3. 4. 5. 6.

d a b c d a

257 .

Chapter 5, E 4. Date of purchase: Cost of machine in dollars: €150,000 ×

$1.00

= $150,000

Date of payment: Amount of payment:

€150,000 ×

$1.25

= $187,500

Exchange loss:

$187,500 –

$150,000

= $37,500

Chapter 5, E 5. 1.

Working capital computed

Current Assets Cash Marketable Securities Notes Receivable (90 days) Accounts Receivable Merchandise Inventory Prepaid Insurance Supplies Total Current Assets Current Liabilities Notes Payable (90 days) Accounts Payable Current Portion of Long-Term Debt Salaries Payable Property Taxes Payable Unearned Revenue Total Current Liabilities

$ 1,200 10,080 20,800 8,160 20,320 320 280 $61,160 $12,000 13,280 8,000 680 1,000 600 35,560 $25,600

Working Capital 2.

Current ratio computed Current Ratio =

Current Assets Current Liabilities

$61,160 $35,560

= 1.72

Chapter 5, E 6. List price Less 30% trade discount Dealer price Shipping cost Cost of pool Less sales discount ($3,500 × 2%)

$5,000 1,500

Net cost of pool

$3,430

$3,500 — $3,500 70 258

Chapter 5, E 7. Mar.

1 Accounts Receivable Sales Sold merchandise on credit to Sun Company, terms 2/10, n/30, FOB shipping point

2,000

3 Sales Returns and Allowances Accounts Receivable Accepted a return from Sun Company for full credit

800

10 Cash Sales Discounts Accounts Receivable Received payment from Sun Company for the sale, less the return and discount Accounts Receivable: $2,000 – $800 = $1,200 Discount: $1,200 × 2% = $24 Payment: $1,200 – $24 = $1,176

1,176 24

11 Accounts Receivable Sales Sold merchandise on credit to Sun Company, terms 2/10, n/30, FOB shipping point

3,200

31 Cash Accounts Receivable Received payment for amount due from Sun Company for the sale of March 11

3,200

2,000

800

1,200

3,200

The total amount received from Sun Company (debits to the Cash account): $1,176 + $3,200 = $4,376

259 .

3,200

Chapter 5, E 8. July

2 Merchandise Inventory Accounts Payable Purchased merchandise on credit from Lucas Company, terms n/20, FOB destination, invoice dated July 1

2,000

6 Accounts Payable Merchandise Inventory Returned some merchandise to Lucas Company for full credit

250

11 Accounts Payable Cash Paid Lucas Company for purchase of July 2 less return Accounts Payable: $2,000 – $250 = $1,750

1,750

14 Merchandise Inventory Accounts Payable Purchased merchandise on credit from Lucas Company, terms n/20, FOB destination, invoice dated July 12

2,250

31 Accounts Payable Cash Paid amount owed Lucas Company for purchase of July 14

2,250

2,000

250

1,750

2,250

The total amount paid to Lucas Company (credits to the Cash account): $1,750 + $2,250 = $4,000

260 .

2,250

Chapter 5, E 9. Parties, Etc. Income Statement For the Year Ended December 31, 2011 Net sales Sales

$249,000 11,750

Less sales returns and allowances Net sales Cost of goods sold*

$237,250 149,350

Gross margin

$ 87,900

Operating expenses Selling expenses General and administrative expenses Total operating expenses

65,000

Income before income taxes Income taxes

$ 22,900 6,000

Net income

$ 16,900

*Cost of goods sold includes freight-in: $142,000 + $7,350 = $149,350

261 .

$21,500 43,500

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Chapter 5, E 10. T accounts set up and entries posted Cash

Accounts Payable

Freight-In

270

1,000

5,000

270

5,000

2,800

400

5,200

Bal.

670

h.*

1,800

Bal.** 12,270

13,000

13,000 Bal.

—

Merchandise Inventory a.

5,000

2,800

4,800

1,000

12,600 Bal.

11,600

$2,800

1,000

–

$1,000

$1,800

** The balance of Cash is a credit because there are no data about the beginning balance and entries have been posted only to the credit side of the account.

262 .

Chapter 5, E 11. T accounts set up and entries posted Cash

Sales

6/25

2,000 *

6/15

2,600

Bal.

2,000

Bal.

2,600 *

Sales Returns Accounts Receivable 6/15

2,600

6/20

600

6/20

600

6/25

2,000

Bal.

600

2,600 Bal.

and Allowances

2,600

— Merchandise Inventory

6/20

350

6/15

350

Cost of Goods Sold 1,500

6/15

1,500 Bal.**

1,500 1,500

1,150

Bal.

6/20

350 350

1,150

* $2,600 – $600 = $2,000 ** The balance of Merchandise Inventory is a credit because there are no data about the beginning balance and a larger amount has been posted to the credit side of the account.

263 .

Chapter 5, E 12. Handy General Store Income Statement For the Year Ended December 31, 2011 Net sales Sales Less sales returns and allowances

$154,500 7,600

Net sales

$146,900

Cost of goods sold Merchandise inventory, December 31, 2010

$14,000

Purchases

$57,400 3,500

Less purchases returns and allowances Net purchases

$53,900 2,800

Freight-in Net cost of purchases

56,700

Cost of goods available for sale

$70,700 10,500

Less merchandise inventory, December 31, 2011

60,200

Cost of goods sold Gross margin

$ 86,700

Operating expenses Selling expenses

$28,200 18,600

General and administrative expenses Total operating expenses

46,800

Income before income taxes Income taxes

$ 39,900 9,000

Net income

$ 30,900

264 .

Chapter 5, E 13. 2011

2010

$349 (p)

$336 (h)

Sales returns and allowances

20 (a)

Net sales

325 (q)

317

266 (b)

Merchandise inventory, beginning

33 (r)

42 (i)

Purchases

192

169

139 (c)

Purchases returns and allowances

28 (j)

Freight-in

28 (s)

Net cost of purchases

189

170 (k)

144 (d)

Cost of goods available for sale

222

212

182

Merchandise inventory, ending

33 (l)

Cost of goods sold

183 (t)

179

140 (e)

Gross margin

142

138 (m)

126

Selling expenses

91 (u)

66 (f)

General and administrative expenses

50 (n)

Total operating expenses

130

128

99 (g)

Income before income taxes

12 (v)

10 (o)

Income taxes

Net income

9 (w)

(in thousands) Sales

265 .

2009 $286

Chapter 5, E 14. T accounts set up and entries posted Cash

Accounts Payable

Purchases

270

1,000

5,000

2,800

5,200

4,800

h.*

1,800

Bal.

12,600

Bal.**

12,270

13,000

13,000 Bal.

— Freight-In b. d.

270 400

Bal.

670 Purchases Returns and Allowances e.

1,000

Bal.

1,000

* $2,800 – $1,000 = $1,800 ** The balance of Cash is a credit because there are no data about the beginning balance and entries have been posted only to the credit side of the account.

266 .

Chapter 5, E 15. T accounts set up and entries posted

6/25

Cash 2,000*

Bal.

2,000

Sales

Accounts Receivable 6/15

2,600

Bal.

600

6/20

600

6/25

2,000

Bal.

600

2,600

—

* $2,600 – $600 = $2,000

267 .

2,600

Bal.

2,600

Sales Returns and Allowances

6/20

2,600

6/15

Chapter 5, E 16. 1.

The 30 percent increase represents about one additional employee on the payroll (after accounting for the raises). It is possible that the branch office manager has either added an unauthorized employee to the payroll or added a fictitious employee to the payroll and then cashed the payroll checks himself or herself.

The large increase in sales returns and allowances immediately following yearend probably means that to meet sales goals, the sales staff inflated the previous year's sales by shipping unordered merchandise or by sending goods on approval. Those goods were subsequently returned for credit in the first two months of 2011.

All other things being equal, a decrease in both gross margin and ending inventory probably indicates the theft or pilferage of inventory by customers or employees.

The cashier in question may be turning in and ringing up discount coupons available in the store and pocketing the cash for the coupons. Businesses often have extra coupons in the store for customers who request them.

Chapter 5, E 17. 1. 2. 3. 4.

b c a d

Chapter 5, E 18. 1. 2. 3. 4. 5.

g e a, c, f g b, c

268 .

Chapter 5, P 1. 1. Income statement prepared Barbara's Video Store, Inc. Income Statement For the Year Ended June 30, 2009 Net sales Sales

$870,824 25,500

Less sales returns and allowances Net sales Cost of goods sold*

$845,324 462,526

Gross margin

$382,798

Operating expenses Selling expenses Store salaries expense

$216,700

Advertising expense

36,400

Store supplies expense

3,328 3,600

Depreciation expense—store equipment Total selling expenses

$260,028

General and administrative expenses Office salaries expense

$ 53,000

Rent expense

28,000

Insurance expense

5,600

Utilities expense

18,320

Office supplies expense

3,628 3,700

Depreciation expense—office equipment Total general and administrative expenses

112,248

Total operating expenses

372,276

Income before income taxes Income taxes

$ 10,522 5,000

Net income

5,522

*Cost of goods sold includes freight-in ($442,370 + $20,156 = $462,526).

269 .

Chapter 5, P 1. (Continued) 2.

User Insight: Income statement discussed

This question is meant to link the income statements in this chapter to the financial statement ratios prepared in the previous chapter. The income statement for Barbara's Video Store, Inc., can be examined (1) as a whole, (2) in components, and (3) in relation to other information. First, overall, the statement shows net income of $5,522, which was earned on net sales of $845,324. This is a profit margin of only 0.65 percent. Second, the components of gross margin and operating expenses can be examined. The gross margin is $382,798, or 45.3 percent of net sales. The operating expenses are $372,276, or 44 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. Third, the net income, $5,522, can be compared with the total assets of the business to compute return on assets and with total stockholders' equity to compute return on equity. An analyst would want to examine the balance sheet in relation to the income statement. When possible, an analysis would also include comparing the ratios above for Barbara's Video Store, Inc., to prior years and to other companies of similar size, within the same industry, and covering the same period of time.

270 .

Chapter 5, P 2. 1. Transactions recorded 2011 July

1 Accounts Receivable Sales Sold merchandise to Tina Lands, terms n/30, FOB shipping point

1,050

1 Cost of Goods Sold Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account

630

3 Merchandise Inventory Accounts Payable Purchased merchandise from Livomax Company, terms n/30, FOB shipping point

1,900

5 Freight-In Cash Paid shipping charges to Team Freight

630

1,900

145 145

8 Merchandise Inventory Freight-In Accounts Payable Purchased merchandise from Arbor Supply Company, terms n/30, FOB shipping point; freight paid by supplier

1,700 100

12 Accounts Payable Merchandise Inventory Returned some of merchandise purchased from Livomax Company

300

15 Accounts Receivable Sales Sold merchandise to John Nuzzo, terms n/30, FOB shipping point

600

15 Cost of Goods Sold Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account

360

271 .

1,050

1,800

300

600

360

Chapter 5, P 2. (Continued) 2011 July 17 Cash Sales Sold merchandise for cash

500 500

17 Cost of Goods Sold Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account

300

18 Sales Returns and Allowances Accounts Receivable Accepted return of merchandise for full credit from Tina Lands

100

18 Merchandise Inventory Cost of Goods Sold To transfer cost of merchandise returned to Merchandise Inventory account

24 Accounts Payable Cash Made payment on account to Livomax Company $1,900 – $300 = $1,600 25 Cash Accounts Receivable Received payment on account from Tina Lands $1,050 – $100 = $950

300

100

1,600 1,600

950 950

2. User Insight: Net sales discussed Net sales reflects gross sales adjusted for any sales discounts, sales returns, or allowances granted the buyer. When companies simply show "sales," it may mean that they have granted no discounts, returns, or allowances, or it may mean that any of these items granted were of an immaterial amount. In effect, "net sales" and "sales" are equivalent.

272 .

Chapter 5, P 3. 1. Income statement prepared Louise's Gourmet Shop, Inc. Income Statement For the Year Ended March 31, 2010 Net sales Sales Less sales returns and allowances

$168,700 5,700

Net sales

$163,000

Cost of goods sold Merchandise inventory, March 31, 2009

$ 38,200

Purchases

$70,200 2,600

Less purchases returns and allowances Net purchases

$67,600 2,300

Freight-in

69,900

Net cost of purchases Cost of goods available for sale

$108,100 29,400

Less merchandise inventory, March 31, 2010

78,700

Cost of goods sold Gross margin

$ 84,300

Operating expenses Selling expenses Store salaries expense

$33,125

Advertising expense

23,800

Store supplies expense

2,880 1,050

Depreciation expense—store equipment Total selling expenses

$ 60,855

General and administrative expenses Office salaries expense

$12,875

Rent expense

2,400

Insurance expense

1,300

Utilities expense

1,560

Office supplies expense

1,075 800

Depreciation expense—office equipment Total general and administrative expenses

20,010 80,865

Total operating expenses Income before income taxes

3,435 1,000

2,435

Income taxes Net income 273 .

Chapter 5, P 3. (Continued) 2.

User Insight: Income statement discussed

This question is meant to get the students thinking about how to analyze financial statements. The income statement for Louise's Gourmet Shop, Inc., can be examined (1) as a whole, (2) in components, and (3) in relation to other information. First, the statement shows net income of $2,435, which was earned on net sales of $163,000. This is a profit margin of only 1.5 percent. Second, the components of gross margin and operating expenses can be examined. The gross margin is $84,300, or 51.7 percent of net sales; the operating expenses are $80,865, or 49.6 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. Third, the net income, $2,435, can be compared with the total assets of the business to compute return on assets and with total stockholders' equity to compute return on equity. An analyst would want to examine the balance sheet in relation to the income statement. When possible, an analysis would also include comparing the ratios above for Louise's Gourmet Shop, Inc., to prior years and to other companies of similar size, within the same industry, and covering the same period of time.

274 .

Chapter 5, P 4. 1. Transactions recorded 2011 July

1 Accounts Receivable Sales Sold merchandise to Tina Lands, terms n/30, FOB shipping point

1,050

3 Purchases Accounts Payable Purchased merchandise from Livomax Company, terms n/30, FOB shipping point

1,900

5 Freight-In Cash Paid shipping charges to Team Freight

1,900

145 145

8 Purchases Freight-In Accounts Payable Purchased merchandise from Arbor Supply Company, terms n/30, FOB shipping point; freight paid by supplier

1,700 100

12 Accounts Payable Purchase Returns and Allowances Returned some of merchandise purchased from Livomax Company

300

15 Accounts Receivable Sales Sold merchandise to John Nuzzo, terms n/30, FOB shipping point

600

17 Cash Sales Sold merchandise for cash

500

18 Sales Returns and Allowances Accounts Receivable Accepted return of merchandise for full credit from Tina Lands

100

275 .

1,050

1,800

300

600

500

100

Chapter 5, P 4. (Continued) 2011 July 24 Accounts Payable Cash Made payment on account to Livomax Company $1,900 – $300 = $1,600 25 Cash Accounts Receivable Received payment on account from Tina Lands $1,050 – $100 = $950

1,600 1,600

950 950

276 .

Chapter 5, P 5. 1. Control activities identified 1.

c, f

c, d, f

a, c, f

a, f

b, c, f

2. User Insight: New control activities explained Authorization Two major points of authorization have been put into the new system. First, the supplies clerk is routinely authorized to release a predetermined amount of supplies to each supervisor based on the job. Second, the purchasing clerk authorizes purchases of supplies based on purchase requisitions received from the supplies clerk. This is an improvement over the old system in that all releases of supplies and purchases of supplies have appropriate approval. Supervisors are discouraged from wasting supplies, and the company is paying the lowest price for supplies. Recording transactions There is no major difference between the old and new systems regarding the recording of transactions. In both cases, the accounting department records the purchase of supplies. Additional inventory records are maintained, however, as explained in the next section. Documents and records Several new documents and records were established by the new system. Requisitions by supervisors, purchase requisitions by the supplies clerk, purchase orders by the purchasing clerk, and receiving reports by the supplies clerk are new documents that establish controls over supplies. These documents are an improvement over the old system in that forms now document the responsibilities of each individual. New inventory records are kept by the accounting department. With these records, the inventory on hand can be verified by taking a physical inventory. This discourages employees from using too many supplies or stealing them. Physical controls Physical controls are established through the designation of a supplies storeroom. This new and essential control procedure protects the supplies from waste and theft, and means that the supplies clerk can be held accountable for the inventory of supplies. Periodic independent verification This control procedure is accomplished by having the warehouse manager take a physical inventory each month and match 277 .

Chapter 5, P 5. (Continued) it against the records maintained by the accounting department. This is a major improvement over the old system because employees are motivated not to waste or steal the supplies and because losses can be uncovered quickly. Separation of duties The new system represents a good example of the separation of duties. The supervisors and the supplies clerk, who have access to the supplies, can obtain them only through proper authorization as documented by the requisitions and the purchase orders. Authorization here is the responsibility of management, which sets the amount to be released to the supervisors, and of the purchasing clerk, who authorizes purchases. The accounting records, including the inventory records, are maintained by the accounting department. The independent verification is conducted by the warehouse supervisor. Sound personnel practices This is an area of apparent weakness in the new system. Many employees have new duties with more rigorous procedures to follow and more forms to complete than before. The case does not specify what steps, if any, were taken to train the employees in the new procedures and to motivate them to accept these procedures. The success of the new system will depend on the employees' understanding of and willingness to carry out their new roles. Some examples: The supplies clerk must be careful to release only the amount of supplies authorized for each job. The warehouse manager must take the physical inventory each month and do so accurately. The purchasing clerk must make a conscious effort to find the best prices for supplies. And access to the supplies storeroom must be limited to the supplies clerk. If anybody can walk into the storeroom, the control is lost.

278 .

Chapter 5, P 6. 1. Multistep income statement prepared Pasha's Delivery, Inc. Income Statement For the Year Ended August 31, 2010 Net sales Sales

$169,000 9,000

Less sales returns and allowances Net sales Cost of goods sold*

$160,000 63,700

Gross margin

$ 96,300

Operating expenses Selling expenses Store salaries expense

$32,825

Advertising expense

24,100

Store supplies expense

2,680 1,250

Depreciation expense—store equipment Total selling expenses

$60,855

General and administrative expenses Office salaries expense

$12,875

Rent expense

2,400

Insurance expense

1,200

Utilities expense

1,560

Office supplies expense

1,175 800

Depreciation expense—office equipment

20,010

Total general and administrative expenses Total operating expenses

80,865

Income before income taxes Income taxes

$ 15,435 2,000

Net income

$ 13,435

*Cost of goods sold includes freight-in

( $61,400

$2,300

$63,700

)

279 .

Chapter 5, P 6. (Continued) 2.

User Insight: Income statement discussed

This question is meant to link the income statements in this chapter to the financial statement ratios prepared in the previous chapter. The income statement for Pasha's Delivery, Inc., can be examined (1) as a whole, (2) in components, and (3) in relation to other information. First, overall, the statement shows net income of $13,435, which was earned on net sales of $160,000. This is a profit margin of 8.4 percent. Second, the components of gross margin and operating expenses can be examined. The gross margin is $96,300 or 60.2 percent of net sales; the operating expenses are $80,865, or 50.5 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. Third, the net income, $13,435, can be compared with the total assets of the business to compute return on assets and with total stockholders' equity to compute return on equity. An analyst also would want to examine the balance sheet in relation to the income statement. When possible, an analysis would also include comparing the ratios above for for Pasha's Delivery, Inc., to prior years and to other companies of similar size, within the same industry, and covering the same period of time.

280 .

Chapter 5, P 7. 1. Transactions recorded 2011 Oct.

7 Accounts Receivable Sales Sold merchandise to Ron Moore, terms n/30, FOB shipping point

3,000

7 Cost of Goods Sold Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account

1,800

8 Merchandise Inventory Accounts Payable Purchased merchandise from Lima Company, terms n/30, FOB shipping point

6,000

9 Freight-In Cash Paid shipping charges to Warta Company for October 8 purchase

1,800

6,000

254 254

10 Merchandise Inventory Freight-In Accounts Payable Purchased merchandise from Maria's Company, terms n/30, FOB shipping point; freight paid by supplier

9,000 600

14 Accounts Receivable Sales Sold merchandise to Kate Lang, terms n/30, FOB shipping point

2,400

14 Cost of Goods Sold Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account

1,440

14 Accounts Payable Merchandise Inventory Returned damaged merchandise to Lima Company for credit

600

281 .

3,000

9,600

2,400

1,440

600

Chapter 5, P 7. (Continued) 2011 Oct. 17 Cash Accounts Receivable Received payment on account from Ron Moore

3,000 3,000

19 Cash Sales Sold merchandise for cash

1,800

19 Cost of Goods Sold Merchandise Inventory To transfer cost of merchandise sold to Cost of Goods Sold account

1,080

20 Accounts Payable Cash Made payment on account to Maria's Company for purchase of October 10

9,600

21 Accounts Payable Cash Made payment on account to Lima Company for purchase of October 8, net of return on October 14 $6,000 – $600 = $5,400

5,400

1,800

1,080

9,600

5,400

24 Sales Returns and Allowances Accounts Receivable Accepted return from Kate Lang

200

24 Merchandise Inventory Cost of Goods Sold To transfer cost of merchandise returned to Merchandise Inventory account

120

200

120

2. User Insight: Cash rebates discussed Cash rebates should not be recorded as revenue because doing so overstates revenues. (Some companies have gotten into trouble for following this practice.) Cash rebates are properly treated as purchases discounts or allowances and deducted from gross purchases.

282 .

Chapter 5, P 8. 1. Income statement prepared Robert's Shop, Inc. Income Statement For the Year Ended March 31, 2011 Net sales Sales Less sales returns and allowances

$168,700 5,700

Net sales

$163,000

Cost of goods sold Merchandise inventory, March 31, 2010 Purchases Less purchases returns and allowances Net purchases

$ 38,200 $70,200 2,600 $67,600 2,300

Freight-in

69,900

Net cost of purchases Cost of goods available for sale

$108,100 29,400

Less merchandise inventory, March 31, 2011

78,700

Cost of goods sold Gross margin

$ 84,300

Operating expenses Selling expenses Store salaries expense

$33,125

Advertising expense

23,800

Store supplies expense

2,880 1,050

Depreciation expense—store equipment Total selling expenses

$ 60,855

General and administrative expenses Office salaries expense

$12,875

Rent expense

2,400

Utilities expense

1,560

Insurance expense

1,300

Office supplies expense

1,075 800

Depreciation expense—office equipment Total general and administrative expenses

20,010 80,865

Total operating expenses Income before income taxes

3,435 1,000

2,435

Income taxes Net income 283 .

Chapter 5, P 8. (Continued) 2.

User Insight: Income statement discussed

This question is meant to get the students thinking about how to analyze financial statements. The income statement for Robert's Shop, Inc., can be examined (1) as a whole, (2) in components, and (3) in relation to other information. First, the statement shows net income of $2,435, which was earned on net sales of $163,000. This is a profit margin of only 1.5 percent. Second, the components of gross margin and operating expenses can be examined. The gross margin is $84,300, or 51.7 percent of net sales; the operating expenses are $80,865, or 49.6 percent of net sales. Net income can be improved by increasing the gross margin and/or by decreasing the operating expenses. Third, the net income, $2,435, can be compared with the total assets of the business to compute return on assets and with total stockholders' equity to compute return on equity. An analyst would want to examine the balance sheet in relation to the income statement. When possible, an analysis would also include comparing the ratios above for Robert's Shop, Inc., to prior years and to other companies of similar size within the same industry for the same period of time.

284 .

Chapter 5, P 9. 1. Transactions recorded 2011 Oct.

7 Accounts Receivable Sales Sold merchandise to Ron Moore, terms n/30, FOB shipping point

3,000

8 Purchases Accounts Payable Purchased merchandise from Lima Company, terms n/30, FOB shipping point

6,000

9 Freight-In Cash Paid freight charges to Warta Company

254

10 Purchases Freight-In Accounts Payable Purchased merchandise from Maria's Company, terms n/30, FOB shipping point; freight paid by supplier

9,000 600

14 Accounts Receivable Sales Sold merchandise to Kate Lang, terms n/30, FOB shipping point

2,400

14 Accounts Payable Purchases Returns and Allowances Returned damaged merchandise to Lima Company for credit

600

17 Cash Accounts Receivable Received payment on account from Ron Moore

3,000

285 .

3,000

6,000

254

9,600

2,400

600

3,000

Chapter 5, P 9. (Continued) 2011 Oct. 19 Cash Sales Sold merchandise for cash

1,800 1,800

20 Accounts Payable Cash Made payment on account to Maria's Company for purchase of October 10

9,600

21 Accounts Payable Cash Made payment on account to Lima Company for purchase of October 8, net of return on October 14 $6,000 – $600 = $5,400 24 Sales Returns and Allowances Accounts Receivable Accepted return from Kate Lang

5,400

9,600

5,400

200 200

286 .

Chapter 5, P 10. 1. Significant internal control weaknesses Cash sales One objective of internal control is to compare the records of assets with the existing assets at reasonable intervals. The comparison of the cash register tape with the cash in the cash drawer at the end of each day accomplishes this objective. However, the comparison should be made by someone other than the person who has custody of the assets. In this case, the salesclerk could misappropriate funds from the cash drawer and report the sales at less than actual. Purchases In this case, invoices are being paid before they are compared with the purchase order and receiving report. An invoice could be paid for goods that have not been properly authorized or for goods that have not been received. The purchasing agent, who has the responsibility to authorize purchases, also certifies that the invoice is correct. It would be possible for the purchasing agent to be involved in a kickback scheme with a supplier. 2. Recommended changes that would improve the system One way of overcoming the internal control weakness over cash sales is to have the salesclerk take the cash drawer to the cashier and count the cash in the presence of the cashier. Another person, such as the manager, should remove the tape from the cash register for comparison with the amount turned in to the cashier. To remedy both of these weaknesses in internal contol over purchases, the receiving report and the purchase order should go to the accounting department to be compared with the invoices before payment is authorized. In addition, prior to payment, the invoice should be approved by the person who submitted the purchase requisition to ensure that he or she actually received the quantity and quality of goods requested. In this way, authorization (the purchasing agent) and custody (the receiving clerk) are separated from recordkeeping (the accounting department).

287 .

Chapter 5, C 1. The operating cycle is the amount of time from the purchase of inventory until it is sold and payment is collected. Amazing Sound Source's operating cycle is 160 days (70 days plus 90 days). The financing period is the time needed for financing of inventory and receivables. For Amazing Sound Source, it is 140 days (160 days minus 20 days). Amazing Sound Source can improve its cash flow management in one or all of the following ways: 1. Reduce the inventory period. (Suggestions: Analyze inventory to reduce inventory on hand; try to get inventory on consignment.) 2. Reduce the receivable period. (Suggestions: Encourage customers to use credit cards instead of giving 90 days' credit; make arrangements with bank to provide credit to customers.) 3. Increase the payable period. (Suggestions: Pay suppliers at last possible time instead of when invoice is received; negotiate longer payment times.) Chapter 5, C 2. Note to the instructor: This case can be used for class discussion or as a writing exercise. It is also excellent for use with small groups, with the participants being asked to develop arguments for either the periodic inventory system or the perpetual inventory system. The Periodic Inventory System An advantage of the periodic inventory system is that it is usually less costly to administer. There may be some merit to the system of relying on the judgment of the store managers. Perhaps this system needs to be strengthened with a better training program for managers and a better system for monitoring sales within the stores. The patterns of sales in different neighborhoods do vary, and the store managers are probably the best people to monitor these trends. The disadvantage of the periodic inventory system is that little information about inventory is available except within each store. Sales in the book business can fluctuate unexpectedly, and top management may not know when one store has run out of a title and another store has been unable to sell it. Another disadvantage of the periodic inventory system is that financial statements are prepared only when a physical inventory is taken (in this case, every six months). The Perpetual Inventory System A principal advantage of the perpetual inventory system is that sales and inventory levels can be monitored on a day-by-day basis. Fast-selling books can be reordered quickly, and slow-selling books can be moved to other stores or returned to the publisher before they have to be offered at lower prices. In addition, financial statements can be prepared frequently, giving management constant feedback on how well the company is doing. Centralization of the records would mean that 288

Chapter 5, C 2. (Continued) sales trends among the stores could be monitored, allowing inventory to be shifted from stores where sales have been slow to those where sales are better. A disadvantage of the perpetual inventory system is the cost to install and maintain it. Employees must be trained to follow procedures in recording sales, purchases, and returns and in maintaining the records. This may be much more costly than hiring and training qualified store managers. Also, the centralization of the records takes considerable autonomy away from the individual store managers, who are in the best position to evaluate their own situations. A solution to this last disadvantage is to give the managers ready access to the perpetual inventory records and let them have a say in decisions about purchases. Note to the instructor: Many specialty store chains, including bookstores, use a perpetual inventory system like the one proposed for Books Unlimited. Sales are monitored at the national or regional level, and individual store managers have little or no say in the titles or other products that are stocked. Chapter 5, C 3. A weak U.S. dollar means that one dollar may be exchanged for less than previously or, conversely, that one euro is now worth more in terms of dollars than it was before. Thus, when McDonald's prepares its financial statements in dollars, sales in Europe translate into more dollars than previously. Assume, for instance, that the company sold €12,000,000 worth of Big Macs in Europe in each of two years. Also assume that in the first year, one euro is worth $1.40 and in the second year, one euro is worth $1.60. In euros, sales appear to be equal from one year to the next, but in dollars, sales increased from $16,800,000 (€12,000,000 × $1.40) to $19,200,000 (€12,000,000 × $1.60). Sales by McDonald's in the United States are not relevant to the discussion because these sales were in dollars and therefore were not affected by the changes in foreign exchange rates.

289 .

Chapter 5, C 4. The control activities that were likely violated in this case are as follows: a.

Authorization: These expenditures were probably not authorized by a person who would understand their implications.

b. Periodic independent verification: There was apparently no independent verification that the work had been done. c.

Separation of duties: It is likely that these expenditures were authorized by the employee who perpetrated the fraud, thus circumventing separation of duties.

d. Sound personnel practices: It is likely that sound personnel practices such as rotation of jobs, required vacations, and bonding were violated and enabled the employee to conceal the fraud.

290 .

Chapter 5, C 5. CVS's operating cycle described Memorandum Date: To: From: Re:

Today's Date Instructor's Name Student's Name CVS's Operating Cycle

The operating cycle is the length of time from the purchase of inventory until it is sold and the proceeds collected. The financing period is the operating cycle less the days of credit received to pay for the inventory. The relative importance of each component of the financing period is as follows: 1.

Purchase of inventory: Maintaining an adequate merchandise inventory is very important to CVS's operating cycle. The company maintains about 45 days' inventory on hand at any one time.

Cash sales and collection on account: Accounts receivable are not as important to CVS as inventory because most of the company's sales are for cash, debit card, or credit card. Its days' receivable is 21.

Payments on account: Because of the number of days' inventory on hand, the days' payable is very important to CVS in financing the inventory. Its days' payable is 19. In summary, the financing period for CVS is about 47 days (45 + 21 – 19). CVS needs to provide inventory financing for somewhat less than two months.

Please let me know if you have any questions.

291 .

Chapter 5, C 6. CVS

(Dollars in millions)

Walgreens

2009

Net sales

$98,729

100.0%

$63,335

100.0%

Cost of sales

78,349

79.4%

45,722

72.2%

Gross margin

$20,380

20.6%

$17,613

27.8%

Total operating expenses

13,942

14.1%

14,366

22.7%

Income from operations

$ 6,438

6.5%

$ 3,247

5.1%

Inventories

$10,343

13.2%

$ 6,789

14.8%

These companies have very comparable operations. Walgreens has a higher gross margin than that of CVS, but has higher operating expenses that more than offset its advantage in gross margin. As a result, CVS is slightly more profitable because its income from operations is higher as a percentage of net sales than Walgreens'. Also, it appears that CVS manages its inventory better because of the lower percentage of inventories to cost of sales.

292 .

Chapter 5, C 7. 1.

Cost of goods sold recomputed 2011

Beginning inventory Purchases Less purchases allowances Purchases Freight-in

2010

$ 53,000

$200,000 15,000

$271,000 20,000

$185,000 19,000

$251,000 27,000

—

Net cost of purchases

204,000

278,000

Cost of goods available for sale Less ending inventory

$257,000 32,000

$278,000 53,000

Cost of goods sold

$225,000

An inventory loss of $25,000 appears to have occurred in 2011. The amount is the difference between the computed inventory level of $57,000 and the actual level of $32,000 shown by the physical inventory. If the actual inventory had been $57,000, the cost of goods sold for 2011 would have been $200,000 ($257,000 in cost of goods available for sale minus $57,000). Net income, therefore, would have been $50,000. The difference between 2010 and 2011 net income can be accounted for as follows: 2011 income before income taxes

$25,000

Manager's salary

$25,000 25,000

Inventory loss

$75,000

2010 income before income taxes

293 .

50,000

Chapter 5, C 7. (Continued) 2.

Possible reasons for the inventory loss suggested

The inventory loss could have occurred as the result of embezzlement or theft. Inventory may have been stolen by shoplifters, by the manager, or by salesclerks. The manager may have failed to record sales of inventory and kept the money paid for the goods because sales declined by $25,000. Perry should take several actions: (1) assume a more active role in managing the original store, including being physically present on a random schedule; (2) institute controls over cash receipts to ensure that they are recorded at the time of sale; (3) establish controls over inventory to prevent customers from leaving the premises without paying; and (4) conduct surprise counts (audits) of cash and inventory.

294 .

CHAPTER 6—Solutions INVENTORIES

Chapter 6, SE 1. 1.

3. d

4. b

5. a

Chapter 6, SE 2. Cost of Goods Sold

Inventory Turnover =

Average Inventory $2,200,000

$2,200,000

$520,000

$480,000 ) ÷ 2

4.2 Times

Number of Days in a Year

Days' Inventory = on Hand =

$560,000

(

Inventory Turnover 365

Days

4.2

Times

= 86.9 Days

Chapter 6, SE 3. Cost of Goods Sold

Inventory Turnover =

= Days' Inventory = on Hand =

Average Inventory $6,500,000 (

$1,780,000 $6,500,000 $1,610,000

$1,440,000

4.0 Times

Number of Days in a Year Inventory Turnover 365

Days

4.0

Times

= 91.3 Days 295

) ÷ 2

Chapter 6, SE 4. Specific identification method: Cost of goods available for sale

$1,370

Less ending inventory From August 8 purchase

( 30 units × $11 )

From August 22 purchase

( 25 units × $12 )

$330 300

630 $ 740

Cost of goods sold Chapter 6, SE 5. Average-cost method—periodic inventory system: Cost of goods available for sale

$1,370

Less ending inventory Average cost times units on hand $10.96 * = $603** 55 units ×

603 $ 767

Cost of goods sold * $1,370

÷ 125 units =

$10.96

** Rounded Chapter 6, SE 6. FIFO method—periodic inventory system: Cost of goods available for sale

$1,370

Less ending inventory From August 22 purchase

( 35 units × $12 )

From August 8 purchase

( 20 units × $11 )

$420 220

640 $ 730

Cost of goods sold Chapter 6, SE 7. LIFO method—periodic inventory system: Cost of goods available for sale

$1,370

Less ending inventory From beginning inventory

( 40 units × $10 )

From August 8 purchase

( 15 units × $11 )

565 $ 805

Cost of goods sold 296 .

$400 165

Chapter 6, SE 8. Periodic Inventory System Specific Identification Method

AverageCost Method

FIFO Method

LIFO Method

$630 740

$603 767

$640 730

$565 805

Ending inventory Cost of goods sold

The cost of goods sold figures range from $730 to $805, a difference of $75, or 10.3 percent. All the results are different. Because this is a period of rising prices, LIFO produces the highest cost of goods sold and will therefore produce the lowest net income and the lowest income taxes. LIFO also produces the lowest ending inventory valuation. The average-cost method produces results between LIFO and FIFO. Chapter 6, SE 9. Average-cost method—perpetual inventory system: Units Aug.

1 Inventory

Amount*

40 50

$10.00

90 (45)

10.56

45 35

10.56 11.19

28 Sale

80 (25)

11.19

$895 ( 280)

31 Inventory

11.18

$615

8 Purchase 8 Balance 15 Sale 15 Balance 22 Purchase 22 Balance

Cost of goods sold

( $475

$280 )

*Rounded

297 .

Cost per Unit* 11.00 10.56 12.00

$400 550 $950 ( 475) $475 420

$755

Chapter 6, SE 10. FIFO method—perpetual inventory system: Units 1 Inventory

Aug.

$10

8 Purchase

40 50

8 Balance

(40) ( 5)

10 11

22 Purchase

45 35

22 Balance

28 Sale

(25)

31 Inventory

$220

420

15 Sale 15 Balance

55 Cost of goods sold ( $455

$400 550

$950

($400) ( 55)

( 455) $495 420

12 $495 420

$915 ( 275)

$640 $730

+ $275 )

298 .

Cost per Unit

Chapter 6, SE 11. LIFO method—perpetual inventory system: Units Aug.

1 Inventory

$10

8 Purchase

40 50

8 Balance

10 11

15 Sale

50 (45)

15 Balance

10 11

22 Purchase

5 35

22 Balance

$400

11 12

28 Sale

35 (25)

55 420

31 Inventory

$400

120

$400 550

11 $400 550

11 $400 55

$950 ( 495) $455 420

$875 ( 300)

$575 $795

Cost of goods sold ( $495 + $300 )

299 .

Cost per Unit

Chapter 6, SE 12. Perpetual Inventory System

Ending inventory Cost of goods sold

Specific Identification Method

AverageCost Method

FIFO Method

LIFO Method

$630 740

$615 755

$640 730

$575 795

The cost of goods sold figures range from $730 to $795, a difference of $65, or 8.9 percent. All the results are different. Because this is a period of rising prices, LIFO produces the highest cost of goods sold and will therefore produce the lowest net income and the lowest income taxes. LIFO also produces the lowest ending inventory valuation. The average-cost method produces results between LIFO and FIFO.

300 .

Chapter 6, E 1. 1. It is both good and bad for a retail store to have a large inventory. It is good from the standpoint that customers want a large selection and they want the items to be available. It is bad from the standpoint that it is more costly to have a large inventory than a smaller inventory. In addition to storage and insurance costs, there is the cost of interest on money borrowed to finance the inventory. 2. The flow of costs is more important because inventory costing ignores the actual flow of goods and assumes a flow of costs. 3. For one thing, the value put on inventory has a direct dollar-for-dollar effect on net income. For another, it is relatively easy to falsify the value placed on the ending inventory and to cover up the falsification. 4. It probably is not. A reduction in the current period ending inventory amount, which results in a lower income, will cause the beginning inventory in the next period to be smaller and will thus increase income in that period. Chapter 6, E 2. 1. The four methods would produce the same results if there were no price changes after the purchase of the beginning inventory. 2. Under the perpetual inventory method, the cost of goods sold and the inventory balance are determined after every transaction. 3. In theory, the perpetual inventory method does not require a physical inventory because the amount of inventory is adjusted after each transaction. In practice, a good control is to periodically take a physical inventory to verify the balance in as the records. The gross profit method does require a physical inventory to match against the estimated inventory to determine the amount of the loss for which a physical inventory is not possible. Both the periodic and the retail methods require physical inventories.

301 .

Chapter 6, E 3. 1. 2. 3. 4. 5. 6. 7.

c d c b a b a

Chapter 6, E 4. Inventory Turnover =

2010 =

2011 =

Cost of Goods Sold Average Inventory $450,000 (

$81,000

$450,000 $75,000

$69,000 ) ÷ 2

6.0 Times

$480,000 (

$96,000

$480,000 $88,500

$81,000 ) ÷ 2

5.4 Times

Number of Days in a Year Days' Inventory = on Hand Inventory Turnover 2010 =

2011 =

365 Days 6.0 Times 365 Days 5.4 Times

60.8 Days

67.6 Days

Just a Buck Discount Stores' inventory is increasing much faster than its sales. As a result, the inventory turnover is decreasing and days' inventory on hand is increasing. This is a negative trend that will reduce profitability and require the company to commit more funds to inventories.

302 .

Chapter 6, E 5. 2011

2010

Sales Cost of goods sold Gross margin Operating expenses

$252,000 168,000

$210,000 90,000

$ 84,000 60,000

$120,000 60,000

Income before income taxes

$ 24,000

$ 60,000

The error in understating the ending inventory for 2010 will not affect the results for 2012. Chapter 6, E 6. According to the convention of consistency, a company must follow the same accounting principles from year to year. Thus, a change to FIFO would violate this convention. If the company does decide to change to FIFO, the full disclosure convention requires that the change be disclosed and the effects of the change described. Following the lower-of-cost-or-market rule for valuing inventory is a conservative method of accounting because it anticipates losses. Fewer adjustments will be anticipated in the future because under FIFO, the most recent prices, which are declining, are used to price inventory. As a result, this is a conservative inventory method in these circumstances as well. Under LIFO, the earlier higher prices in inventory needed to be adjusted downward.

303 .

Chapter 6, E 7. 1.

Inventory costs assigned by the specific identification method

June

15 Purchase

200 cases

@ $28

$ 5,600

Jan.

1 Inventory

100 cases

@ $23

2,300

Oct.

15 Purchase

100 cases

@ $28

Dec.

15 Purchase

100 cases

@ $30

2,800 3,000 $13,700

Cost of goods sold Ending inventory $18,275 2.

–

$13,700

$4,575

Inventory costs assigned by the average-cost method

Average unit cost:

$18,275

675

cases =

$27.07*

Cost of goods available for sale

$18,275

Less Dec. 31 inventory 4,737

175 cases × $27.07

$13,538

Cost of goods sold *Rounded 3.

Inventory costs assigned by the FIFO method

Cost of goods available for sale

$18,275

Less Dec. 31 inventory 100 cases @ $30 from Dec. 15 purchase 75 cases @ $28 from Oct. 15 purchase

$3,000 2,100

175 cases

5,100

Cost of goods sold

$13,175

Inventory costs assigned by the LIFO method

Cost of goods available for sale

$18,275

Less Dec. 31 inventory 125 cases @ $23 from Jan. 1 inventory 50 cases @ $26 from Feb. 25 purchase 175 cases

4,175 $14,100

Cost of goods sold 304 .

$2,875 1,300

Chapter 6, E 7. (Continued) In this period of rising prices, the FIFO method resulted in the highest value for inventory on the balance sheet and the lowest cost of goods sold on the income statement, bringing about the highest net income. The LIFO method resulted in the lowest value for inventory on the balance sheet and the highest value for cost of goods sold on the income statement, bringing about the lowest net income. The averagecost method falls between both measures. The specific identification method is randomly related to periods of changing prices. Chapter 6, E 8. 1. Cost of goods sold computed by FIFO method Year 1

Year 2

Year 3

— $117,600

$ 21,000 144,000

$ 24,000 150,000

Ending inventory

$117,600 21,000

$165,000 24,000

$174,000 30,000

Cost of goods sold

$ 96,600

$141,000

$144,000

Year 1

Year 2

Year 3

— $117,600

$ 21,000 144,000

$ 21,000 150,000

Ending inventory

$117,600 21,000

$165,000 21,000

$171,000 21,000

Cost of goods sold

$ 96,600

$144,000

$150,000

Beginning inventory Purchases Cost of goods available for sale

2. Cost of goods sold computed by LIFO method

Beginning inventory Purchases Cost of goods available for sale

Under the FIFO method, the ending inventory takes on the unit price of the purchases each year. Under the LIFO method, the ending inventory retains the original purchase price of $42 per unit in each of the three years, and the number of units in the ending inventory stays at 500 each year. As a result, cost of goods sold in years 2 and 3 equals purchases.

305 .

Chapter 6, E 9. 1,300 units × $60

Sales Beginning inventory Purchases

150 units × 400 units × 800 units × 300 units ×

$30 $33 $36 $39

1,650 units

Cost of goods available for sale

$78,000 $ 4,500 13,200 28,800 11,700 $58,200

Periodic inventory system—average-cost method: Sales

$78,000

Cost of goods sold Cost of goods available for sale Less ending inventory ( 350* units × Cost of goods sold

$35.27 ** )

$58,200 12,345 45,855 $32,145

Gross margin Periodic inventory system—FIFO method: Sales

$78,000

Cost of goods sold Cost of goods available for sale

$58,200

†

13,500

Less ending inventory

44,700

Cost of goods sold

$33,300

Gross margin * 1,650 units –

1,300 units

$58,200

1,650 units

= $35.27 (rounded)

†

300 units ×

$39

50 units ×

$36

350 units

$11,700 1,800 $13,500

306 .

Chapter 6, E 9. (Continued) Periodic inventory system—LIFO method: Sales Cost of goods sold Cost of goods available for sale Less ending inventory* Cost of goods sold

$78,000 $58,200 11,100 47,100 $30,900

Gross margin * 150 units × 200 units ×

$30 $33

= $ 4,500 6,600 = $11,100

The unit cost of merchandise rose steadily during the month of June. When prices are rising, LIFO results in the most recent (highest) costs being assigned to cost of goods sold and the earliest (lowest) costs being carried forward as inventory. As a result, the gross margin under LIFO was $2,400 ($33,300 – $30,900) less than it was under FIFO. The average-cost method falls between the other two methods.

307 .

Chapter 6, E 10. FIFO Method

LIFO Method

$2,400,000

$ 240,000

840,000 750,000

$1,830,000

Sales 120,000

× $20

Cost of goods sold Beginning inventory 20,000 × $12 Purchases 60,000 × $14 50,000 × $15 Cost of goods available for sale Less ending inventory FIFO

( 10,000

$15 )

150,000

LIFO

( 10,000

$12 )

_________ $1,680,000

$1,710,000

$ 720,000 550,000

$ 690,000 550,000

Income taxes expense (30%)

$ 170,000 51,000

$ 140,000 42,000

Net income

$ 119,000

Cost of goods sold Gross margin Operating expenses Income before income taxes

120,000

98,000

FIFO produces the higher reported net income, but from a cash flow standpoint, the only difference under FIFO and LIFO is the amount of income taxes paid (note that sales, purchases, and operating expenses are the same under both methods). Therefore, LIFO produces a more favorable cash flow of $9,000 ($51,000 – $42,000). The reason is that under LIFO, the most recent purchases (at $15) are included in cost of goods sold and deducted from sales instead of beginning inventory (at $12). As long as prices are increasing, LIFO usually results in lower income taxes and thus a better cash flow than FIFO does.

308 .

Chapter 6, E 10. (Continued) If a year-end purchase of 10,000 cases at $15 per case is made, the following will result: FIFO Method

LIFO Method

$2,400,000

× $12

$ 240,000

60,000

× $14

840,000

50,000

× $15

10,000

× $15

750,000 150,000

Cost of goods available for sale

$1,980,000

Sales 120,000

× $20

Cost of goods sold Beginning inventory 20,000 Purchases

Less ending inventory FIFO

( 20,000 × $15 )

300,000

LIFO

( 20,000 × $12 )

_________ $1,680,000

$1,740,000

$ 720,000 550,000

$ 660,000 550,000

Income taxes expense (30%)

$ 170,000 51,000

$ 110,000 33,000

Net income

$ 119,000

Cost of goods sold Gross margin Operating expenses Income before income taxes

240,000

77,000

The results under the FIFO method are the same with or without the purchase, but income taxes under LIFO are $9,000 less ($42,000 – $33,000) with the year-end purchase, and net income is $21,000 less ($98,000 – $77,000). The reason for this outcome under LIFO is that a LIFO liquidation is avoided by buying the 10,000 cases at the end of the year. In this way, all 20,000 cases of the LIFO beginning inventory at $12 per case are maintained as the ending inventory. Without this purchase, 10,000 units at $12 per case are included in the cost of goods sold because the ending inventory is below the beginning inventory level. Many companies using the LIFO method try to avoid letting the ending inventory fall below the beginning level to avoid paying increased income taxes.

309 .

Chapter 6, E 11. Perpetual inventory system—average-cost method Date June

Units

Cost*

Amount

150 400

$30.00

$ 4,500 13,200

550 800

32.18

1,350 (1,300)

34.44 34.44

$46,500 ( 44,772)

24 Purchase

50 300

34.56 39.00

$ 1,728 11,700

30 Inventory

350

$38.37

$13,428

1 Inventory 4 Purchase 4 Balance 12 Purchase 12 Balance 16 Sale 16 Balance

Sales**

33.00 36.00

$17,700 28,800

Cost of goods sold

$78,000 44,772

Gross margin

$33,228

* Rounded ** 1,300

$60

$78,000

310 .

Chapter 6, E 11. (Continued) Perpetual inventory system—FIFO method Date June

Units

Cost

Amount

1 Inventory 4 Purchase

150 400

$30.00

$ 4,500 13,200

4 Balance

150

30.00

400 800

33.00

150

30.00

400

33.00

800

36.00

(150)

30.00

(400) (750)

33.00 36.00

( 44,700)

20 Balance 24 Purchase

50 300

36.00

$ 1,800 11,700

30 Inventory

50 300

36.00

12 Purchase 12 Balance

16 Sale

350 Sales*

36.00

39.00

$17,700 28,800

$46,500

39.00 $13,500

Cost of goods sold

$78,000 44,700

Gross margin

$33,300

* 1,300

$60

= $78,000

311 .

33.00

Chapter 6, E 11. (Continued) Perpetual inventory system—LIFO method Date June

1 Inventory 4 Purchase 4 Balance 12 Purchase 12 Balance

16 Sale

16 Balance 24 Purchase 30 Inventory

Units

Cost

Amount

150 400

$ 4,500 13,200

150

$30.00 33.00 30.00

400 800

33.00 36.00

$17,700 28,800

150 400

30.00 33.00

800 (800) (400) (100)

36.00 36.00 33.00 30.00

( 45,000)

50 300

30.00 39.00

$ 1,500 11,700

50 300

30.00 39.00

350 Sales*

$46,500

$13,200

Cost of goods sold

$78,000 45,000

Gross margin

$33,000

* 1,300

$60

= $78,000

The difference in gross margin under FIFO and LIFO of $300 ($33,300 – $33,000) results from the difference in ending inventory under the two methods. Since prices rose from $30 to $39 per unit during the period, the LIFO method, which charges the most recent prices to cost of goods sold, resulted in the lowest gross margin from sales. The average-cost method produced a gross margin of $33,228, which is between those of FIFO and LIFO.

312 .

Chapter 6, E 12. Goods available for sale and ending inventory in units Units

Cost

Total

Beginning inventory

100

$ 4

$ 400

Purchase 1

320

Purchase 2

720

Purchase 3

Purchase 4

150 90

2,700 2,160

Goods available for sale

440

Sale in units

250

Ending inventory in units

190

313 .

$6,300

Chapter 6, E 12. (Continued) 1. Periodic inventory system a. Specific identification method: Sales

$8,000

Cost of goods available for sale

$6,300 3,200

Less ending inventory* Cost of goods sold

3,100

Gross margin

$4,900

* Purchase 1

40 units ×

$ 320

Purchase 2

60 units ×

$12

Purchase 4

90 units ×

$24

720 2,160 $3,200

b. Average-cost method: Sales Cost of goods available for sale Less ending inventory*

$8,000 $6,300 2,721

Cost of goods sold

3,579

Gross margin

$4,421

* Average cost 190 units ×

$6,300

$14.32

440

units = $14.32**

$2,721

** Rounded c. FIFO method: Sales

$8,000

Cost of goods available for sale

$6,300 3,960

Less ending inventory* Cost of goods sold

2,340

Gross margin

$5,660

* Purchase 4

90 units ×

$24

Purchase 3

100 units ×

$18

$2,160 1,800 $3,960

314 .

Chapter 6, E 12. (Continued) d. LIFO method: Sales

$8,000

Cost of goods available for sale

$6,300 1,320

Less ending inventory* Cost of goods sold

4,980

Gross margin

$3,020

* Beginning inventory

100 units × $ 4

$ 400

Purchase 1

40 units × $ 8

Purchase 2

50 units × $12

320 600 $1,320

2. Perpetual inventory system a. Average-cost method: Sales Cost of goods sold

$8,000 2,958

Gross margin

$5,042

Beginning inventory Purchase 1 Balance Purchase 2 Balance

Cost*

Amount*

100 40

$ 4.00

$ 400 320

140 60

5.14

200 150

Purchase 3 Balance

8.00 12.00 7.20 18.00

350 (250)

11.83 11.82

Purchase 4

100 90

Ending inventory

190

Sale Balance

* Rounded

315 .

Units

11.83 24.00 17.59

$ 720 720 $1,440 2,700 $4,140 ( 2,958) $1,182 2,160 $3,342

Chapter 6, E 12. (Continued) b. FIFO method: Sales Cost of goods sold*

$8,000 2,340

Gross margin

$5,660

* Sale 1 From beginning inventory

100

units

$ 4

$ 400

From purchase 1

units

$ 8

320

From purchase 2

60 50

units

$12

units units

$18

720 900

From purchase 3

250

Cost of goods sold Ending inventory

$6,300

–

$2,340

$3,960

c. LIFO method: Sales Cost of goods sold*

$8,000 3,740

Gross margin

$4,260

* Sale 1 From purchase 3

150

units

$18

$2,700

From purchase 2

60 40

units

$12

units units

$ 8

720 320

From purchase 1

250

Cost of goods sold Ending inventory

$6,300

–

$3,740

316 .

$2,560

$3,740

Chapter 6, E 13. 1.

Ending inventory estimated by retail method Cost

Retail

Beginning inventory

$ 40,000

$ 60,000

Net purchases (excluding freight-in)

140,000 10,400

220,000 _______

$190,400

$280,000

Freight-in Goods available for sale Ratio of cost to retail price:

$190,400

= 68%

$280,000

250,000

Net sales during the period

$ 30,000

Estimated ending inventory at retail Ratio of cost to retail

68% $ 20,400

Estimated cost of ending inventory 2.

Loss estimated

Estimated cost of ending inventory

$20,400

Physical inventory at retail

$18,000

Ratio of cost to retail

68%

Estimated cost of physical inventory

12,240

Estimated cost of inventory shrinkage

$ 8,160

Chapter 6, E 14. Beginning inventory at cost Purchases at cost (including freight-in of $27,400)

$ 90,000 587,400

Cost of goods available for sale

$677,400

Less estimated cost of goods sold: Sales at selling price Less estimated gross margin of 40% Estimated cost of goods sold

540,000

Estimated loss of inventory in fire

$137,400

317 .

$900,000 360,000

Chapter 6, P 1. 1.

Schedule of cost of goods available for sale prepared

Units

Price

Total Cost

34,000

$11.00

$ 374,000

February

40,000

12.00

$ 480,000

March

80,000

12.40

992,000

May

60,000

12.60

756,000

July

100,000

12.80

1,280,000

September

12.60

November

80,000 30,000

1,008,000 390,000

Total purchases

390,000

$4,906,000

424,000

$5,280,000

Beginning inventory Purchases

Cost of goods available for sale

13.00

Income before income taxes computed

a. Average-cost method: Sales

$7,860,000 393,000

$20

Cost of goods sold Cost of goods available for sale

$5,280,000

(see schedule) 385,950

Less ending inventory*

4,894,050

Cost of goods sold Gross margin Selling and administrative expenses

$2,965,950 2,551,000

Income before income taxes

$ 414,950

* Cost of goods available for sale Divided by total units available

Cost per unit

$5,280,000 424,000 $12.45 **

Multiplied by units in ending inventory ( 424,000 Ending inventory

–

393,000 )

31,000 $385,950

** Rounded. 318 .

Chapter 6, P 1. (Continued) b. FIFO method: Sales Cost of goods sold Cost of goods available for sale (see schedule) Less ending inventory* Cost of goods sold Gross margin Selling and administrative expenses

$7,860,000

$5,280,000 402,600 4,877,400 $ 2,982,600 2,551,000 $

Income before income taxes * November purchases ( 30,000 units x $13.00 September purchases 1,000 units x $12.60 ( Ending inventory

431,600

) $390,000 )

12,600 $402,600

c. LIFO method: Sales Cost of goods sold Cost of goods available for sale (see schedule) Less ending inventory* Cost of goods sold Gross margin Selling and administrative expenses

$7,860,000

$5,280,000 341,000 4,939,000 $ 2,921,000 2,551,000 $

Income before income taxes *

31,000 units from beginning inventory

319 .

$11.00

$341,000

370,000

Chapter 6, P 1. (Continued) 3.

User Insight: Key ratios computed and discussed Average-Cost

FIFO

LIFO

Cost of goods sold

$4,894,050

$4,877,400

$4,939,000

Average inventory

$379,975

$388,300

$357,500

$385,950

( Inventory turnover

$402,600

12.9 times ( $4,894,050

Days' inventory on hand

$374,000 ) ÷ 2 (

$379,975 )

12.6 times ( $4,877,400

28.3 days ( 365 days

12.9 times )

+ $374,000 ) ÷ 2 ( ÷

$388,300 )

365 days

12.6 times )

$374,000 ) ÷ 2

13.8 times ( $4,939,000

29.0 days (

$341,000

$357,500 )

26.4 days (

365 days

13.8 times )

In periods of rising prices, the LIFO method will always result in a higher inventory turnover and lower days' inventory on hand. When comparing inventory ratios for two or more companies, the inventory methods used by the companies should be considered.

320 .

Chapter 6, P 2. 1.

Periodic inventory system—average-cost method

April 1 beginning inventory

Units

Unit Price*

Amount

$204.00

$10,200

100

220.00

22,000

150

214.67

$32,200

214.67

12,880

Purchase April 10 Cost of goods available for sale Sale 90

April 17

April 30 ending inventory*

$19,320

Cost of goods sold for April May 1 beginning inventory

Units

Unit Price

Amount

May 2

100

$216

$21,600

May 14

50 60

224

11,200 14,040

$214.67

$12,880

Purchases

May 22

234

Cost of goods available for sale

210 270

46,840 221.19

$59,720

221.19

15,483

Sale 200

May 30

May 31 ending inventory*

$44,237

Cost of goods sold for May *Rounded.

321 .

Chapter 6, P 2. (Continued) 2.

Periodic inventory system—FIFO method

April 1 beginning inventory

Units

Unit Price

Amount

$204

$10,200

100

220

22,000

Purchase April 10 Cost of goods available for sale

150

$32,200

Sale 90

April 17

April 30 ending inventory*

220

13,200 $19,000

Cost of goods sold for April *From purchase on April 10. May 1 beginning inventory

Units

Unit Price

Amount

May 2

100

$216

$21,600

May 14

50 60

224

11,200 14,040

$220

$13,200

Purchases

May 22

234

Cost of goods available for sale

210

46,840

270

$60,040

Sale 200

May 30

16,280

May 31 ending inventory*

$43,760

Cost of goods sold for May * May 22 purchase

(

units

$234 )

May 14 purchase

(

units

$224 )

$14,040 2,240 $16,280

Total

322 .

Chapter 6, P 2. (Continued) 1. 3. Periodic inventory system—LIFO method

April 1 beginning inventory Purchase April 10 Cost of goods available for sale Sale April 17

Units

Unit Price

Amount

$204

$10,200

100

220

22,000

150

$32,200

90 60

April 30 ending inventory*

12,400 $19,800

Cost of goods sold for April *April 1 beginning inventory ( 50 units x $204 ) $10,200 April 10 Purchase 2,200 ( 10 units x $220 ) $12,400 Total May 1 beginning inventory Unit Units Price

$12,400

Purchases $21,600 May 2 100 $216 11,200 May 14 50 224 14,040 60 May 22 234 Cost of goods available for sale Sale May 30

210

46,840

270

$59,240

May 31 ending inventory*

Amount

*April 1 beginning inventory ( 50 units x $204

)

$10,200

April 10 purchase ( 10 units x

$220

)

2,200

May 2 purchase ( 10 units x

$216

)

2,160 $14,560 323

14,560 $44,680

Cost of goods sold for May

Total

200

Chapter 6, P 2. (Continued) 4. User Insight: Effects on cash flows discussed The inventory costing method chosen by a company does not affect cash flows from operations from the purchase and sale of goods because the amount actually paid for the purchases or the amount for which goods are sold is the same regardless of the method used. The purpose of the inventory costing method is to assign the costs that have been incurred. However, the amount of cash paid for income taxes can differ under the methods because they affect the computation of taxable income, which will differ depending on the inventory costing method used.

324 .

Chapter 6, P 3. 1.

Perpetual inventory system—average-cost method Date

Apr.

1 Beginning inventory 10 Purchase 10 Balance 17 Sale 30 Ending inventory

May

2 Purchase 2 Balance 14 Purchase 14 Balance 22 Purchase 22 Balance 30 Sale

Units

Cost*

Amount*

50 100

$204.00

$10,200 22,000

150 ( 90)

214.67

60 100

214.67

160 50

215.50

210 60

217.52

270 (200)

221.19

31 Ending inventory

220.00 214.67 216.00 224.00 234.00 221.19 221.19

$32,200 ( 19,320) $12,880 21,600 $34,480 11,200 $45,680 14,040 $59,720 ( 44,237) $15,483

*Rounded. Cost of goods sold for April equals the total cost of the sale made on April 17, or $19,320. Cost of goods sold for May equals the total cost of the sale made on May 30, or $44,237.

325 .

Chapter 6, P 3. (Continued) 2.

Perpetual inventory system—FIFO method Date

Apr.

1 Beginning inventory 10 Purchase 10 Balance

Cost

Amount

50 100

$204 220 204 220 204 220 220 216 220 216 224 220 216 224 234 220 216 224 234 220 216 224 224 234

$10,200 22,000

50 100 ( 50) ( 40)

17 Sale 30 Ending inventory 2 Purchase 2 Balance

May

Units

60 100 60 100 50

14 Purchase 14 Balance

60 100 50 60

22 Purchase 22 Balance

60 100 50 60 ( 60) (100) ( 40)

30 Sale

31 Ending inventory

10 60 70

$32,200 ( 19,000) $13,200 21,600 $34,800 11,200

$46,000 14,040

$60,040

( 43,760)

$16,280

Cost of goods sold for April equals the total cost of the sale made on April 17, or $19,000. Cost of goods sold for May equals the total cost of the sale made on May 30, or $43,760.

326 .

Chapter 6, P 3. (Continued) 3.

Perpetual inventory system—LIFO method Date

Apr.

1 Beginning inventory 10 Purchase 10 Balance

Cost

Amount

50 100

$204 220 204 220 220 204 220 216 204 220 216 224 204 220 216 224 234 204 220 216 224 234 234 224 216 204 220

$10,200 22,000

50 100 ( 90)

17 Sale 30 Ending inventory May

Units

50 10 100

2 Purchase 2 Balance

50 10 100 50

14 Purchase 14 Balance

50 10 100 50 60

22 Purchase 22 Balance

50 10 100 50 60 ( 60) ( 50) ( 90)

30 Sale

31 Ending inventory

50 10 10 70

$32,200 ( 19,800) $12,400 21,600

$34,000 11,200

$45,200 14,040

$59,240

( 44,680)

216 $14,560

Cost of goods sold for April equals the total cost of the sale made on April 17, or $19,800. Cost of goods sold for May equals the total cost of the sale made on May 30, or $44,680. 327 .

Chapter 6, P 3. (Continued) 4. User Insight: Inventory valuation discussed In a long period of rising prices, how realistic the inventory value of the balance sheet is will depend on the inventory method used by the company. For instance, if the company uses the average method, the inventory should reflect the average price paid over the past year. If the LIFO method is used, the inventory prices will likely reflect lower prices paid many years before. If the FIFO method is used, the inventory will reflect the most recent prices. Thus, FIFO ending inventory will reflect the most realistic current prices, and LIFO ending inventory will reflect the oldest and most unrealistic prices.

328 .

Chapter 6, P 4. 1.

Month-end inventory at cost estimated

Beginning inventory

Cost

Retail

$102,976

$148,600

143,466

217,000

Net purchases for the period: Purchases Purchases returns and allowances

(

Freight-in

$244,256

Goods available for sale Ratio of cost to retail price:

4,086) 1,900

$244,256 $359,200

(

6,400) _______

$359,200

= 68%

Net sales during the period: Sales

$218,366

Sales returns and allowances

(

Net sales

$216,500

1,866)

$142,700

Estimated ending inventory at retail 68%

Ratio of cost to retail Estimated cost of ending inventory $142,700 2.

x 68% =

$ 97,036

October 31 physical inventory $124,900

x 68% =

Estimated inventory shortage at cost and retail

User Insight: Retail method discussed

84,932

124,900

$ 12,104

$ 17,800

The retail method is an efficient way for companies to operate because sales employees in many locations can take the inventory in their store or outlet simply by recording the retail price of all the goods at their location. They don't need to know the cost, which can be estimated by the home office.

329 .

Chapter 6, P 5. 1. Inventory loss estimated Rudy Brothers Schedule to Estimate Inventory Destroyed April 22, 2010 Beginning inventory at cost

$363,700.00

Purchases at cost

$603,050.00

Purchases returns

(

Freight-in

2,676.50) 13,275.00 613,648.50

Net purchases Cost of goods available for sale

$977,348.50

Less estimated cost of goods sold Sales

$989,762.50 ( 7,450.00)

Sales returns Net sales

$982,312.50 432,217.50

Less estimated gross margin of 44% Estimated cost of goods sold

550,095.00

Estimated cost of ending inventory Less merchandise in showroom

$427,253.50 100,740.00

Estimated loss of inventory in fire

$326,513.50

2. User Insight: Reasons for estimating inventory Management may want to estimate the cost of inventory for interim reports or estimate the amount of inventory lost or destroyed by theft or other hazards. Insurance companies often estimate inventories to verify loss claims.

330 .

Chapter 6, P 6. 1.

Schedule of cost of goods available for sale prepared

Units 34,000

$11.00

Total Cost $ 374,000

February

40,000

12.00

$ 480,000

March

80,000

12.40

992,000

May

60,000

12.60

756,000

July

100,000

12.80

1,280,000

September

12.60

November

80,000 30,000

1,008,000 390,000

Total purchases

390,000

$4,906,000

424,000

$5,280,000

Beginning inventory

Price

Purchases

Cost of goods available for sale 2.

13.00

Income before income taxes computed

a. Average-cost method: Sales

$7,860,000 393,000

$20

Cost of goods sold Cost of goods available for sale

$5,280,000

(see schedule) 385,950

Less ending inventory*

4,894,050

Cost of goods sold Gross margin Selling and administrative expenses

$2,965,950 2,551,000

Income before income taxes

$ 414,950

* Cost of goods available for sale Divided by total units available

Cost per unit

$5,280,000 424,000 $

12.45 **

Multiplied by units in ending inventory ( 424,000 Ending inventory

–

31,000

393,000 ) ×

$ 385,950

** Rounded 331 .

Chapter 6, P 6. (Continued) b. FIFO method: Sales

$7,860,000

Cost of goods sold Cost of goods available for sale (see schedule)

$5,280,000 402,600

Less ending inventory*

4,877,400

Cost of goods sold Gross margin Selling and administrative expenses

$2,982,600 2,551,000

Income before income taxes

$ 431,600

* November purchases ( 30,000 units × $13.00

) $390,000

September purchases 1,000 units × $12.60

(

Ending inventory

12,600

)

$402,600

c. LIFO method: Sales

$7,860,000

Cost of goods sold Cost of goods available for sale (see schedule)

$5,280,000 341,000

Less ending inventory*

4,939,000

Cost of goods sold Gross margin Selling and administrative expenses

$2,921,000 2,551,000

Income before income taxes

$ 370,000

31,000 units from beginning inventory

332 .

$11.00

$341,000

Chapter 6, P 6. (Continued) 3.

User Insight: Financial ratios computed and discussed Average-Cost

FIFO

LIFO

Cost of goods sold

$4,894,050

$4,877,400

$4,939,000

Average inventory

$379,975

$388,300

$357,500

(

$385,950

Inventory turnover

$374,000

) ÷ 2

(

$402,600

12.9 Times (

$4,894,050

Days' inventory on hand

+ ÷

$379,975

$374,000

) ÷ 2

(

12.6 Times )

(

$4,877,400

28.3 Days ( 365 Days

12.9 Times

(

365 Days

$388,300 ) 12.6 Times

$374,000

( $4,939,000

$357,500 )

26.4 Days )

(

365 Days

13.8 Times

333 .

) ÷ 2

13.8 Times

29.0 Days )

$341,000

)

Chapter 6, P 7. 1.

Periodic inventory system—average-cost method

April 1 beginning inventory

Units

Unit Price*

Amount

$204.00

$10,200

100

220.00

22,000

150

214.67

$32,200

214.67

12,880

Purchase April 10 Cost of goods available for sale Sale 90

April 17

April 30 ending inventory*

$19,320

Cost of goods sold for April May 1 beginning inventory

Units

Unit Price

Amount

May 2

100

$216

$21,600

May 14

50 60

224

11,200 14,040

$214.67

$12,880

Purchases

May 22

234

Cost of goods available for sale

210 270

46,840 221.19

$59,720

221.19

15,483

Sale 200

May 30

May 31 ending inventory*

$44,237

Cost of goods sold for May *Rounded

334 .

Chapter 6, P 7. (Continued) 2.

Periodic inventory system—FIFO method

April 1 beginning inventory

Units

Unit Price

Amount

$204

$10,200

100

220

22,000

Purchase April 10 Cost of goods available for sale

150

$32,200

Sale 90

April 17

April 30 ending inventory*

220

13,200 $19,000

Cost of goods sold for April *From purchase on April 10 May 1 beginning inventory

Units

Unit Price

Amount

May 2

100

$216

$21,600

May 14

50 60

224

11,200 14,040

$220

$13,200

Purchases

May 22

234

Cost of goods available for sale

210

46,840

270

$60,040

Sale 200

May 30

16,280

May 31 ending inventory*

$43,760

Cost of goods sold for May * May 22 purchase

(

units

$234 )

May 14 purchase

(

units

$224 )

$16,280

Total

335 .

$14,040 2,240

Chapter 6, P 7. (Continued) 3.

Periodic inventory system—LIFO method

April 1 beginning inventory Purchase April 10

Units 50

Unit Price $204

Amount $10,200

100

220

22,000

Cost of goods available for sale Sale April 17

150

April 30 ending inventory*

$32,200

90 12,400 $19,800

Cost of goods sold for April *April 1 beginning inventory ( 50 units × $204 ) April 10 purchase ( 10 units × $220 )

$10,200 2,200 $12,400

Total May 1 beginning inventory Unit Units Price

$12,400

210

46,840

270

$59,240

Amount

Purchases $21,600 May 2 100 $216 11,200 May 14 50 224 14,040 60 May 22 234 Cost of goods available for sale Sale

200

May 30

May 31 ending inventory*

$44,680

Cost of goods sold for May *April 1 beginning inventory ( 50 units × $204

)

$10,200

April 10 purchase ( 10 units ×

$220

)

2,200

May 2 purchase ( 10 units ×

$216

)

2,160 $14,560

Total

336 .

14,560

Chapter 6, P 7. (Continued) 4. User Insight: Effects on cash flows discussed The inventory costing method chosen by a company does not affect cash flows from operations from the purchase and sale of goods because the amount actually paid for the purchases or the amount for which goods are sold is the same regardless of the method used. The purpose of the inventory costing method is to assign the costs that have been incurred. However, the amount of cash paid for income taxes can differ under the methods because they affect the computation of taxable income, which will differ depending on the inventory costing method used.

337 .

Chapter 6, P 8. 1.

Perpetual inventory system—average-cost method Date

Apr.

1 Beginning inventory 10 Purchase 10 Balance 17 Sale 30 Ending inventory

May

2 Purchase 2 Balance 14 Purchase 14 Balance 22 Purchase 22 Balance 30 Sale

Units

Cost*

Amount*

50 100

$204.00

$10,200 22,000

150 ( 90)

214.67

60 100

214.67

160 50

215.50

210 60

217.52

270 (200)

221.19

31 Ending inventory

220.00 214.67 216.00 224.00 234.00 221.19 221.19

$32,200 ( 19,320) $12,880 21,600 $34,480 11,200 $45,680 14,040 $59,720 ( 44,238) $15,482

*Rounded Cost of goods sold for April equals the total cost of the sale made on April 17, or $19,320. Cost of goods sold for May equals the total cost of the sale made on May 30, or $44,238.

338 .

Chapter 6, P 8. (Continued) 2.

Perpetual inventory system—FIFO method Date

Apr.

1 Beginning inventory 10 Purchase 10 Balance

Cost

Amount

50 100

$204 220 204

$10,200 22,000

220 204

$32,200

220 220

( 19,000)

50 100 ( 50) ( 40)

17 Sale

May

Units

30 Ending inventory 2 Purchase 2 Balance

60 100

14 Purchase 14 Balance

22 Purchase 22 Balance

30 Sale

31 Ending inventory

60 100 50

216 220 216 224

60 100

220 216

50 60

224 234

220

100 50

216 224

60 ( 60)

234 220

(100) ( 40)

216 224 224 234

10 60 70

$13,200 21,600 $34,800 11,200

$46,000 14,040

$60,040

( 43,760)

$16,280

Cost of goods sold for April equals the total cost of the sale made on April 17, or $19,000. Cost of goods sold for May equals the total cost of the sale made on May 30, or $43,760.

339 .

Chapter 6, P 8. (Continued) 3.

Perpetual inventory system—LIFO method Date

Apr.

1 Beginning inventory 10 Purchase 10 Balance

Cost

Amount

50 100

$204 220 204 220 220 204 220 216 204 220 216 224 204 220 216 224 234 204 220 216 224 234 234 224 216 204 220

$10,200 22,000

50 100 ( 90)

17 Sale 30 Ending inventory May

Units

50 10 100

2 Purchase 2 Balance

50 10 100 50

14 Purchase 14 Balance

50 10 100 50 60

22 Purchase 22 Balance

50 10 100 50 60 ( 60) ( 50) ( 90)

30 Sale

31 Ending inventory

50 10 10 70

$32,200 ( 19,800) $12,400 21,600

$34,000 11,200

$45,200 14,040

$59,240

( 44,680)

216 $14,560

Cost of goods sold for April equals the total cost of the sale made on April 17, or $19,800. Cost of goods sold for May equals the total cost of the sale made on May 30, or $44,680. 340 .

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Chapter 6, P 8. (Continued) 4. User Insight: Inventory valuation discussed In a long period of rising prices, how realistic the inventory value of the balance sheet is will depend on the inventory method used by the company. For instance, if the company uses the average-cost method, the inventory should reflect the average price paid over the past year. If the LIFO method is used, the inventory prices will likely reflect lower prices paid many years before. If the FIFO method is used, the inventory will reflect the most recent prices. Thus, FIFO ending inventory will reflect the most realistic current prices, and LIFO ending inventory will reflect the oldest and most unrealistic prices. Inventory turnover ratios would normally be higher under LIFO than they would under FIFO. The reason for this is that the denominator in computing inventory turnover is the average value of the inventory during the year. LIFO normally has lower values than FIFO does.

341 .

Chapter 6, P 9. 1.

Month-end inventory at cost estimated

Beginning inventory

Cost

Retail

$ 51,488

$ 74,300

71,733

108,500

Net purchases for the period: Purchases Purchases returns and allowances

(

2,043) 950

Freight-in

$122,128

Goods available for sale Ratio of cost to retail price:

(

$122,128 $179,600

3,200) — $179,600

= 68%

Net sales during the period: $109,183

Sales (

Sales returns and allowances

933) $108,250

Net sales Estimated ending inventory at retail

$ 71,350 68%

Ratio of cost to retail Estimated cost of ending inventory $71,350 2.

× 68% =

$ 48,518

August 31 physical inventory $62,450

42,466

× 68% =

Estimated inventory shortage at cost and retail

User Insight: Retail method discussed

6,052

62,450 $

8,900

342 .

Chapter 6, P 10. 1. Inventory loss estimated Pearly Tooth Corporation Schedule to Estimate Inventory Destroyed May 5, 2011 Beginning inventory at cost

$ 727,400

Purchases at cost

$1,206,100

Purchases returns

(

Freight-in

5,353) 26,550 1,227,297

Net purchases Cost of goods available for sale

$1,954,697

Less estimated cost of goods sold Sales

$1,979,525 ( 14,900)

Sales returns Net sales Less estimated gross margin of 48%

$1,964,625 943,020

Estimated cost of goods sold

1,021,605

Estimated cost of ending inventory Less merchandise in showroom

$ 933,092 201,480

Estimated loss of inventory in fire

$ 731,612

2. User Insight: Reasons for estimating inventory Management may want to estimate the cost of inventory for interim reports or estimate the amount of inventory lost or destroyed by theft, fire, or other hazards. Insurance companies often estimate inventories to verify loss claims.

343 .

Chapter 6, C 1. Since JCPenney's inventory turnover is 3.4, its average inventory on hand is about 107 days compared to Dell's, which is about 7 days. This is a big business advantage to Dell because Dell does not incur the cost of maintaining an inventory for about 100 days less than JCPenney does. Further, it customizes its computers to what customers want at the moment and avoids the problem of inventory obsolescence, or having more inventory than people want. Comparison among companies is important because it enables the management of the companies to benchmark themselves against other well-managed companies. Dell's inventory management provides a challenge to JCPenney's management, but it is probably not the best match because although they both sell to the end customer, the nature of their businesses is very different. JCPenney must display inventory for customers to see and try on and is subject to seasonal fashions. It would be more useful to compare JCPenney with a company like Sears. Using supply-chain management in a just-in-time operating environment allows companies to use technology to attempt to reduce their levels of inventory. Under supply-chain management, a company uses the Internet for business-tobusiness (B2B) e-commerce to manage its inventory and purchasing. In a justin-time operating environment, the company uses supply-chain management to work closely with suppliers to coordinate and schedule shipments so that goods arrive just in time as they are needed. This strategy has enabled Dell to become one of the most efficient companies in history.

344 .

Chapter 6, C 2. 1.

The effect of an overstatement of ending merchandise inventory is to overstate the reported net income (or reduce the net loss) of the business. In the case of Crazy Eddie, the overstatement of inventory by $52 million means that income before income taxes had been overstated (or losses understated) in prior accounting periods by $52 million.

Yes, it would be expected in a company that is experiencing financial difficulty. An overstatement of ending inventory is a way in which a company can cover up disappointing results and inflate the reported net income. This is possible because the amount of the overstatement is a cost that is carried forward to future accounting periods as an asset (inventory) rather than being charged as part of cost of goods sold in the current period. In fact, Crazy Eddie was experiencing severe operating losses prior to the takeover by the new management team. The discovery of the missing inventory required an immediate write-down of the inventory cost by $52 million and the reporting of a corresponding loss on the income statement. A further investigation should have been conducted to determine what really happened to the $52 million in merchandise inventory. Was the shortfall caused by bookkeeping errors, or was there an actual physical loss?

Chapter 6, C 3. LIFO—or last-in, first-out—is an inventory pricing method that transfers the costs of the most recent purchases to cost of goods sold while retaining the costs of the earliest purchases in ending inventory. It represents an assumption about cost flows that usually does not correspond to the actual flow of goods. Since the costs of the most recent purchases, which are charged against revenues through cost of goods sold, are usually higher in times of rising prices, the reported income and the resulting cash outflow from income taxes is lower. The opposite effects result in times of declining prices. These tendencies explain the difference in the inventory costing methods used by the chemical and computer industries since an important motivation in both industries is to reduce income taxes. Although costs fluctuate in the chemical industry, the long-term trend is upward. Thus, LIFO will generally enable companies in this industry to pay less in income taxes. In the computer industry, however, costs have headed downward for many years as a result of technological advances; so LIFO is not the most appropriate method to use.

345 .

Chapter 6, C 4. The LCM rule resulted in a write-down in the first year of $325 million because the market value of the inventory was $325 million less than cost under the LIFO costing method. The inconsistency between the two years is that in the first year when the market value was down, income was reduced by the amount that cost exceeded market value. However, in the next year when market value exceeded the LIFO cost, income was not increased by the amount that market value exceeded cost. This inconsistency is a prime example of the application of the accounting convention of conservatism, which states that losses (cost exceeds market) are recorded, but gains (market exceeds cost) are not recorded until a definite transaction occurs. If prices decline enough in the third year so that market falls below cost, another write-down would appear on the income statement. Chapter 6, C 5. A company like ExxonMobil may choose LIFO because management believes that LIFO is more closely tied to the reality that goods must be replaced when sold and that LIFO may result in lower income taxes. When the most recent cost of a good is charged against the sales price, an amount approximating replacement cost is used. In periods of rising prices, the cost of the most recent purchase will be higher than the costs of earlier purchases, resulting in a lower income before income taxes. Consequently, in this situation, income taxes will be less under LIFO. Thus, although the actual transactions during the year (sales, net purchases, operating expenses, and so on) are the same, income taxes will be less if LIFO is used. In recent years, oil prices have been going up, which would be advantageous under LIFO.

346 .

Chapter 6, C 6. CVS uses the lower-of-FIFO-cost-or-market rule as determined by the retail inventory method. When there are no changes in prices, LIFO and FIFO will produce the same results. This is the case with CVS. It is unlikely that very much of the inventory is valued at market. Market value would normally come into play for CVS if it bought inventory that it was unable to sell at regular prices but had to sell at prices below cost. The retail inventory method is ideal for retail companies that use a standard markup on each item of merchandise inventory. Employees can take the physical inventory by recording quantity and selling prices. These data can then be converted to cost by the company's accountants. The inventory turnover slightly decreased, from 8.1 times in 2008 to 8.0 times in 2009, resulting in a slight increase in days' inventory on hand of 0.5 day. CVS's Inventory Turnover (dollar amounts in millions): Cost of Goods Sold

Inventory Turnover =

2009 =

Average Inventory $78,349 (

$78,349

2008 =

$10,343

$9,748

$9,153

8.0 Times

) ÷ 2

$69,182 (

$9,153 $69,182 $8,581

$8,008

8.1 Times

) ÷ 2

CVS's Days' Inventory on Hand Days' Inventory on Hand = t

2009 = 2008 =

347 .

Number of Days in a Year Inventory Turnover 365 Days 8.0 Times 365 Days 8.1 Times

45.6 Days

45.1 Days

Chapter 6, C 7. 1. Inventory turnover and days' inventory on hand calculated (dollar amounts in millions)

CVS's Inventory Turnover (from C 6): 2009

8.0 times

2008

8.1 times

CVS's Average Days' Inventory on Hand (from C 6): 2009

45.6 days

2008

45.1 days

Walgreens' Inventory Turnover: Cost of Goods Sold

Inventory Turnover = 2009 =

Average Inventory $45,722 (

$45,722

= 2008 =

$6,789

$7,019

$7,249

6.5 Times

) ÷ 2

$42,391 (

$7,249 $42,391 $7,020

$6,790

6.0 Times

) ÷ 2

Walgreens' Days' Inventory on Hand: Days' Inventory on Hand = t

2009 = 2008 =

Number of Days in a Year Inventory Turnover 365 Days 6.5 Times 365 Days 6.0 Times

56.2 Days

60.8 Days

2. Inventory ratios discussed CVS's inventory turnover slightly decreased from 8.1 times in 2008 to 8.0 times in 2009, but Walgreens' inventory turnover increased from 6.0 times in 2008 to 6.5 times in 2009. The most important conclusion to draw is that CVS makes more efficient use of inventory as measured by its inventory turnovers. It only had to finance inventory for 45.6 days in 2009, whereas Walgreens had to finance its inventory for 56.2 days, a difference of about 10 days. 348 .

Chapter 6, C 8. Because the goods ordered by The Executive Woman have not been separated, they will be included in the inventory count on December 31. If the auditors do not detect this situation, the 2011 ending inventory will be overstated. This overcounting, combined with the inclusion of the sale in 2011, will lead to an overstatement of 2011 income before income taxes by the amount of the cost of the inventory not separated for shipment. This overstatement will lead, in turn, to an understatement of 2012 income before income taxes because the 2012 beginning inventory will be overstated by the amount of the shipment. Lutz's action not only was unethical, but also is an example of fraudulent financial reporting, or deliberate misstatement of financial records.

349 .

Chapter 6, C 9. 1.

Income statements and balance sheets prepared RT Company Income Statement For the Month Ended July 31, 2011 (a) FIFO

(b) LIFO

Sales Cost of goods sold Gross margin Operating expenses Income before income taxes Income taxes expense (40%)

$195,000 150,000

$195,000 160,000

$ 45,000 15,000

$ 35,000 15,000

$ 30,000 12,000

$ 20,000 8,000

Net income

$ 18,000

$ 12,000

(a) FIFO

(b) LIFO

$400 18 ____ $418

$400 12 ____ $412

RT Company Balance Sheet July 31, 2011 (All figures in thousands) Assets Cash* Inventory Total assets

(a) FIFO

(b) LIFO

$258 160 ____ $418

$262 150 ____ $412

Stockholders' Equity Common stock Retained earnings Total stockholders' equity

Since there was a rise in the cost of the product, the LIFO method produces a lower net income and a lower asset value for inventory.

* Cash balance, July 1 Add receipt: sale of truck Deduct payments: Inventory purchases

$150 160

Operating expenses Subtotal Income taxes paid Cash balance, July 31 350 .

$310 15

(a) FIFO

(b) LIFO

$400 195

$595

325

$270 12

$270 8

$258

$262

Chapter 6, C 9. (Continued) 2.

Dividend policy discussed

In the FIFO case, a dividend of $18,000 would be declared. This transaction would reduce cash and retained earnings by the same amount. In the LIFO case, a dividend exactly equal to net income would reduce Cash and Retained Earnings by $12,000. After payment of the dividend, the balance sheets under FIFO and LIFO would appear as follows: RT Company Balance Sheet July 31, 2011 (All figures in thousands) Assets

Stockholders' Equity FIFO

LIFO

Inventory

$240 160

$250 150

Total assets

$400

Cash

FIFO

LIFO

Common stock

$400

Total stockholders'

____ $400

equity

Compared with the beginning of the month, RT still has $400,000 in assets and $400,000 in stockholders' equity, but the composition of the assets has changed. On July 31, RT has assets of $240,000 in cash and one truck worth $160,000 in the FIFO case and assets of $250,000 in cash and one truck worth $150,000 in the LIFO case. Under this dividend policy and the FIFO method, the company has shrunk more of its liquid assets by returning part of them to the stockholders. Economically, the company is less well off using the FIFO method. It is for this reason that some authorities believe that in periods of generally rising prices, the LIFO method should be used. The LIFO method is also more realistic in representing RT's income because it matches the more current costs against revenues.

351 .

Chapter 6, C 9. (Continued) 3.

Consequences of additional price increase discussed

A further increase in cost compounds the problem discussed in 2 . The question is whether management should declare cash dividends equal to net income under the LIFO method when the business must pay more to replenish its inventory. A going concern must have inventory in order to stay in business. Some authorities would argue that a profit has not been made until the inventory has been replaced. Thus, the proper figure to use in determining cost of goods sold and valuing inventory, according to these authorities, is replacement cost—in this case, $170,000. The company's board of directors should pay a dividend of only $10,000 less income taxes (sales of $195,000 – replacement cost of goods sold of $170,000 – expenses of $15,000 = $10,000; $10,000 – taxes of $4,000 = $6,000). (For purposes of illustration, it is assumed here that replacement cost is acceptable for income tax purposes.) Under these assumptions, the company would have $260,000 in cash plus one truck after the dividend and taxes were paid. In this way, the company can pay $170,000 for another truck in the next accounting period and be equally well off. (Note: We have not considered the complicated question of whether the company can raise selling prices to its customers to partially or totally offset the increases in the cost of the trucks.)

352 .

CHAPTER 7—Solutions CASH AND RECEIVABLES Chapter 7, SE 1. 1. c (also could be a) 2. a 3. b 4. d Chapter 7, SE 2. a. Net Sales

Receivable Turnover =

Average Accounts Receivable $720,000 (

$90,000 $720,000 $80,000

$70,000

9.0 Times

b. Days' Sales = Uncollected =

Days in a Year Receivable Turnover 365 Days 9.0 Times

353 .

= 40.6 Days

) ÷ 2

Chapter 7, SE 3. a. Net Sales

Receivable Turnover =

Average Accounts Receivable $1,080,000 ( $135,000 $1,080,000 $117,500

$100,000 ) ÷ 2

9.2 Times

b. Days in a Year

Days' Sales = Uncollected =

Receivable Turnover 365 Days 9.2 Times

= 39.7 Days

Chapter 7, SE 4. Currency and coins on hand

Deposits in checking accounts U.S. Treasury bills

1,500 15,000

Cash and cash equivalents

$16,750

250

Chapter 7, SE 5. Balance per bank, April 30 Add deposits in transit

$7,294.15 981.36

Less outstanding checks

$8,275.51 4,543.33

Adjusted bank balance, April 30

$3,732.18

Balance per books, April 30 Add interest income

$3,719.22 12.96

Adjusted book balance, April 30

$3,732.18

354 .

Chapter 7, SE 6. Balance per bank, June 30 Add deposits in transit

$4,862.77 654.24

Less outstanding checks

$5,517.01 3,028.89

Adjusted bank balance, June 30

$2,488.12

Balance per books, June 30 Add interest income

$2,479.48 8.64

Adjusted book balance, June 30

$2,488.12

Chapter 7, SE 7. Oct.

31 Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense $750,000 × 0.01 = $7,500

7,500 7,500

Chapter 7, SE 8. a. Sept. 30 Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense $129,000 – $27,000 = $102,000 b. Sept. 30 Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense $129,000 + $21,000 = $150,000

355 .

102,000 102,000

150,000 150,000

Chapter 7, SE 9. a. June

30 Uncollectible Accounts Expense Allowance for Uncollectible Accounts

68,000 68,000

To record estimated uncollectible accounts expense $86,000

–

$18,000

= $68,000

b. June

30 Uncollectible Accounts Expense Allowance for Uncollectible Accounts

100,000 100,000

To record estimated uncollectible accounts expense $86,000

$14,000

= $100,000

Chapter 7, SE 10. Before Write-Off

After Write-Off

Allowance for uncollectible accounts

$25,400 4,900

$23,200 2,700

Net accounts receivable

$20,500

Accounts receivable

Net accounts receivable is the same before and after the write-off.

356 .

Chapter 7, SE 11. a. Maturity date:

November 23

Days remaining in August (31 – 25) Days in September

6 30

Days in October Days in November

31 23

Total days

b. Interest at maturity:

$443.84

Rate of Interest

Principal

$20,000

× 9 / 100 ×

c. Maturity value:

Time

90 / 365 =

Interest $443.84

$20,443.84

Principal

Interest

= Maturity Value

$20,000.00

$443.84

$20,443.84

– Chapter 7, SE 12. a. Maturity date:

June 19

Days remaining in March (31 – 21) Days in April

Days in May Days in June

31 19

Total days

b. Interest at maturity:

$517.81

Rate of Interest

Principal

$30,000

× 7 / 100 ×

c. Maturity value:

Time

Interest

90 / 365 =

$517.81

$30,517.81

Principal

Interest

= Maturity Value

$30,000.00

$517.81

$30,517.81

357 .

Chapter 7, E 1. 1.

Seasonal businesses have varying needs for cash throughout the year. These include toy companies, college textbook publishers, amusement parks, construction companies, and sports equipment companies. Businesses whose need for cash is relatively stable over the year would include grocery stores, drugstores, and fast-food restaurants.

The primary advantage when a company finances its receivables is improved financial flexibility (cash flows).

The results of increasing credit terms from 15 to 30 days are a smaller receivable turnover and more average days to collect. These changes occur because average accounts receivable increases relative to sales. The change will have an adverse effect on cash flows because, on average, the company will have to wait longer to receive cash from sales.

A decreasing receivable turnover and an increasing days' sales uncollected from period to period, especially in the absence of changes in credit policies or economic conditions, might mean that management is underestimating the amount of losses from uncollectible amounts. If underestimating of uncollectibles enabled management to receive cash bonus awards, the actions would be unethical.

Chapter 7, E 2. 1.

The matching rule is violated by the direct charge-off method because uncollectible accounts expense is recorded in an accounting period different from the one in which the sale takes place.

Both Allowance for Uncollectible Accounts and Accumulated Depreciation are contra-asset accounts, but their purposes are different. Allowance for Uncoltible Accounts serves to value accounts receivable at its net realizable value. On the other hand, Accumulated Depreciation shows how much of the cost of plant and equipment has been allocated as an expense to previous accounting periods. It does not serve to value plant assets at net realizable value.

An accrual of interest income is not required if the interest income earned as of the end of the period was received on the last day of the accounting period.

358 .

Chapter 7, E 3. 1. 2. 3. 4. 5. 6. 7. 8. 9.

a b b (also could be a) c (also could be a) d a b (also could be a) b (also could be d) b

Chapter 7, E 4. Key Ratios: Net Sales

a. Receivable Turnover =

Average Accounts Receivable $3,200,000 $400,000

(

$3,200,000 $380,000

$360,000 ) ÷ 2

8.4 Times

Days in a Year

b. Days' Sales = Uncollected =

Receivable Turnover 365 Days 8.4 Times

= 43.5 Days

Chapter 7, E 5. Currency and coins on hand

Money orders from customers Deposits in checking accounts U.S. Treasury bills

10,000 64,000 180,000

Cash and cash equivalents

$259,600

Note: The remaining items are short-term investments.

359 .

5,600

Chapter 7, E 6. Balance per bank, May 31 Add deposits in transit

$35,510.88 4,509.62

Less outstanding checks

$40,020.50 15,636.32

Adjusted bank balance, May 31

$24,384.18

Balance per books, May 31 Less bank service charge

$24,423.88 39.70

Adjusted book balance, May 31

$24,384.18

Chapter 7, E 7. Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense $3,787,500 × 0.008

30,300 30,300

The balance of Allowance for Uncollectible Accounts after this adjustment is $36,750 ($30,300 + $6,450). Chapter 7, E 8. a.

Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense and bring the allowance account to a balance of $1,675 ( $1,675 – $200 )

1,475

Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense and bring the allowance account to a balance of $1,675 ( $1,675 + $200 )

1,875

1,475

1,875

The balance of Allowance for Uncollectible Accounts after each of these adjustments is the same, $1,675.

360 .

Chapter 7, E 9. 1. T accounts prepared to determine ending balances: Accounts Receivable Bal.

215,000

Collections

1,475,000

Credit sales

1,600,000

Write-offs

17,500

Bal.

322,500 Allowance for Uncollectible Accounts

Write-offs

17,500

Bal.

1,800

Bal.

15,700

2. a. Percentage of net sales method applied Adjusting entry: Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense $1,600,000 $22,400 × 0.014 =

361 .

22,400 22,400

Chapter 7, E 9. (Continued) Balance sheet presentation: Accounts receivable Less allowance for uncollectible accounts

$322,500 20,600

Accounts receivable, net

$301,900

Allowance for Uncollectible Accounts Write-offs

17,500

Bal. Adjustment

15,700

Bal.

20,600

22,400

2. b. Aging of accounts receivable method applied Adjusting entry: Uncollectible Accounts Expense

21,150

Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense Estimated uncollectible accounts

21,150

$19,350

Debit balance in Allowance for Uncollectible Accounts

1,800

Uncollectible accounts expense

$21,150

Balance sheet presentation: Accounts receivable Less allowance for uncollectible accounts

$322,500 19,350

Accounts receivable, net

$303,150

Allowance for Uncollectible Accounts Write-offs

17,500

Bal.

15,700

Adjustment

21,150

Bal.

19,350

362 .

Chapter 7, E 10. a.

Percentage of net sales method: Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense for the year $5,700,000 × 0.015 = $85,500

85,500 85,500

The balance of Allowance for Uncollectible Accounts after this adjustment is $61,500 ( $85,500 – $24,000 ) . b.

Accounts receivable aging method: Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense for the year $70,000 + $24,000 = $94,000

94,000 94,000

The balance of Allowance for Uncollectible Accounts after this adjustment is $70,000 ( $94,000 – $24,000 ) . c.

The results are different because these are estimation methods. They would not be expected to be exactly the same. The aging of accounts receivable method is usually considered more reliable because it is a direct valuation method that can take into account current conditions. For example, the percentage of net sales method does not directly take into account the debit balance in the allowance account, which may have resulted from changed conditions or the quality of the accounts receivable.

363 .

Chapter 7, E 11. Journal entries for uncollectible accounts prepared a.

Percentage of net sales method: 31 Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense $2,300,000 × 0.014 = $32,200

July

The resulting balance of Allowance for Uncollectible Accounts is $3,400 ). ( $32,200 –

32,200 32,200

$28,800

If the beginning balance of Allowance for Uncollectible Accounts had been a credit, the entry would have been the same, but the resulting balance would have been $35,600 $3,400 ) . ( $32,200 + b.

Accounts receivable aging method: 31 Uncollectible Accounts Expense Allowance for Uncollectible Accounts To record estimated uncollectible accounts expense (The debit balance in the allowance account must be added to the estimated uncollectible accounts.) $30,000 $3,400 = $33,400 +

July

The resulting balance of Allowance for Uncollectible Accounts is $3,400 ). ( $33,400 –

33,400 33,400

$30,000

If the beginning balance of Allowance for Uncollectible Accounts was a credit, the entry would be $26,600 ( $30,000 – $3,400 ), but the ending balance would have been the same, or $30,000 ( $26,600 $3,400 + c.

364 .

Chapter 7, E 12. Accounts Receivable Bal. Sale

130,000 14,400 Collection

Bal.

139,600 Write-off

Bal.

4,800 9,600

130,000 Allowance for Uncollectible Accounts

Write-off

Bal.

12,800

Bal.

3,200

9,600

Before Write-Off

After Write-Off

Accounts receivable Allowance for uncollectible accounts

$139,600 12,800

$130,000 3,200

Net accounts receivables

$126,800

Chapter 7, E 13. a. b.

$38,760 $27,200

c. d. e.

$30,600 $51,000 $18,360

90 / 365 60 / 365 × 9 / 100 × 30 / 365 × 15 / 100 × 120 / 365 × 6 / 100 × 60 / 365 × 10 / 100 × × 12 / 100 ×

365 .

= $955.73 = $536.55 = $226.36 = $2,515.07 = $181.08

Chapter 7, E 14. Maturity date:

May 16

Days remaining in February (28 – 15) Days in March

Days in April Days in May

30 16

Total days

Interest at maturity:

$1,775.34 Rate of Interest

Principal

$72,000

× 10 /

Maturity value: Principal

100

Time

90 / 365

Interest

= $1,775.34

$73,775.34 +

Interest

= Maturity Value

######### +

$1,775.34

$73,775.34

Chapter 7, E 15. Maturity date:

March 1

Days remaining in December (31 – 1) Days in January

Days in February Days in March

28 1

Total days

– Interest in 2011:

$147.95 Rate of Interest

Principal

$15,000

× 12 /

Interest in 2012:

Time

Interest

30 / 365

$147.95

Time

Interest

60 / 365

$295.89

$295.89 Rate of Interest

Principal

$15,000

× 12 /

Maturity value: Principal

100

$15,443.84 +

Interest

= Maturity Value

######### +

$443.84

$15,443.84

366

Chapter 7, E 16. a. January 5, accepted a 60-day, 10% note for $2,400 Maturity date: March 6 Days remaining in January (31 – 5)

Days in February

28 – 6

Days in March

Total days Interest at maturity:

$39.45 Rate of Interest

Principal

$2,400

× 10 / 100 ×

Maturity value:

Time

= Interest

60 / 365 =

$39.45

$2,439.45

Principal

Interest

= Maturity Value

$2,400.00

$39.45

$2,439.45

b. March 9, accepted a 60-day, 12% note for $1,500 Maturity date: May 8 Days remaining in March (31 – 9)

Days in April Days in May

30 – 8

Total days

– 60

Interest at maturity:

$29.59 Rate of Interest

Principal

$1,500

× 12 / 100 ×

Maturity value:

Time

60 / 365 =

$1,529.59

Principal

Interest

= Maturity Value

$1,500.00

$29.59

$1,529.59

367 .

= Interest $29.59

Chapter 7, P 1. 1. Bank reconciliation prepared Unique Globe, Inc. Bank Reconciliation May 31, 2010 Balance per bank, May 31

$53,451.46

Add: Deposit in transit

$ 5,220.94

Check of another company mistakenly 750.00

deducted by bank

5,970.94

Less outstanding checks

$59,422.40 3,936.80

Adjusted bank balance, May 31

$55,485.60

Balance per books, May 31

$43,784.16

Add: Note receivable collected by bank

$12,000.00

Interest on note collected by bank

200.00 250.00

Interest on average balance

12,450.00 $56,234.16

Less: Check recorded incorrectly in check register Bank service charge

540.00 30.00 178.56

NSF check of Eve Lay

748.56 $55,485.60

Adjusted book balance, May 31

368 .

Chapter 7, P 1. (Continued) 2.

Journal entries prepared

2010 May 31 Cash Notes Receivable Interest Income Note and interest collected by bank

12,200.00 12,000.00 200.00

31 Cash Interest Income Interest on average bank account balance

250.00

31 Merchandise Inventory Cash To correct an incorrect entry for purchase of merchandise $1,920 – $1,380 = $540

540.00

31 Bank Service Charges Expense Cash Bank service charge for May

30.00

31 Accounts Receivable Cash NSF check of Eve Lay returned by bank

178.56

250.00

540.00

30.00

178.56

The adjusted cash balance of $55,485.60 should appear on the balance sheet.

User Insight: Importance of bank reconciliation discussed

A bank reconciliation is a necessary internal control because certain events and items — for example, a note receivable collected by bank, interest income on a note, interest income, overstatement of deposits, collection fees, NSF checks, or service charges — which are unknown on internal book records, must be updated to reflect current data. As an outside record, the bank statement provides a check on the internal accounting records of the company.

369 .

Chapter 7, P 2. 1.

T accounts prepared and data entered Accounts Receivable

Bal.

640,000 (b) Sales returns and allowances

(a) Credit sales

Collections from customers

2,104,000 (c)

106,800 1,986,000

(d) Write-offs Bal.

39,600

611,600 Allowance for Uncollectible Accounts

(d) Write-offs

39,600

Bal.

6,200

Bal.

33,400

Uncollectible Accounts Expense and ending balance of Allowance for Uncollectible Accounts determined

Percentage of net sales method: Uncollectible Accounts Expense

Net credit sales

= (

Allowance for Uncollectible Accounts

Accounts Receivable, Net

$2,104,000

$49,930

$43,730

$611,600

$567,870

x 2.5 percent – $106,800 ) x

–

$6,200

–

$43,730

$6,200

–

$48,000

0.025

Accounts receivable aging method: Uncollectible Accounts Expense

$48,000

$54,200

Allowance for Uncollectible Accounts

$48,000

Accounts Receivable, Net

$611,600

$563,600

370 .

Chapter 7, P 2. (Continued) 3.

Receivable turnover and days' sales uncollected calculated Receivable Turnover =

†

$611,600 $640,000 Rounded

– –

$48,000 $33,400

$106,800

$563,600 * + $606,600 **) ÷

(

$1,997,200 $585,100

Days' Sales Uncollected = * **

–

$2,104,000

= =

= 3.4 times 365 days 3.4 times

107.4 days†

$563,600 $606,600

User Insight: Difference in methods and rationales discussed

Because the percentage of net sales method and the accounts receivable aging method are both estimates and are based on different assumptions, it is expected that they would differ in their effects. Also, the amount of Uncollectible Accounts Expense under the accounts receivable aging method depends partially on how good the estimates of losses were in the prior year because the amount of expense is affected by the current balance of Allowance for Uncollectible Accounts, which in this case has a debit balance. Underlying the percentage of net sales method is the assumption that the best way to estimate uncollectible accounts is to consider a portion of every sales dollar to be an amount that will not be collected. This is known as an income statement approach. Underlying the accounts receivable aging method is the assumption that the best way to estimate uncollectible accounts is to consider the portion of the accounts receivable now existing that may not be collected. This is a balance sheet approach.

371 .

Chapter 7, P 3. 1. Aging analysis completed Ciao Style Store Aging Analysis of Accounts Receivable January 31, 2011

Total

Not Yet Due

1–30 Days Past Due

31–60 Days Past Due

61–90 Days Past Due

Over 90 Days Past Due

$793,791

$438,933

$149,614

$106,400

$57,442

$41,402

Customer Account Balance Forward J. Kras

11,077

T. Lopez

9,314

L. Zapal

8,664

R. Caputo

780

E. Rago

14,710

S. Smith

6,316 4,389

4,389

_______

$849,041

$452,636

$175,401

$115,064

$63,758

$42,182

A. Quinn

11,077 9,314 8,664 780 14,710 6,316

2. End-of-year balances computed Accounts Receivable Beginning balance Credit sales

$ 442,341 3,722,000

Subtotal

$4,164,341

Less: Sales returns and allowances

Accounts written off

60,000 44,300 3,211,000

Collections from customers

3,315,300 $ 849,041

Ending balance Allowance for Uncollectible Accounts Beginning credit balance

43,700 44,300

600

Less accounts written off Debit balance at end of year

372 .

Chapter 7, P 3. (Continued) 3. Analysis of estimated uncollectible accounts prepared Ciao Style Store Estimated Uncollectible Accounts January 31, 2011

Amount

Percentage Considered Uncollectible

Allowance for Uncollectible Accounts

Not yet due

$452,636

$ 9,052.72

1–30 days past due

175,401

8,770.05

31–60 days past due

115,064

17,259.60

61–90 days past due

63,758 42,182

15,939.50 21,091.00

Over 90 days past due

$849,041

$72,112.87

4. Uncollectible accounts expense calculated Desired balance Debit balance in allowance account

$72,113 600

Amount of expense

$72,713

5. User insight: Role of estimates discussed Estimates play an important role in applying the aging analysis method. Businesses analyze their accounts receivable history to determine the estimated percentage uncollectible in each category. These percentages are multiplied by the amount in each category in order to determine the estimated, or target, balance of Allowance for Uncollectible Accounts. Factors that might affect these estimates include the length of history used when analyzing accounts receivable, credit policy, current economy, regional layoffs, and seasonal factors.

373 .

Chapter 7, P 4.

1. Maturity date, interest on the note, and maturity value for each note determined May 3, accepted $30,000, 90-day, 12% note receivable Maturity date:

August 1

Days remaining in May (31 – 3) Days in June Days in July Days in August

28 30 31 – 1

Total days

– 90

Interest at maturity:

$887.67

Principal

Rate of Interest

$30,000

12 / 100 x

Maturity value:

Time

Interest

90 / 365 =

$887.67

$30,887.67

Principal

Interest

= Maturity Value

$30,000.00

$887.67

$30,887.67

May 16, accepted $16,000, 60-day, 13% note receivable Maturity date:

July 15

Days remaining in May (31 – 16) Days in June Days in July

15 30 – 15

Total days

– 60

Interest at maturity:

$341.92

Principal

Rate of Interest

$16,000

13 / 100 x

Maturity value:

Time

Interest

60 / 365 =

$341.92

$16,341.92

Principal

Interest

= Maturity Value

$16,000.00

$341.92

$16,341.92

374 .

Chapter 7, P 4. (Continued) May 31, accepted $15,000, 90-day, 11% note receivable Maturity date:

August 29

Days remaining in May (31 – 31) Days in June Days in July Days in August

– – –

Total days

0 30 31 29 90

Interest at maturity: $406.85 Rate of Interest

Principal

$15,000

x 11 / 100 x

Time

Interest

90 / 365 =

$406.85

Maturity value: $15,406.85 Principal

Interest

= Maturity Value

$15,000.00

$406.85

$15,406.85

2. Interest income on June 30 reported Accrued interest income as of June 30 Date of Note

Rate of Interest

Principal

May 3 May 16 May 31

$30,000 $16,000 $15,000

x 12 / 100 x x 13 / 100 x x 11 / 100 x

Time

– Interest

58 / 365 45 / 365 30 / 365

$572.05 256.44 135.62

$964.11 3. User Insight: Cash flow effect discussed Since interest income on these notes receivable will not be received until maturity, the cash flow impact on June 30 is zero.

375 .

Chapter 7, P 5. 1. Bank reconciliation prepared Lotus Lake, Inc. Bank Reconciliation May 31, 2011 Balance per bank, May 31

$53,451.46

Add: Deposit in transit

$ 5,220.94

Check of another company mistakenly deducted 750.00

by bank

5,970.94

Less outstanding checks

$59,422.40 3,936.80

Adjusted bank balance, May 31

$55,485.60

Balance per books, May 31

$43,784.16

Add: Note receivable collected by bank

$12,000.00

Interest on note collected by bank

200.00 250.00

Interest on average balance

12,450.00 $56,234.16

Less: Check recorded incorrectly in check register Bank service charge

540.00 30.00 178.56

NSF check of Justin Curtis

748.56 $55,485.60

Adjusted book balance, May 31

376 .

Chapter 7, P 5. (Continued) 2.

Journal entries prepared

2011 May 31 Cash Notes Receivable Interest Income To record note and interest collected by bank

12,200.00 12,000.00 200.00

31 Cash Interest Income To record interest on average bank account balance

250.00

31 Equipment Cash To correct an incorrect entry for purchase of equipment $1,920 – $1,380 = $540

540.00

31 Bank Service Charges Expense Cash To record bank service charge for May

30.00

31 Accounts Receivable Cash To record NSF check of Justin Curtis returned by bank

178.56

250.00

540.00

30.00

178.56

The adjusted cash balance of $55,485.60 should appear on the balance sheet.

User Insight: Importance of bank reconciliation discussed

A bank reconciliation is a necessary internal control because certain events and items—for example, a note receivable collected by a bank, interest income on a note, interest income, overstatement of deposits, collection fees, NSF checks, or service charges—which are unknown on internal book records, must be updated to reflect current data. As an outside record, the bank statement provides a check on the internal accounting records of the company.

377 .

Chapter 7, P 6. 1.

T accounts prepared and data entered Accounts Receivable

Bal. Credit sales

640,000

Sales returns and allowances

106,800

2,104,000

Collections from customers

1,986,000

Write-offs Bal.

39,600

611,600 Allowance for Uncollectible Accounts

(d) Write-offs

39,600

Bal.

6,200

Bal.

33,400

Uncollectible accounts expense and ending balance of Allowance for Uncollectible Accounts determined

Percentage of net sales method: Uncollectible Accounts Expense = Net Credit Sales × 0.025 = ( $2,104,000 – $106,800 ) × 0.025 = $49,930

Allowance for Uncollectible Accounts = $49,930

– $6,200

= $43,730 Accounts Receivable, Net = $611,600

– $43,730

= $567,870 b.

Accounts receivable aging method: Uncollectible Accounts Expense = $48,000

+ $6,200

= $54,200 Allowance for Uncollectible Accounts = $48,000 Accounts Receivable, Net = $611,600 = $563,600

378 .

– $48,000

Chapter 7, P 6. (Continued) 3.

Receivable turnover and days' sales uncollected calculated Receivable Turnover =

(

$2,104,000

–

$563,600 * +

$606,600

$1,997,200 $585,100

* $611,600 ** $640,000 4.

– –

$48,000 $33,400

= =

**) ÷

= 3.4 Times 365 Days

Days' Sales Uncollected =

$106,800

3.4 Times

107.4 Days

$563,600 $606,600

User Insight: Difference in methods and rationales discussed

Because the percentage of net sales method and the accounts receivable aging method are both estimates and are based on different assumptions, it is expected that they would differ in their effects. Also, the amount of uncollectible accounts expense under the accounts receivable aging method depends partially on how good the estimates of losses were in the prior year because the amount of expense is affected by the current balance of Allowance for Uncollectible Accounts, which in this case has a debit balance. Underlying the percentage of net sales method is the assumption that the best way to estimate uncollectible accounts is to consider a portion of every sales dollar to be an amount that will not be collected. This is known as an income statement approach. Underlying the accounts receivable aging method is the assumption that the best way to estimate uncollectible accounts is to consider the portion of the accounts receivable now existing that may not be collected. This is a balance sheet approach.

379 .

Chapter 7, P 7. 1. Aging analysis completed Fossella Fashions Aging Analysis of Accounts Receivable January 31, 2011

Total

Not Yet Due

1–30 Days Past Due

31–60 Days Past Due

61–90 Days Past Due

Over 90 Days Past Due

$793,791

$438,933

$149,614

$106,400

$57,442

$41,402

Customer Account Balance Forward K. Baker

11,077

L. Dawson

9,314

Z. Kopara

8,664

C. Mural

780

R. Otis

14,710

B. Softy

6,316 4,389

4,389

_______

$849,041

$452,636

$175,401

$115,064

$63,758

$42,182

T. Wilson

11,077 9,314 8,664 780 14,710 6,316

2. End-of-year balances computed Accounts Receivable Beginning balance Credit sales

$ 442,341 3,722,000

Subtotal

$4,164,341

Less: Sales returns and allowances Accounts written off

60,000

44,300 3,211,000

Collections from customers

3,315,300 $ 849,041

Ending balance Allowance for Uncollectible Accounts Beginning credit balance

43,700 44,300

600

Less accounts written off Debit balance at end of year

380 .

Chapter 7, P 7. (Continued) 3. Analysis of estimated uncollectible accounts prepared Fossella Fashions Estimated Uncollectible Accounts January 31, 2011

Amount

Percentage Considered Uncollectible

Allowance for Uncollectible Accounts

Not yet due

$452,636

$ 9,052.72

1–30 days past due

175,401

8,770.05

31–60 days past due

115,064

17,259.60

61–90 days past due

63,758 42,182

15,939.50 21,091.00

Over 90 days past due

$849,041

$72,112.87

4. Uncollectible accounts expense calculated Desired balance Debit balance in allowance account

$72,113 600

Amount of expense

$72,713

381 .

Chapter 7, P 8. 1.

Maturity date, interest on the note, and maturity value for each note determined

March 3, accepted $60,000, 90-day, 10% note receivable Maturity date:

June 1

Days remaining in March (31 – 3)

Days in April

Days in May Days in June

31 – 1

Total days

– 90

Interest at maturity:

$1,479.45

Principal

Rate of Interest

$60,000

10 / 100 ×

Maturity value:

Time

Interest

90 / 365 = $1,479.45

$61,479.45

Principal

Interest

= Maturity Value

$60,000.00

$1,479.45

$61,479.45

March 16, accepted $32,000, 60-day, 11% note receivable Maturity date:

May 15

Days remaining in March (31 – 16)

Days in April Days in May

30 – 15

Total days

– 60

Interest at maturity:

$578.63

Principal

Rate of Interest

$32,000

11 / 100 ×

Maturity value:

Time

Interest

60 / 365 =

$578.63

$32,578.63

Principal

Interest

= Maturity Value

$32,000.00

$578.63

$32,578.63

382 .

Chapter 7, P 8. (Continued) March 31, accepted $30,000, 90-day, 9% note receivable Maturity date:

June 29

Days remaining in March (31 – 31)

Days in April

Days in May

– 31 – 29 – 90

Days in June Total days Interest at maturity:

$665.75

Principal

Rate of Interest

$30,000

9 / 100 ×

Maturity value:

Time

Interest

90 / 365 =

$665.75

$30,665.75

Principal

Interest

= Maturity Value

$30,000

$665.75

$30,665.75

2. Interest income on April 30 reported Accrued interest income as of April 30 Date of Note

Rate of Interest

Principal

March 3

$60,000

March 16

$32,000

March 31

$30,000

× 10 / 100 × × 11 / 100 × × 9 / 100 ×

Time

58 / 365 45 / 365 30 / 365

– Interest $ 953.42 433.97 221.92 $1,609.31

3. User Insight: Cash flow effect discussed Since interest income on these notes receivable will not be paid until maturity, the cash flow impact on June 30 is zero.

383 .

Chapter 7, C 1. Mitsubishi established the generous credit terms of 14 months without interest and payments because management felt that such terms would increase sales dramatically. Customers could make large purchases without emptying their pockets. There are three main costs to Mitsubishi. First, a credit department and billing operation are needed to handle the new credit customers. The small fee charged to the dealer will help cover that cost. Second, there is an implicit interest cost associated with carrying the no-interest receivables until the following September. Third, there is the cost of uncollectible accounts. In accordance with the matching rule, each year Mitsubishi will need to estimate the amount of unlectible accounts that will arise from these credit sales and record it as an adjusting entry. Chapter 7, C 2. Estimates are necessary in accounting for receivables because not all the receivables will be collected. To comply with the matching rule, an estimated loss of uncollectible accounts expense must be recognized in the year in which the sales are made. If CompuCredit had used the industry average for the estimated losses, it would have recognized uncollectible accounts expense of 7 percent of $1.3 billion in accounts receivable, or $91,000,000, instead of 10 percent, or $130,000,000. Thus, its income would have been $39,000,000 more. The best gauge as to whether estimates are reasonable is past experience with the same type of accounts. This can change, of course, if conditions change, such as when a recession occurs. CompuCredit should monitor the losses it experiences carefully and be prepared to increase its allowance for uncollectible accounts if it appears that losses will exceed 10 percent. Chapter 7, C 3. The financing alternatives available to Gerard for raising the needed cash are as follows: 1. 2. 3.

Pledge the accounts receivable against a loan from the bank. Sell or factor the accounts receivable. Sell or discount the notes to the bank or to another source.

Since Gerard sells its appliances to large, established customers, the accounts and notes receivable, which total $12 million, should provide adequate security to raise the needed $10 million in cash. Gerard might also be able to improve its cash situation by offering more attractive terms for early payment, such as a sales discount (for example, 2/10, n/60). 384

Chapter 7, C 4. The receivable turnover ratios of Fosters and Heineken reveal that Fosters generally has more generous credit terms than Heineken does because it allows its customers a longer time to pay. By computing the days' sales uncollected, it is possible to determine how long it takes on average for the companies to collect a receivable. This ratio is computed by dividing the number of days in a year by the receivable turnover. This measure for Fosters is 93.6 days and 81.1 days and for Heineken is 54.5 and 59.8 days for 2008 and 2009, respectively. Although days' sales uncollected for Fosters are decreasing, it takes Fosters longer to collect a receivable than it does Heineken. Thus, proportionately, Fosters has more capital tied up in its receivables. However, it is not possible to determine which company has the better credit policy because the companies operate in different countries where the business practices may need to be compared to the business practices of other companies in the same industry. It is possible to say that Fosters' receivable turnover showed more improvement than Heineken's.

385 .

Chapter 7, C 5. 1. Financial ratios computed (dollar amounts in thousands) 2011

2010

2009

Ratio of Uncollectible Accounts Expense To Net Sales* To Accounts Receivable

$30,000 $9,820,000 $30,000 $1,046,000

= 0.31%

= 2.9%

$33,400 $9,730,000 $33,400 $1,048,000

= 0.34%

= 3.2%

$31,600 $9,888,000 $31,600 $1,008,000

= 0.32%

= 3.1%

Ratio of Allowance for Uncollectible Accounts To Accounts Receivable

$37,200 $1,046,000

= 3.6%

$42,400 $1,048,000

*Two decimal places needed to show any difference

386 .

= 4.0%

$49,000 $1,008,000

= 4.9%

Chapter 7, C 5. (Continued) 2. Receivable turnover and days' sales uncollected calculated Net Sales

Receivable Turnover =

Average Accounts Receivable

(Note: The net accounts receivable needs to be calculated for 2011, 2010, and 2009.) 2011 =

$9,820,000 (

$9,820,000

2010 =

$1,006,900

Days' Sales Uncollected =

2011 =

2010 =

2009 =

(

$1,005,600 $9,730,000 $982,300

$1,005,600

9.8 Times

) ÷ 2

$959,000

9.9 Times

) ÷ 2

$9,888,000 (

$982,300 $9,888,000 $956,150

$930,000

= 10.3 Times

Days in a Year Receivable Turnover 365 Days 9.8 Times 365 Days 9.9 Times 365 Days 10.3 Times

387 .

$9,730,000

2009 =

$1,008,200

= 37.2 Days

= 36.9 Days

= 35.4 Days

) ÷ 2

Chapter 7, C 5. (Continued) 3.

Ratios interpreted

Apparently, management thinks collections will improve in 2011 (due perhaps to an improved economy) because the percentage of estimated uncollectible accounts expense in relation to both net sales and accounts receivable has decreased in 2011. Thus, the ratio of allowance for uncollectible accounts to accounts receivable has decreased from 4.9 percent in 2009 to 3.6 percent in 2011. This opinion is also supported by the fact that the net accounts written off in total for the three years exceed the total provisions made for uncollectible accounts expense. However, perhaps management has been underestimating the amounts that are uncollectible. The receivable turnover has deteriorated slowly but steadily over the past three years, and it now takes an additional 1.8 days to collect the average account (37.2 days versus 35.4 days). All of these are negative trends that must be watched carefully in 2012.

388 .

Chapter 7, C 6. 1.

CVS had $1,086 million in cash and cash equivalents in 2009. It is likely that most of this amount is cash equivalents because the company will want to earn interest on its cash when it isn't needed for business operations.

CVS had accounts receivable of $5,457 million in 2009. Although the company makes few sales to consumers on credit, its note on accounts receivable states that most of its receivables are amounts due from insurance companies and other providers and most are for pharmacy prescriptions. The amount of the allowance for uncollectibles is $272 million, a relatively small amount because the insurance companies and other providers pay well.

As a drug and pharmacy company, CVS's seasonal needs for cash are likely to be fairly steady during the course of the year. However, there is some variation. In Note 15, it may be observed that the sales are lowest in the first and third quarters (January to March and July to September) of the year. The fourth quarter (October to December) has the most sales. Thus, the company is likely to have excess cash from operations after the fourth quarter (which is also the balance sheet date) and in the first half of the year. More cash for operations will be needed in the last quarter.

389 .

Chapter 7, C 7. 1. Receivable turnover and days' sales uncollected calculated (in millions) CVS's Receivable Turnover Net Sales

Receivable Turnover =

2009 =

Average Accounts Receivable $98,729.0 (

$98,729.0

2008 =

$5,457.0

$5,420.5

$5,384.0

= 18.2 Times

$87,472.0 (

$5,384.0 $87,472.0 $4,982.0

$4,580.0

= 17.6 Times

CVS's Days' Sales Uncollected Days' Sales Uncollected =

2009 =

2008 =

365 days Receivable Turnover 365 Days 18.2 Times 365 Days 17.6 Times

*Rounded

390 .

) ÷ 2

= 20.1 Days* = 20.7 Days*

) ÷ 2

Chapter 7, C 7. (Continued) Walgreens' Receivable Turnover Net Sales

Receivable Turnover =

2009 =

Average Accounts Receivable $63,335.0 $2,496.0

(

$63,335.0

2008 =

$2,511.5

$2,527.0

) ÷ 2

= 25.2 Times

$59,034.0 $2,527.0

(

$59,034.0

$2,382.0

$2,237.0

) ÷ 2

= 24.8 Times

Walgreens' Days' Sales Uncollected Days' Sales Uncollected =

2009 = 2008 =

Days in a Year Receivable Turnover 365 Days 25.2 Times 365 Days 24.8 Times

= 14.5 Days = 14.7 Days

2. Both companies have relatively small amounts of accounts receivable as evidenced by the high receivable turnovers and short days' sales uncollected. This is expected because both CVS and Walgreens sell mostly to retail customers who pay with cash or credit cards or to insurance companies (for prescriptions) that pay quickly. On a basis relative to sales, CVS has about as many receivables as Walgreens does, as shown by the receivables turnovers. This probably means that CVS has some insurance accounts for its pharmacy items.

391 .

Chapter 7, C 8. This case addresses several issues that get at the heart of the question, does accounting matter? The main issue is whether accounting should be used to accomplish short-term business goals even if, in the process, it distorts reality. Because the restructuring of the insurance company may portend worse times in the community, Mullin Interiors may not always be able to adjust its accounts as it wishes. Because the size of those loans is determined by past financial performance, the bank may be harmed by overcommitting on loans to Mullin Interiors that may not be repaid. For Veronica Mullin to submit to the bank financial statements that she knows are unrealistic is, in effect, lying and thus is unethical. Moreover, an adjustment is not a meaningless accounting number. The estimate of losses from uncollected accounts refers to real losses that can be expected in the future. They must be planned for, and it is self-deceiving not to recognize them. Mullin and her employees may ultimately suffer because of her failure to acknowledge the losses now. Companies often use inappropriate accounting practices to disguise reality in the first stage of a downturn, only to end up in bankruptcy later. Realistic accounting estimates can enable management to take action at the appropriate time.

392 .

CHAPTER 8—Solutions CURRENT LIABILITIES AND FAIR VALUE ACCOUNTING Chapter 8, SE 1. 1. d 2. c

3. 4.

e b

5. a

Chapter 8, SE 2. Financial Ratios: Working Capital = Current Assets – Current Liabilities = Payables Turnover =

Days' Payable =

$65,000

–

$40,000

$25,000

Cost of Goods Sold +/– Change in Merchandise Inventory Average Accounts Payable $230,000 (

$35,000

$240,000 $30,000

$10,000 $25,000 ) ÷ 2

8.0 Times

365 Days Payables Turnover

393 .

365 Days 8.0 Times

= 45.6 Days

Chapter 8, SE 3. Financial Ratios: Working Capital =

Current Assets – Current Liablities

Payables Turnover =

$87,000

$56,000

$31,000

Cost of Goods Sold +/– Change in Merchandise Inventory Average Accounts Payable $274,000 (

$48,000 $290,000

Day's Payable =

–

$40,000

+ +

$16,000 $32,000 ) ÷ 2

= 7.3 Times

365 Days Payables Turnover

365 Days 7.3 Times

= 50.0 Days

Chapter 8, SE 4. 1. a Chapter 2. d 8, SE 4. 3. b

4. a 5. b 6. d

7. c

Chapter 8, SE 4

394 .

Chapter 8, SE 5. 1.

Aug.

31 Cash Notes Payable Bank loan for 60 days at 12 percent, interest not included

480,000.00 480,000.00

in face of note 2.

Oct.

30 Notes Payable Interest Expense Cash

480,000.00 9,468.49 489,468.49

Payment of note plus interest $480,000 × 12 / 100 × 60 / 365 = $9,468.49 Chapter 8, SE 6. 1. Total payroll for April equals salaries: Components of the payroll: Employees' federal income taxes payable Social security tax payable Medicare tax payable Medical insurance premiums payable Wages payable Payroll expenses: Social security tax payable Medicare tax payable Medical insurance premiums payable Federal unemployment tax payable State unemployment tax payable

= = = =

$65,800 $52,640 $2,505.60 $16,912.80

395 .

6,468.00 13,160.00 335,840.00

$ 27,652.00 6,468.00 52,640.00 2,505.60 16,912.80 $106,178.40

Total payroll expenses Computations: $13,160 ÷ 0.20 $65,800 – $13,160 $313,200 × 0.008 $313,200 × 0.054

$ 62,880.00 27,652.00

$446,000.00

Total monthly payroll 2.

$446,000.00

Chapter 8, SE 7. Oct. 31 Product Warranty Expense Estimated Product Warranty Liability To record estimated product warranty expense, calculated as follows: Number of units sold 52,000 0.05 Rate of replacement ×

32,500 32,500

Estimated units to be replaced Estimated cost per unit Estimated liability

2,600 $12.50

$32,500

31 Estimated Product Warranty Liability Merchandise Inventory To record replacement of clocks under warranty ( 2,800 clocks × $12.50 )

35,000 35,000

Chapter 8, SE 8. 1. Mar. 31 Cash Notes Payable Bank loan for 60 days at 10 percent, interest not included in face of note

360,000.00

2. May 30 Notes Payable Interest Expense Cash Payment of note plus interest $360,000 × 10 / 100 × 60 / 365 = $5,917.81

360,000.00 5,917.81

396 .

360,000.00

365,917.81

Chapter 8, SE 9. July 31 Product Warranty Expense Estimated Product Warranty Liability To record estimated product warranty expense, calculated as follows: Number of units sold 78,000 0.06 Rate of replacement ×

86,580 86,580

Estimated units to be replaced Estimated cost per unit

4,680 $18.50 $86,580

Estimated liability

31 Estimated Product Warranty Liability Merchandise Inventory To record replacement of calculator under warranty ( 4,900 calculators × $18.50 )

90,650 90,650

Chapter 8, SE 10. 1. Single payment of $36,000 at 4% for 12 years (see Table 1 in Appendix B) $36,000 × 0.625

= $22,500

2. Twelve annual payments of $3,000 at 4% (see Table 2 in Appendix B) $3,000

× 9.385

= $28,155

3. Single payment of $7,000 at 8% for 5 years (see Table 1 in Appendix B) $7,000

× 0.681

= $4,767

4. Five annual payments of $7,000 at 8% (see Table 2 in Appendix B) $7,000

× 3.993

= $27,951

397 .

Chapter 8, SE 11. To find the present value of the purchase transaction: $ 7,200 annual net cash flow 5.335 factor, Table 2 in Appendix B, for 8 years at 10 percent

$38,412 present value of net cash flows 30,000 less machine purchase price $ 8,412 net present value of transaction

–

At a required rate of return of 10 percent, the present value of the cash flows is greater than the cost of the machine. Purchasing the machine appears to be a smart business decision. Chapter 8, SE 12. To find the present value of the purchase transaction: $10,800 annual net cash flow 5.033 factor, Table 2 in Appendix B, for 7 years at 9 percent

$54,356 present value of net cash flows 45,000 less machine purchase price $ 9,356 net present value of transaction

–

At a required rate of return of 9 percent, the present value of the cash flows is greater than the cost of the machine. Purchasing the machine appears to be a smart business decision. –

398 .

– 8, E 1. × Chapter 1. No, the contract should not be considered a liability on the books for the team until it is in fact a definitely determinable liability. The FASB does require companies to disclose in a note to their financial statements any contingent liabilities and commitments they may have. 2. An increasing payables turnover is good for the company in the sense that it is able to pay its creditors in fewer days. It must have the cash flow to do this. However, an increasing payables turnover is bad for the company because the days' payable is less, which means the firm has less time to pay its bills. By decreasing the days' payable, a firm may not be taking advantage of a creditor's willingness to finance its operating cash needs. 3. They never affect cash flows at the time of the entry, but they may require payment of a liability in the future. 4. A commitment would be recognized in the accounting records when a transaction has occurred, such as when a purchase agreement is followed up and completed or when a lease payment is made. Chapter 8, E 2. 1. Because your friend is paying interest only on the loan, not on the past accumulated interest, he or she is paying simple interest. 2. The payer is better off because the receiver has to wait a year for the payment, thus giving up what could be earned on the payment if it had been made at the beginning of the year. 3. Three different methods of computing fair value are needed because there is not always an external market for nearly identical assets or liabilities (level 1). As a result, present value (level 2) or similar assets or liabilities (level 3) need to be used. 4. The present value concept allows the decision maker to compare various alternatives in the present, when business decisions are actually made. Chapter 8, E 3. 1. c 2. d 3. b

4. 5. 6.

e c d

7. 8.

a a

399 .

Chapter 8, E 4. Financial Ratios: 2010: Working Capital = Current Assets – Current Liabilities = Payables Turnover =

= Days' Payable =

$620,000

–

$400,000

$220,000

Cost of Goods Sold +/– Change in Merchandise Inventory Average Accounts Payable $1,700,000 ( $260,000 $1,860,000 $240,000

+ +

$160,000

$220,000 ) ÷

= 7.8 Times

365 Days Payables Turnover

365 Days 7.8 Times

= 46.8 Days

2011: Working Capital = Current Assets – Current Liabilities = Payables Turnover =

= Days' Payable =

$840,000

–

$640,000

$200,000

Cost of Goods Sold +/– Change in Merchandise Inventory Average Accounts Payable –

$1,900,000 ( $300,000 $1,840,000 $280,000

$60,000

$260,000 ) ÷

= 6.6 Times

365 Days Payables Turnover

365 Days 6.6 Times

= 55.3 Days

Ronaldo's working capital has declined from $220,000 to $200,000 because current liabilities have increased more than current assets. Also, the payables turnover has declined from 7.8 times to 6.6 times, resulting in a longer days' payable of 8.5 days (55.3 days – 46.8 days). This may mean that Ronaldo is having liquidity problems in generating enough cash flow to pay its accounts payable on a timely basis.

400 .

Chapter 8, E 5. 1. Oct. 31 Cash Notes Payable Bank loan for 60 days at 11 percent; interest not included in face amount of note 2. Nov. 30 Interest Expense Interest Payable 30 days' interest on note

240,000.00 240,000.00

2,169.86 2,169.86

$240,000 × 11 / 100 × 30 / 365 = $2,169.86 3. Dec. 30 Notes Payable Interest Payable Interest Expense Cash

240,000.00 2,169.86 2,169.86 244,339.72

Payment of note plus interest $240,000 × 11 / 100 × 30 / 365 = $2,169.86 Chapter 8, E 6. 1. Amount of service revenue determined Service revenue for the month: $490,200 ÷ 1.14 = $430,000 2. Journal entry prepared Aug.

31 Accounts Receivable Service Revenue Federal Excise Tax Payable Sales Tax Payable Revenue and related liabilities $430,000 × 9 / 100 = $38,700 $430,000 × 5 / 100 = $21,500

401 .

490,200 430,000 38,700 21,500

Chapter 8, E 7. 1.

$371,000.00

Total payroll for October equals wages: Components of the payroll: Employees' federal income taxes payable

$ 94,884.00

Employees' state income taxes payable

15,636.00

Social security tax payable

23,002.00

Medicare tax payable

5,380.00

Medical insurance premiums payable

12,870.00 219,228.00

Wages payable

$371,000.00

Total monthly payroll 2.

Payroll expenses: Social security tax payable

$23,002.00

Medicare tax payable

5,380.00

Medical insurance premiums payable

51,480.00

Federal unemployment tax payable

457.92 3,090.96

State unemployment tax payable

$83,410.88

Total payroll expenses Computations: $12,870

0.20

$64,350

–

$12,870

$51,480

$57,240

0.008

$457.92

$57,240

0.054

$3,090.96

402 .

Chapter 8, E 8. 1. Estimated liability recorded July

31 Product Warranty Expense Estimated Product Warranty Liability To record estimated product warranty expense, calculated as follows: Number of units sold 13,000 Rate of replacement

910 ×

Estimated liability

91,000

0.07

Estimated units to be replaced Estimated cost per unit

91,000

$100 $91,000

2. Games' replacement recorded July

31 Estimated Product Warranty Liability Merchandise Inventory

140,000 140,000

To record replacement of games under warranty ( 1,400 games ×

$100 )

Chapter 8, E 9. 1. Employee benefit for July vacation estimated ( $300,000 – *

$20,000

) × 0.65 ×

0.061 * = $11,102

÷ 49 = 0.061 (rounded)

2. and 3. Journal entries prepared July

31 Vacation Pay Expense Estimated Liability for Vacation Pay

11,102 11,102

To record estimated vacation pay expense for July 31 Estimated Liability for Vacation Pay Cash (or Wages Payable) Wages of employees on vacation

403 .

20,000 20,000

Chapter 8, E 10.

$12,600.00 annual rent 3.993 factor, from Table 2 in Appendix B, for present value of $1 per period, for 5 periods at 8% $50,311.80 present value of rent to be paid for 5 years

Daniels should expect to pay $50,311.80. Chapter 8, E 11. 1. Single payment of $24,000 at 6% for 12 years (see Table 1 in Appendix B) $24,000 × 0.497 = $11,928 2. Twelve annual payments of $2,000 at 6% (see Table 2 in Appendix B) $2,000 × 8.384 = $16,768 3. Single payment of $5,000 at 9% for 5 years (see Table 1 in Appendix B) $5,000 × 0.650 = $3,250 4. Five annual payments of $5,000 at 9% (see Table 2 in Appendix B) $5,000 × 3.890 = $19,450

404 .

Chapter 8, E 12.

Years

Rate

Factor from Table 1*

Present Value of $30,000

0.650

$30,000

$19,500

0.422

30,000

12,660

0.784

30,000

23,520

0.614

30,000

18,420

*In Appendix B Chapter 8, E 13.

Payments

Rate

Factor from Table 2*

5.582

$600

$3,349.20

9.295

600

5,577.00

5.206

600

3,123.60

8.244

600

4,946.40

*In Appendix B

405 .

Present Value of $600 Payments

Chapter 8, E 14. To find the present value of the purchase transaction:

$ 2,600.00 annual net cash flow 4.639 factor, from Table 2 in Appendix B, for 8 years at 14%

–

$12,061.40 present value of net cash flows 15,000.00 less machine purchase price ($ 2,938.60) net present value of transaction

At a required rate of return of 14 percent, the cost of the machine is greater than the present value of the cash flows the machine will generate. Purchasing the machine does not appear to be a smart business decision. Chapter 8, E 15. Since the 16 percent annual interest is compounded quarterly, the applicable interest rate is 4 percent (16 percent ÷ 4 quarters in a year), and the number of periods is 3 (9 months ÷ 3 months in a quarter). The actual sale (purchase) price is computed as follows (see Table 1 in Appendix B): Future Payment

Factor (3 periods, 4%)

Present Value

$400,000

0.889

$355,600

406 .

Chapter 8, E 16. Otis's offer to sell: From Table 2 in Appendix B: Periodic Cash Flow

Factor (20 periods, 12%)

Present Value

$200,000

7.469

$1,493,800

Periodic Cash Flow

Factor (10 periods, 12%)

Present Value

$160,000

5.650

$904,000

Betley's offer to buy: From Table 2 in Appendix B:

The range between the offer to buy and the offer to sell is from $904,000 to $1,493,800.

407 .

Chapter 8, P 1. 1. Current liabilities, contingencies, and commitments identified 1. 2. 3. 4. 5. 6. 7.

l m o k g f d

8. 9. 10. 11. 12. 13. 14.

a n b c e i j

2. User Insight: Nature of current liabilities The items that would not be expected to be listed on a balance sheet include contingent liabilities and commitments. The items that would be listed on the balance sheet with a dollar amount and the ones that would involve the most judgment or discretion include the estimated liabilities, such as income taxes payable, property taxes payable, promotional costs, product warranty liability, and vacation pay liability.

408 .

Chapter 8, P 2. 1. Transactions recorded 2011 May

21 Accounts Payable Notes Payable

9,000.00 9,000.00

60-day, 14% note given to supplier in settlement of trade account payable June 30 Interest Expense

138.08

Interest Payable

138.08

To accrue interest expense at end of year $9,000

× 14 / 100 × 40 / 365 = $138.08 July 20 Notes Payable Interest Expense

9,000.00

Interest Payable

138.08

69.04

Cash

9,207.12

Paid note plus interest $9,000

× 14 / 100 × 60 / 365 = $207.12 $207.12 – $138.08 = $69.04 2. User Insight: Other current liability discussed When a company has notes payable, the user would also expect to see a current liability for interest payable on the note. If interest payable does not appear, it may mean the company has paid the interest to date, or it may mean the company has forgotten to make the adjusting entry to accrue the interest on the notes.

409 .

Chapter 8, P 3. 1.

Journal entries prepared

a. 2011 July 31 Wages Expense Employees' Federal Income Taxes Payable

69,623.00 17,791.00

Employees' State Income Taxes Payable

2,923.00

Social Security Tax Payable

4,313.00

Medicare Tax Payable

1,009.00

Medical Insurance Premiums Payable

2,400.00

Wages Payable

41,187.00

To record the payroll b. July 31 Payroll Taxes and Benefits Expense Social Security Tax Payable

17,583.66 4,313.00

Medicare Tax Payable

1,009.00

Medical Insurance Premiums Payable

9,600.00

Federal Unemployment Tax Payable

343.44

State Unemployment Tax Payable

2,318.22

To record payroll expenses Computations: $2,400 0.20 ÷ $12,000 – $2,400 $42,930 × 0.008 $42,930 × 0.054 2.

= = = =

$12,000 $9,600 $343.44 $2,318.22

Cost of new employee estimated

Lazur Corporation incurred $17,583.66 in payroll taxes and benefits on payroll expenses of $69,623, or 25.3 percent. Thus, for a new $1,000-per-month position, $1,253 [ $1,000 + ( $1,000 × 0.253 ) ] should be budgeted.

410 .

Chapter 8, P 4. 1.

Journal entries prepared

a. Jan.

Jan.

31 Cash Estimated Product Warranty Liability Service Fees Revenue Merchandise Inventory To record warranty replacements and related revenue during January

18,884 17,530

31 Product Warranty Expense Estimated Product Warranty Liability To record estimated warranty expense for January, computed as follows: HDTVs sold × percent expected to require repair × average cost of parts 450 × 0.20 × $120 = $10,800

10,800

18,884 17,530

10,800

Balance of Estimated Product Warranty Liability account computed

Beginning balance

$28,600

Less cost of warranty parts used Plus estimated liability for HDTVs sold

( 17,530) 10,800

Ending balance

$21,870

User Insight: Product warranty liability estimation discussed

If the product warranty liability is overestimated, the current year's income is understated and future years' income will be overstated.

411 .

Chapter 8, P 5. 1. Current liabilities determined The current liabilities of Garcia Cycle Repair as of December 31, 2010, are as follows: Accounts payable

$ 9,000.00

Notes payable

2,500.00

Property taxes payable

2,310.00

Sales tax payable (

$44,270

x 0.05 )

2,213.50

Social security tax payable (

$18,200

x 0.062 x

2 )

2,256.80

Medicare tax payable (

$18,200

x 0.0145 x

2 )

527.80

State unemployment tax payable ( $7,000 x

x 0.054 )

756.00

Federal unemployment tax payable ( $7,000 x 2

x 0.008 )

Employees' federal income taxes payable

112.00 476.00 $20,152.10

Total current liabilities 2. User Insight: Additional information identified

Current liabilities may exist for which there is no documentary evidence or for which the documents are missing. For instance, there may be a bank loan or other loan outstanding, missing invoices, or accrued liabilities. Garcia should be questioned about the possibility of these liabilities, and his bank contacted, if necessary. In addition, Garcia may have to pay penalties and interest to the state or federal government because of the failure to remit the taxes payable on a timely basis. Inquiries should be made of the proper officials to determine if such penalties and interest are due. Furthermore, the note from Garcia's father-in-law may be interestbearing and would thus require an adjustment to accrue interest payable. Also, the two employees may have accrued vacation pay. This would require setting up an estimated liability. There may also be an estimated liability on cycle repairs. City and/or state income tax withholding for the employees may be another overlooked liability.

412 .

Chapter 8, P 5. (Continued) 3. User Insight: Liquidity ratios computed and evaluated (cents omitted) Working Capital = Current Assets – Current Liabilities =

Payables Turnover =

Days' Payable =

$16,300

–

$20,152 *

= ($3,852)

Cost of Goods Sold +/– Change in Merchandise Inventory Accounts Payable $31,125

$11,750

$9,000 $42,875 $9,000

= 4.8 times

365 days Payables Turnover

365 days 4.8 times

= 76.0 days

Garcia has a negative working capital of $3,852, and the payables turnover is only 4.8 times. This position means that it takes on average 76.0 days for the company to pay its accounts payable. Although the company is said to be profitable, its liquidity is highly questionable. A majority of its current assets are motorcycle inventory, which must be sold before it will generate cash, and most of its current liabilities must be paid sooner than the 76.0 days would indicate. *Rounded.

413 .

Chapter 8, P 6. 1. Present value applied a.

Present value of a single payment (Table 1) Factor: 8%, 4 periods $75,000

0.735

Initial deposit = b.

$55,125

Present value of an ordinary annuity (Table 2) Factor: 8%, 5 periods $50,000

3.993

Purchase price =

$199,650

2. User insight: Usefulness of present value discussed The fundamental reason present value is a useful tool in making business decisions is that it allows the decision maker to compare various alternatives in the present, when business decisions are actually made.

414 .

Chapter 8, P 7. 1. Transactions recorded 2011 Nov. 25 Equipment Notes Payable

86,400.00 86,400.00

Purchase of loading cart with a 60-day, 10% note Dec. 31 Interest Expense Interest Payable

852.16 852.16

To accrue interest expense $86,400 × 10 / 100 × 36 / 365 = $852.16 2012 Jan.

24 Notes Payable Interest Expense

86,400.00

Interest Payable

852.16

568.11

Cash

87,820.27

To record payment of note plus interest for equipment $86,400 × 10 / 100 × 60 / 365 = $1,420.27 $1,420.27

–

$852.16

$568.11

2. User Insight: Other current liability discussed When a company has notes payable, the user would also expect to see a current liability for interest payable on the note. If interest payable does not appear, it may mean the company has paid the interest to date, or it may mean the company has forgotten to make the adjusting entry to accrue the interest on the notes.

415 .

Chapter 8, P 8. 1. Transactions recorded a. 2011 Oct.

31 Wages Expense Employees' Federal Income Taxes

185,500.00

Payable

47,442.00

Employees' State Income Taxes Payable

7,818.00

Social Security Tax Payable

11,501.00

Medicare Tax Payable

2,690.00

Medical Insurance Premiums Payable

6,400.00

Wages Payable

109,649.00

To record the payroll b. Oct.

31 Payroll Taxes and Benefits Expense Social Security Tax Payable

46,888.76 11,501.00

Medicare Tax Payable

2,690.00

Medical Insurance Premiums Payable

25,600.00

Federal Unemployment Tax Payable

915.84

State Unemployment Tax Payable

6,181.92

To record payroll expenses Computations: $6,400 ÷ 0.20 $32,000 – $6,400 $114,480 × 0.008 $114,480 × 0.054

= = = =

$32,000 $25,600 $915.84 $6,181.92

2. Cost of new employee estimated Hammer Company incurred $46,888.76 in payroll taxes and benefits on payroll expenses of $185,500, or 25.3 percent. Thus, for a new $2,000-per-month position, $2,506 [ $2,000 + ( $2,000 × 0.253 ) ] should be budgeted.

416 .

Chapter 8, P 9. 1.

Journal entries prepared

a. Sept. 30 Cash Estimated Product Warranty Liability Service Fees Revenue Merchandise Inventory Warranty replacements and related revenue during September 250 × $120 = $30,000

4,930 30,000

b. Sept. 30 Product Warranty Expense Estimated Product Warranty Liability To record estimated warranty expense for September, computed as follows: Cell phones sold × percent expected to require replacement × average cost of cell phones 2,800 × 0.03 × $120 = $10,080

10,080

4,930 30,000

10,080

Balance of Estimated Product Warranty Liability account computed

Beginning balance

$104,000

Less cost of cell phones replaced

(

Plus estimated liability for cell phones sold

$ 84,080

Ending balance 3.

30,000) 10,080

User Insight: Product warranty liability estimation discussed

If the product warranty liability is underestimated, the current year's income is overstated and future years' income will be understated.

417 .

Chapter 8, P 10. 1. Current liabilities determined The current liabilities of Linda's Salon as of December 31, 2011, are as follows: Accounts payable

$ 7,500.00

Notes payable

3,000.00

Property taxes payable

1,970.00

Sales tax payable $39,430

(

0.05 )

1,971.50

Social security tax payable $17,750

(

× 0.062 ×

)

2,201.00

2 )

514.75

Medicare tax payable $17,750

(

0.0145

State unemployment tax payable ( $7,000

0.054 )

756.00

Federal unemployment tax payable ( $7,000

0.008 )

112.00 516.00

Employees' federal income taxes payable

$18,541.25

Total current liabilities 2. User Insight: Additional information identified

Current liabilities may exist for which there is no documentary evidence or for which the documents are missing. For instance, there may be a bank loan or another loan outstanding, missing invoices, or accrued liabilities. Lopez should be questioned about the possibility of these liabilities and her bank contacted, if necessary. In addition, Lopez may have to pay penalties and interest to the state or federal government because of the failure to remit the taxes payable on a timely basis. Inquiries should be made of the proper officials to determine if such penalties and interest are due. Furthermore, the note from Lopez's father-in-law may be interest-bearing and would thus require an adjustment to accrue interest payable. Also, the two employees may have accrued vacation pay. This would require setting up an estimated liability. State and federal income tax withholdings for the employees may be other overlooked liabilities.

418 .

Chapter 8, P 10. (Continued) 3. User Insight: Working capital, payables turnover, and days' payable computed and evaluated (cents omitted) Working Capital = Current Assets – Current Liabilities = Payables Turnover =

Days' Payable =

$15,800

–

$18,541

= ($2,741)

Cost of Goods Sold +/– Change in Merchandise Inventory Accounts Payable $27,631

$9,980

$7,500 $37,611 $7,500

= 5.0 Times

365 Days Payables Turnover

365 Days 5.0 Times

= 73.0 Days

Lopez has a negative working capital of $2,741, and the payables turnover is only 5.0 times. This position means that it takes, on average, 73.0 days for the company to pay its accounts payable. Although the company is said to be profitable, its liquidity is highly questionable. A majority of its current assets are beauty supplies inventory, which must be sold before it will generate cash, and most of its current liabilities must be paid sooner than the 73.0 days would indicate.

419 .

Chapter 8, P 11. 1. Present value applied a.

Present value of a future payment (Table 1 in Appendix B) Factor: 10%, 3 periods $500,000

0.751

$375,500

Liability for purchase agreement b.

$375,500

Present value of an ordinary annuity (Table 2 in Appendix B) Factor: 10%, 4 periods $50,000

3.170

Cost of buyout =

$158,500

2. User Insight: Usefulness of present value discussed The fundamental reason present value is a useful tool in making business decisions is that it allows the decision maker to compare various alternatives in the present, when business decisions are actually made.

420 .

Chapter 8, P 12. 1. Present value applied a.

Present value of a future payment (Table 1 in Appendix B) Factor: 10%, 6 periods $650,000

0.564

$366,600

Liability for purchase agreement b.

$366,600

Present value of an ordinary annuity (Table 2 in Appendix B) Factor: 10%, 5 periods $70,000

Cost of buyout

3.791 =

$265,370

421 .

Chapter 8, C 1. If the expense and corresponding liability of frequent flyer programs are recognized, operating income would be reduced and current liabilities would be increased. This is an example of an estimated liability. As a result of the triple mileage bonus in 2011, the future free rate is estimated at 2.5 percent. Under the matching principle, the 2.5 percent rate is the appropriate rate to use in 2011 because the triple mileage bonus system is meant to increase travel and attract passengers in 2011, and thus the cost should be charged to 2011. Students will have different views about the best way to estimate this expense. One estimate of the cost for 2011 would be 2.5 percent of 2011 passenger transportation revenues of $966.3 million, or $24.2 million. This amount treats the lost revenue because of free passengers as an expense and represents the value of the service provided. The sum of $24.2 million is 28.1 percent of 2011 operating income ($24.2 million ÷ $86.1 million), indicating that the airline incurs significant obligations as a result of these programs. Another estimate of the cost would be a percentage of variable operating costs. (This calculation assumes that idle capacity is used for these passengers, with additional aircraft or other fixed charges not needed.) However, to accommodate a 2.5 percent increase in passengers, the company will need to increase the number of baggage handlers and ticket agents. It will also have to pay more for fuel and other variable costs. Since 2.5 percent of total passenger transportation operating expenses before depreciation and amortization is $20.1 million ($802.8 million × 0.025), this amount would decrease operating income by 23.3 percent. Finally, some students may argue that only the marginal costs of serving passengers who are flying free should be expensed because these people fill seats that would otherwise be empty. The implication is that the expense and liability would be much lower than 2.5 percent of revenues or 2.5 percent of variable operating expenses. This approach assumes that existing employees will be more efficient or productive in their jobs and that the airline will not have to increase salaries or related wage costs. Most students will acknowledge that the estimated cost of this program should include additional aircraft fuel, passenger food and supplies, and other miscellaneous costs of the frequent flyer program. Many students will acknowledge the need for increased personnel to issue free tickets, compute and record mileage credit earned, mail monthly statements to frequent flyers, and handle any disputed mileage credits. These costs have already been expensed as incurred. The above computations illustrate why airlines are reluctant to recognize frequent flyer programs in their financial statements. Recognition may have a significantly negative effect on both income and liabilities in an already financially stretched industry. However, a strong argument can be made for recording these estimated 422 .

Chapter 8, C 1. (Continued) liabilities. Liabilities refer to probable future sacrifices of economic benefits arising from present obligations of one entity to transfer assets or provide future services to other entities as a result of past transactions. In this case, FlyJet incurs a present obligation to provide a service (free flight) based on past transactions (previous paid flights). This transaction appears to be no different from other estimated liabilities that are currently recorded, such as warranty expenses, cents-off coupon expenses, and rebates. On the other side, airlines argue that these are not liabilities because the trips are scheduled so that free passengers use seats that would not have been taken by paying passengers. In other words, the airline is giving up no revenue in accommodating free travelers and is incurring very little marginal cost. Chapter 8, C 2. When Citibank "set up a reserve," it recorded a loss (debit) and established a liability (credit). This would indicate that the company and its auditors believed that even though the case had not been heard in court, the two conditions the FASB established for determining when a contingency should be entered in the accounting records had been met—that is, (1) the liability must be probable and (2) it must be reasonably estimated. Chapter 8, C 3. Present value is relevant because the price of the auto must take into account the interest cost to Cadillac. Cadillac will have to pay interest while it waits for its money in monthly payments over five years. Since it will have to pay interest of 8 percent on the funds it borrows during that time, the present value of the car is the present value of an annuity equal to the monthly payments times the 8 percent factor. Since the customer does not have to borrow money for the transaction, the relevant rate is Cadillac's. If the customer is willing and able to pay for the car up front, it is possible to negotiate for a lower price because the present value of the car is less than the offered selling price.

423 .

Chapter 8, C 4. Payables turnover and days' payable computed and compared (in millions) Payables Turnover =

Sun Microsystems =

Cisco Systems =

Days' Payable = Sun Microsystems = Cisco Systems =

Cost of Goods Sold +/– Change in Inventory Accounts Payable –

$6,718

$114

$1,027 $6,604 $1,027 $13,023

6.4 Times

–

$161

$675 $12,862 $675

= 19.1 Times

Number of Days in a Year Payables Turnover 365 Days 6.4 Times 365 Days 19.1 Times

= 57.0 Days = 19.1 Days

Cisco Systems pays its accounts payable more than 37 days faster than Sun Microsystems does. Cisco Systems pays its year-end level of payables 19.1 times a year, or every 19.1 days, whereas Sun Microsystems pays its year-end level of payables 6.4 times, or every 57.0 days. The resulting impact on cash flows would be expected to be better for Sun Microsystems because it uses the cash for an additional 37 days before paying its accounts. The computer industry's payables turnover is 5.6 times, and its days' payable is 65.2 days. Sun Microsystems is close to the industry average, but Cisco Systems pays faster than the industry average. (Note: The difference may also reflect Cisco's being in a much stronger financial position than Sun Microsystems is.)

424 .

Chapter 8, C 5. The FASB has established two conditions for determining when a contingency should be entered in the accounting records: (1) the liability must be probable and (2) it must be reasonably estimated. By calling the outstanding rebates a "commitment" rather than a "contingency," General Motors is recognizing that it is probable that these rebates will be exercised and that the company will be liable for them. Also, by putting a dollar amount on the outstanding rebates, General Motors is acknowledging that it can be reasonably estimated. Thus, the only reasoning the company can use for not recording them as expenses and estimated liabilities is that according to the matching rule, they should be matched against the sales of the cars "as reductions in revenues at the time of vehicle sale." However, it is possible to disagree with this logic. It may be argued that since the liability arises at the time of the use of the credit card, it should be recorded at that time even though it is estimated. The only question would be the classification of the "debit" to offset the liability. An expense would be debited if it were determined that the offering of the rebate generated credit card revenue. Or if it is argued, as General Motors does, that the expense is for the purpose of generating car revenue, it would be recorded as a prepaid expense. The prepaid expense would be transferred to an expense account using an adjusting entry when the rebates are used to offset the sale of a car.

425 .

Chapter 8, C 6. Commitments and contingencies discussed Note 12 on commitments and contingencies describes a guarantee in connection with the sale of some stores that management feels the ultimate disposition of will not have adverse effects on the business. The company is involved in several lawsuits that management says are without merit and that the company will fight. The company's Caremark, Inc. subsidiary is subject to a lawsuit, and the company has a Medicaid dispute. The disclosure of commitments and contingencies is important because they represent expected future payments and potential liabilities that need to be considered when examining the performance of the company.

426 .

Chapter 8, C 7. Payables turnover and days' payable computed (in millions) CVS: Cost of Goods Sold +/– Change in Merchandise Inventory

Payables Turnover =

2009 =

Average Accounts Payable $78,349 (

$79,539

2008 =

Days' Payable =

2009 =

2008 =

$3,560

$3,681

$3,801

21.6 Times

$69,182 (

$3,801 $70,326 $3,697

)

$3,593

19.0 Times

)

365 Days Payables Turnover 365 Days 21.6 Times 365 Days 19.0 Times

$1,144

16.9 Days

19.2 Days

427 .

$1,190

Chapter 8, C 7. (Continued) Walgreens: Cost of Goods Sold +/– Change in Merchandise Inventory

Payables Turnover =

2009 =

Average Accounts Payable

(

Days' Payable =

2009 =

2008 =

$4,308 $45,262

2008 =

–

$460

$4,289

) ÷

10.5 Times

$45,722

$4,299 $42,391 (

$4,289 $42,850 $4,012

$459

$3,734

) ÷

10.7 Times

365 Days Payables Turnover 365 Days 10.5 Times 365 Days 10.7 Times

34.8 Days

34.1 Days

CVS and Walgreens manage their payables in different ways. CVS has reduced its days' payable in 2009 to about half those of Walgreens. Thus, CVS pays its creditors more quickly. Walgreens currently makes more use of creditors for financing in its operating cycle.

428 .

Chapter 8, C 8. The alternatives available to Swift are as follows: 1.

Do nothing and overlook the wrongdoing.

Raise the issue with the boss and recommend that the workers be added to the regular payroll.

Resign and look for another job.

Resign and report the infraction to the appropriate federal and state authorities.

Failure to withhold and remit income and payroll taxes is a serious criminal offense. Alternative 1 is the worst choice because it is unethical to be associated with an illegal activity. Swift would be subjecting himself to possible criminal action, and if the maneuver were discovered, it would be difficult for Swift ever to get an accounting job again. Although Alternative 3 is probably the least confrontational action, it is also unethical because it ignores the fact that an illegal act is being committed. Alternative 4 is an appropriate action that does not ignore the fact that an illegal act has been committed, but it may be difficult for a student to conceive of going to the authorities. Also, it does not give the boss a chance to correct his actions. Alternative 2 is the most ethical action because it confronts the illegal act and gives the boss a chance to correct the situation. Swift may lose his job, but this will also happen under Alternatives 3 and 4. This case actually happened to one of the author's students, who sought the author's advice (names have been changed). The student needed the job badly and was afraid of losing it, but recognized that an important aspect of being an accountant is behaving ethically. He did talk to the boss, who, it turned out, had been feeling guilty about his practices and wanted to rectify the situation. He asked the student to update and computerize the payroll system and make sure the restaurant was in compliance with all laws. The student also got a raise and a promotion. An ethical act will not always turn out so well, but in this case, it paid off.

429 .

Chapter 8, C 9. Memorandum Date: To: From: Re:

Today's Date Devon Turner Student Management Contract Offer

Management's offer does not accurately reflect the value to you because it does not take into account the time value of money. You will have to wait until the fourth year to receive the first $6.0 million, the fifth year to receive $9.0 million, the sixth year to receive $12.0 million, and the seventh year to receive $15.0 million. Although the average per year is $10.5 million, the present value to you is much less, as is shown by using a table to calculate the present value of the offer: $ 6,000,000

0.683 (4 years, 10%)

$ 4,098,000

$ 9,000,000

0.621 (5 years, 10%)

5,589,000

$12,000,000

0.564 (6 years, 10%)

$15,000,000

0.513 (7 years, 10%)

6,768,000 7,695,000

Total Present Value of Offer

$24,150,000

Present Value Average per Year

$ 6,037,500

Because the offer lies so far in the future, it is actually worth only about $6.0 million per year to you at the present time, using the interest rate of 10 percent. To receive a present value of $10.5 million per year, you might propose a signing bonus of $17,850,000 ($42,000,000 – $24,150,000). Since management is unlikely to agree to this bonus, the range of the possible bonus is from zero or no bonus to $17,850,000. Other considerations in evaluating the offer are as follows: 1.

The choice of interest rate should be considered. The bank prime rate may not properly reflect the amount of risk.

Whether or not the contract is guaranteed if you are injured or otherwise cannot play will affect the amount of risk.

If you refuse the new contract, you could have a few bad years or become injured and thus not be offered any contract for future years.

The new contract may not adequately reflect increases in salaries over the next three years. What if other players with similar records are making $18 million per year in four years?

430 .

CHAPTER 9—Solutions LONG-TERM ASSETS

Chapter 9, SE 1. 1. b 2. a 3. c

4. 5.

b c

Chapter 9, SE 2. Free Net Cash Flows from = – Dividends – Cash Flow Operating Activities

$23,000

$194,000

–

$25,000

–

Purchases of Plant Assets

Sales of Plant Assets

$158,000

$12,000

This amount of free cash flow is the amount of cash that Sun Corporation has available for other purposes, such as expansion or investment, after it deducts the funds it has committed to continue operations at the planned level. Chapter 9, SE 3. 1. 2. 3. 4.

b c a a

5. 6. 7. 8.

c b c c

431 .

Chapter 9, SE 4. Asset

Appraisal

Percentage

Apportionment*

Land

$ 400,000

25.0%

$ 375,000

Land improvements

12.5%

Building

200,000 1,000,000

Total

$1,600,000

62.5% 100.0%

187,500 937,500

$1,500,000

× 25.0% =

$ 375,000

Land improvements $1,500,000

× 12.5% =

Building

× 62.5% =

187,500 937,500

* Land

$1,500,000

$1,500,000 Chapter 9, SE 5. Asset Land Land improvements Building

Appraisal

Percentage

Apportionment*

$ 600,000

33.3%

$ 566,100

300,000 900,000

16.7%

283,900 850,000

$1,800,000

50.0% 100.0%

$1,700,000

× 33.3% =

$ 566,100

Land improvements $1,700,000

× 16.7% =

Building

× 50.0% =

283,900 850,000

Total * Land

$1,700,000

432 .

Chapter 9, SE 6. Depreciation for each year: $8,250 $750 ) ÷ 4 years = $1,875 ( – Chapter 9, SE 7. Depreciation for 2,400

Year 1:

( $8,250

–

$750 ) ×

Year 2:

( $8,250

–

$750 ) ×

Year 3:

( $8,250

–

$750 ) ×

Year 4:

( $8,250

–

$750 ) ×

Year 1:

$8,250.00

× 50%*

Year 2:

(

$8,250.00

–

$4,125.00 ) × 50%

= $2,062.50

Year 3:

(

$4,125.00

–

$2,062.50 ) × 50%

= $1,031.25

$7,500.00

–

$7,218.75

= $ 281.25**

= $2,250

8,000 2,000

= $1,875

8,000 2,200

= $2,063*

8,000 1,400

= $1,313*

8,000

*Rounded Chapter 9, SE 8. Depreciation for

Year 4: * 2 †

= $4,125.00

†

25% = 50%

$4,125.00 +

$2,062.50

$1,031.25

$7,218.75

** Remaining amount to reduce to residual value: $1,031.25 – $750.00

(residual value)

433 .

$281.25

Chapter 9, SE 9. Year 1:

50% * × $11,200 = $5,600

Year 2:

50%

( $11,200

–

$5,600

) = 50% ×

$5,600

= $2,800

Year 3:

50%

(

$5,600

–

$2,800

) = 50% ×

$2,800

= $1,400

Year 4:

$1,400

* 100%

– Estimated Residual Value = ÷ 4 years =

25%

$1,400

–

$1,200

= $200

× 2 = 50%

Chapter 9, SE 10. Carrying Value = Equipment – Accumulated Depreciation

= $16,200 – $9,000 = $ 7,200 2.

Asset discarded as having no value

Gain (Loss) on Disposal of Equipment = Cash Received – Carrying Value =

– $7,200

= ($7,200) b.

Asset sold for $3,000 cash Gain (Loss) on Sale of Equipment

= Cash Received – Carrying Value =

$3,000

– $7,200

= ($4,200) Asset sold for $8,000 cash

Gain (Loss) on Sale of Equipment

= Cash Received – Carrying Value =

$8,000

= $800

434 .

– $7,200

Chapter 9, SE 11. Carrying Value = Equipment – Accumulated Depreciation

$24,300

$10,800

– $13,500

Asset discarded as having no value Gain (Loss) on Disposal of Equipment = Cash Received – Carrying Value

– $10,800

= ($10,800) b.

Asset sold for $4,500 cash = Cash Received – Carrying Value

Gain (Loss) on Sale of Equipment

$4,500

– $10,800

= ($6,300) c.

Asset sold for $12,000 cash = Cash Received – Carrying Value

Gain (Loss) on Sale of Equipment

$12,000

– $10,800

= $1,200 Chapter 9, SE 12. Depletion charge per ton: (

$24,000,000

–

$3,600,000 ) ÷ 8,000,000

tons = $2.55 per ton

Depletion expense for the first year: 900,000 tons ×

$2.55

$2,295,000

Depreciation expense for the first year: $28,800,000

(

900,000 tons ÷

8,000,000 tons ) = $3,240,000

435 .

Chapter 9, SE 13. Depletion charge per ton: (

$16,000,000

–

$2,400,000

) ÷ 4,000,000 tons = $3.40 per ton

Depletion expense for the first year: 600,000 tons ×

$3.40

= $2,040,000

Depreciation expense for the first year: $19,200,000

× ( 600,000 tons

4,000,000 tons

) =

$2,880,000

Chapter 9, SE 14. The research and development costs are expensed as incurred. The costs after the working program was developed should be capitalized and amortized over the software's useful life. After one year, the software would appear on the balance sheet as follows: Intangible assets Software* *

$175,000

$140,000 – (

$175,000

÷ 5 years )

= $140,000

Chapter 9, SE 15. The research and development costs are expensed as incurred. The costs after the working program was developed should be capitalized and amortized over the software's useful life. After one year, the software would appear on the balance sheet as follows: Intangible assets Software* *

$264,000

$220,000 – (

$264,000

÷ 6 years )

436 .

= $220,000

Chapter 9, E 1. 1.

On the date of acquisition, the carrying value equals the current market value. After that, it would be a coincidence if the carrying value equaled the market value.

The major advantage for a company that has positive free cash flow is that it has extra funds to invest and expand.

A higher land valuation has the effect of increasing income because a smaller building valuation results in a lower amount to depreciate over the building's useful life.

An accelerated depreciation method is best for companies facing rapid technological change. Companies use it to minimize the risk of obsolescence.

Chapter 9, E 2. 1.

If cash received for the asset equals its carrying value, then no gain or loss occurs.

Annual depletion refers to units extracted, but depletion expense includes only units sold. So annual depletion does not equal depletion expense when units extracted do not equal units sold.

A company would amortize a patent over fewer years than the patent will last because the company would intend to sell the product over fewer years than the life of the patent.

A company would spend millions of dollars on goodwill because the company anticipates superior earnings and believes it will more than recoup the goodwill it purchased.

437 .

Chapter 9, E 3. 1. c

5. a

2. c

6. b

3. c

7. b

4. b Chapter 9, E 4. Management should purchase the new machine because it will earn a return on investment of at least 9 percent, as shown by a positive net present value, calculated as follows: Present Value Acquisition cost Present value factor 1.000 ×

= 1.000

$24,000

($24,000)

Net annual cash flows Present value factor

= 3.890

(Table 2: 5 periods, 9% ) 3.890 ×

$6,000

23,340

Disposal price Present value factor

= 0.650

(Table 1: 5 periods, 9% ) 0.650 ×

1,300

$2,000 $

Net present value

438 .

640

Chapter 9, E 5. Free Cash Flow

Net Cash Flows from – Operating Activities

Dividends

–

$50,000

–

($242,000) =

$216,000

Purchases of Sales of + Plant Assets Plant Assets

$462,000

$54,000

These results tell us that this company has a liquidity problem and needs to raise more cash through financing activities to finance its purchase of plant assets. Chapter 9, E 6. 1.

RE, OR

CE, B

CE, A

CE, N

CE, ER

RE, N

Chapter 9, E 7. Cost of land: Purchase price

$300,000

Broker's fees

24,000

Title search and other fees

2,200

Demolition

8,000 4,200

Grading

$338,400

Total cost of land Cost of land improvements: Paving parking lots

$ 40,000

Lighting for parking lots

32,000 6,400

Signs for parking lots

$ 78,400

Total cost of land improvements

A total of $338,400 should be debited to the Land account, and $78,400 should be debited to the Land Improvements account.

439 .

Chapter 9, E 8. Asset

Appraisal

Percentage

Apportionment*

Land

$ 60,000

20%

$ 48,000

Building

135,000 105,000

45% 35%

108,000 84,000

$300,000

100%

$240,000

Equipment

* Land

$240,000

20%

$ 48,000

Building

$240,000

45%

Equipment

$240,000

35%

108,000 84,000 $240,000

Chapter 9, E 9. Cost and depreciable cost of tractor: Purchase price

$70,000

New tires

4,400 5,600

Overhaul Total cost Less residual value

$80,000 8,000

Depreciable cost

$72,000

First year's depreciation: $72,000

$12,000

440 .

Chapter 9, E 10. Cost Less estimated residual value

$45,000 7,500

Depreciable cost

$37,500

Depreciation computed by straight-line method:

$37,500

$7,500

Depreciation computed by production method:

$37,500

48,000 ÷

200,000

$9,000

Depreciation computed by double-declining-balance method: 2010 40%* × $45,000 = $18,000

2011 40%

= 40%

* 100%

( $45,000 $27,000

years

= 20%

–

$18,000

)

$10,800 ×

= 40%

Adjusting entry: Depreciation Expense—Drilling Truck Accumulated Depreciation—Drilling Truck To record depreciation for 2012 using the doubledeclining-balance method

10,800 10,800

Balance sheet presentation: Property, plant, and equipment Drilling truck

$45,000 28,800

Less accumulated depreciation*

$16,200 *

$18,000

$10,800

$28,800

Year 1: 50%* × Year 2: 50% ×

$1,120

= $560

Chapter 9, E 11.

(

$1,120

–

$560

50%

$560

50%

$280

= $280 = $140

$140

–

$120

= $ 20

Year 3: 50%

Year 4: $140

–

$560 $280 ( – ) Estimated Residual Value

* 100%

years

25%

2 441

)

= 50%

Chapter 9, E 12. Cost Residual value

$623,120 63,120

Depreciable cost

$560,000

First-year depreciation: $560,000

÷ 10 =

$ 56,000

Second-year depreciation: $560,000

56,000

÷ 10 =

Accumulated depreciation: $112,000 Remaining depreciable cost: $560,000

–

$112,000

$448,000

Remaining useful life: 7 years – 2 years =

5 years

Third-year depreciation: $448,000

÷ 5 =

$ 89,600

442 .

Chapter 9, E 13. Carrying Value = Equipment – Accumulated Depreciation, Equipment = $16,200 – $9,000 =

$7,200

1. Asset discarded as having no value Gain (Loss) on Disposal of Equipment = Cash Received – Carrying Value = $0 – $7,200 = ($7,200) 2. Asset sold for $3,000 cash Gain (Loss) on Sale of Equipment = Cash Received – Carrying Value = $3,000 – $7,200 = ($4,200) 3. Asset sold for $9,000 cash Gain (Loss) on Sale of Equipment = Cash Received – Carrying Value = $9,000 – $7,200 = $1,800

443 .

Chapter 9, E 14. 2014 July

1. 2014 July

*( $2,500 2. 2014 July

3. 2014 July

1 Depreciation Expense—Computer Accumulated Depreciation—Computer To record one-half year's depreciation on computer ( $2,500 – $250 ) ÷ 5 years × 6 / 12 = $225

225

1 Accumulated Depreciation—Computer Loss on Disposal of Computer Computer Computer discarded after 3 1/2 years 3.5 years × $450* = $1,575

1,575 925

–

$250

) ÷ 5 years =

225

2,500

$450 / year

1 Cash Accumulated Depreciation—Computer Loss on Sale of Computer Computer Computer sold for $400; loss recognized

400 1,575 525

1 Cash Accumulated Depreciation—Computer Gain on Sale of Computer Computer Computer sold for $1,100; gain recognized

1,100 1,575

2,500

Chapter 9, E 15. Depletion charge per ton: ( $8,800,000

– $600,000 ) ÷

5,000,000

Depletion expense for the first year: 750,000 tons

$1.64

= $1,230,000

444 .

tons = $1.64 per ton

175 2,500

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Chapter 9, E 16. 1.

Cost of copyright Estimated useful life

$ 40,000 4 ÷

Annual amortization

$ 10,000

Cost of trademark

$320,000

years

No annual amortization but subject to annual impairment test. Note that the copyright is limited by the period over which it will produce revenue, whereas the trademark has an indefinite life and is thus not amortized but is evaluated annually for impairment. Chapter 9, E 17. (a)

(b)

(c)

(d)

Patent Cash To record purchase of patent

1,030,000

Patent Cash Successful defense of patent

450,000

Amortization Expense Patent Patent Annual amortization of patent $1,480,000 ÷ 10 years =

148,000

Loss on Write-off of Patent Patent Write-off of worthless patent $1,480,000 – ( $148,000 = $1,184,000

445 .

1,030,000

450,000

148,000 $148,000 1,184,000 1,184,000 ×

2 )

Chapter 9, P 1. 1. Long-term assets identified 1. 2. 3. 4. 5. 6.

i d k a e g

7. c 8. j 9. b 10 h 11. f .

2. User Insight: Effects on earnings and cash flows identified The items that would be seen on an income statement are (g) depreciation, (h) depletion, (i) amortization, and (j) revenue expenditure. Of these, only revenue expenditure would result in an outlay of cash.

446 .

Chapter 9, P 2. 1. Schedule prepared Siber Computers Schedule of Proper Charges for Training Center December 31, 2010 Land Improvements

Land Attorney's fee

$ 35,200

Cost of land

597,000

Building

Equipment

Architect's fee, building design

$ 102,000

Building

1,025,000

Parking lot and sidewalk

$135,600

Electrical wiring, building

168,000

Landscaping

55,000

Survey cost

8,900

Training equipment, etc.

$136,400

Equipment installation

65,600

Cost of grading the land

14,000

Soundproofing Administrative salary Total cost

14,400

7,200

58,700 43,200

$724,500

$142,800

$1,396,900

7,200 $209,200

2. User Insight: Impact of classifications discussed The classification of the above items among several accounts will affect profitability because each of the items has a different useful life. Land, for instance, is presumed to have an unlimited life and is not depreciated. The other accounts will be depreciated over different useful lives, thereby increasing expenses over those lives. All of this is in the interest of achieving a proper application of the matching rule.

447 .

Chapter 9, P 3. 1.

Depreciation computed Depreciation Table

Depreciation Method

Year

Straight-line

$330,000 * ÷

330,000

Depreciation

Carrying Value

$ 82,500

$277,500

82,500

195,000

330,000

82,500

112,500

330,000

82,500

30,000

$330,000 * x

$ 99,000

261,000

330,000

132,000

129,000

330,000

66,000

63,000

330,000

Double-

$360,000

declining-

balance

Production

Computation

6,000 20,000 8,000 20,000 4,000 20,000 2,000

33,000

30,000

20,000 50%†

$180,000

180,000

50%

90,000

50%

45,000

–

$30,000

15,000** **

30,000

* $360,000 – $30,000 = $330,000 † 100% ÷ 4 years = 25% × 2 = 50% ** To reduce to estimated residual value. 2.

Gain or loss determined

If the robot was sold for $375,000 after year 2, the gain or loss under each method follows: a. b. c.

a gain of a gain of a gain of

$180,000 $246,000 $285,000

( ( (

$375,000 $375,000 $375,000

– – –

$195,000 $129,000 $ 90,000

) ) )

448 .

Chapter 9, P 3. (Continued) 3.

User Insight: Patterns of depreciation and effects on profitability and cash flows

Straight-line results in equal amounts of annual depreciation over the four years. The production method results in variable amounts of depreciation and is unpredictable from year to year. The accelerated method results in more depreciation in the earlier years and less in the later years. The method of depreciation thus affects the reported profitability of the company, but has no effect on operating cash flows. The entry to record depreciation expense does not involve the Cash account. Cash was expended as an investing activity when the asset was purchased.

449 .

Chapter 9, P 4. 1.

Depreciation computed Depreciation Table

Depreciation Method

Year

Straight-line

$651,000 *

651,000

Depreciation

Carrying Value

$108,500

$612,500

108,500

504,000

651,000

108,500

395,500

651,000

108,500

287,000

651,000

108,500

178,500

651,000

108,500

70,000

$651,000*

$117,180

$603,820

651,000

130,200

473,620

651,000

162,750

310,870

651,000

97,650

213,220

651,000

78,120

135,100

651,000

Double-

$721,000

declining-

balance

Production

Computation

1,800 10,000 2,000 10,000 2,500 10,000 1,500 10,000 1,200 10,000 1,000

65,100

70,000

10,000 33.34%†

$240,381

$480,619

480,619

33.34%

160,238

320,380

33.34%

106,815

213,566

33.34%

71,203

142,363

33.34%

47,464

94,899

–

$70,000

24,899** **

70,000

* $721,000 – $70,000 = $651,000 † 100% ÷ 6 years = 16.67% x 2 ** To reduce to estimated residual value.

= 33.34%

450 .

Chapter 9, P 4. (Continued) 2.

†

Gain or loss determined

If the crane was sold for $500,000 after year 3, the gain or loss under each method follows: a.

a gain of

$104,500

( $500,000

–

$395,500 )

a gain of

$189,130

( $500,000

–

$310,870 )

a gain of

$286,434

( $500,000

–

$213,566 )

User Insight: Patterns of depreciation and effects on profitability and cash flows

Straight-line results in equal amounts of annual depreciation over the six years. The production method results in variable amounts of depreciation and is unpredictable from year to year. The accelerated method results in more depreciation in the earlier years and less in the later years. The method of depreciation thus affects the reported profitability of the company, but has no effect on operating cash flows. The entry to record depreciation expense does not involve the Cash account. Cash was expended as an investing activity when the asset was purchased.

451 .

Chapter 9, P 5. 1. Depletion charge per ton computed Cost of land and ore

$ 3,300,000 ( 600,000)

Residual value of land Cost of ore Estimated tons of ore

$ 2,700,000 10,000,000 $

Depletion charge per ton

0.27

2. Depletion expense computed Tons of ore mined and sold Depletion charge per ton

450,000 $ 0.27 $121,500

Depletion expense 3. Depreciation expense determined for buildings Cost of buildings

$300,000

Percentage of depletion (

450,000

10,000,000

)

Depreciation expense

0.045 $ 13,500

4. Depreciation expense determined for equipment Cost of equipment

$360,000

Percentage of depletion

a. Depreciation proportional to depletion

0.045 $ 16,200

b. Depreciation, straight-line method (

$360,000

$ 36,000

10 years)

5. User Insight: Effect of change in depletion expense discussed If the company sold and mined 250,000 tons of ore instead of 450,000, the amount of depletion expense and depreciation expense would decrease. The changes in depletion expense and depreciation expense, in and of themselves, will not affect cash flows, but the decrease in revenues will decrease cash flows. Profitability will also decrease due to the lower sales.

452 .

Chapter 9, P 6. 1. Schedule prepared Pappas Computers Schedule of Proper Charges for Training Center December 31, 2011 Land Attorney's fee

$ 35,200

Cost of land

597,000

Land Improvements

Building

Equipment

Architect's fee, building design

$ 102,000

Building

1,025,000

Parking lot and sidewalk

$135,600

Electrical wiring, building

168,000

Landscaping

55,000

Survey cost

8,900

Training equipment, etc.

$136,400

Equipment installation

65,600

Cost of grading the land

14,000

Soundproofing Administrative salary Total cost

14,400

7,200

58,700 43,200

$724,500

$142,800

$1,396,900

7,200 $209,200

453 .

Chapter 9, P 7. 1.

Depreciation computed Depreciation Table Depreciation Method

Depreciation $ 82,500

$277,500

Computation $330,000 * ÷ 4

330,000

82,500

195,000

330,000

82,500

112,500

330,000

82,500

30,000

$330,000

$ 99,000

$261,000

330,000

132,000

129,000

330,000

66,000

63,000

330,000

33,000

30,000

Double-

$360,000

50% †

$180,000

declining-

180,000

50%

90,000

balance

90,000

50%

45,000

–

$30,000

15,000

30,000 **

Straight-line

Production

Year

Carrying Value

6,000 20,000 8,000 20,000 4,000 20,000 2,000 20,000

$30,000 = $330,000 * $360,000 – † 100% ÷ 4 years = 25% × 2 = 50% ** To reduce to estimated residual value 2.

Gain or loss determined

If the robot was sold for $375,000 after year 2, the gain or loss under each method would be as follows: a. b. c.

a gain of a gain of a gain of

$180,000 $246,000 $285,000

( ( (

$375,000 $375,000 $375,000

454 .

– – –

$195,000 $129,000 $ 90,000

) ) )

Chapter 9, P 7. (Continued) 3.

User Insight: Patterns of depreciation and effects on profitability and cash flows

Straight-line results in equal amounts of annual depreciation over the four years. The production method results in variable amounts of depreciation and is unpredictable from year to year. The accelerated method results in more depreciation in the earlier years and less in the later years. The method of depreciation thus affects the reported profitability of the company but has no effect on operating cash flows. The entry to record depreciation expense does not involve the Cash account. Cash was expended as an investing activity when the asset was purchased.

455 .

Chapter 9, P 8. 1. Depletion charge per ton computed Cost of land and ore

$ 3,300,000 ( 600,000)

Residual value of land Cost of ore Estimated tons of ore

$ 2,700,000 10,000,000 $

Depletion charge per ton

0.27

2. Depletion expense computed Tons of ore mined and sold Depletion charge per ton

450,000 $0.27 $121,500

Depletion expense 3. Depreciation expense determined for buildings Cost of buildings

$300,000

Percentage of depletion (

450,000

10,000,000 )

0.045 $ 13,500

Depreciation expense 4. Depreciation expense determined for equipment Cost of equipment Percentage of depletion

a. Depreciation proportional to depletion

$360,000 0.045 $ 16,200

b. Depreciation, straight-line method (

$360,000

$ 36,000

10 years)

456 .

Chapter 9, P 9. 1.

Depreciation computed Depreciation Table Depreciation Method

$ 93,000

$422,000

1 2

465,000

93,000

329,000

465,000

93,000

236,000

465,000

93,000

143,000

465,000

93,000

50,000

$465,000

$ 93,000

$422,000

465,000

103,333

318,667

465,000

129,167

189,500

465,000

77,500

112,000

465,000

62,000

50,000

Double-

$515,000

40%

$206,000

$309,000

declining-

309,000

40%

123,600

185,400

balance

185,400

40%

74,160

111,240

40%

44,496

66,744

– $50,000

16,744

50,000 **

Production

Depreciation

Computation $465,000 * ÷ 5

Straight-line

Year

Carrying Value

3,600 18,000 4,000 18,000 5,000 18,000 3,000 18,000 2,400 18,000 †

** $515,000 – $50,000 = $465,000 100% ÷ 5 years = 20% × 2 ** To reduce to estimated residual value *

†

= 40%

457 .

Chapter 9, P 9. (Continued) 2.

†

Gain or loss determined

If the truck was sold for $300,000 after year 3, the gain or loss under each method would be as follows: a.

a gain of

$ 64,000

( $300,000

–

$236,000 )

a gain of

$110,500

( $300,000

–

$189,500 )

a gain of

$188,760

( $300,000

–

$111,240 )

User Insight: Patterns of depreciation and effects on profitability and cash flows

Straight-line results in equal amounts of annual depreciation over the five years. The production method results in variable amounts of depreciation and is unpredictable from year to year. The accelerated method results in more depreciation in the earlier years and less in the later years. The method of depreciation thus affects the reported profitability of the company but has no effect on operating cash flows. The entry to record depreciation expense does not involve the Cash account. Cash was expended as an investing activity when the asset was purchased.

458 .

Chapter 9, C 1. The advantage to the airlines of increasing the useful life of aircraft is that the annual depreciation charge will decrease. This will serve to increase earnings or reduce losses of the airlines. However, changing the amount of the annual depreciation expense will not affect the amount of cash flows. Whatever problems the airlines have with liquidity will continue. It is true that the useful lives of most longterm assets can be extended by good maintenance and testing, but the assets will eventually have to be replaced simply because new technology will make them obsolete. The costs of these assets benefit the useful lives of the assets and should be allocated to that life to achieve a proper matching of revenue and expenses. These depreciable costs are separate and apart from the maintenance and testing costs that are expenses in the years in which they occur. Chapter 9, C 2. Asset impairment occurs when the carrying value of a long-term asset exceeds its fair value. When an impairment occurs, a loss is recorded and the recorded value of the asset is reduced. This entry reduces the earnings of the current period but does not affect cash flows. The concept of impairment is considered a conservative method because it recognizes losses when fair value is below carrying value, but it does not recognize gains when the fair value exceeds carrying value. This is in line with the convention of conservatism, which holds that losses should be anticipated but gains should be deferred. Chapter 9, C 3. The two principal estimates that must be made to compute the annual depreciation charge are the estimated useful life and the residual value. The two most important factors that must be taken into consideration in making these estimates are the extent of physical deterioration that will occur and the rate at which the asset will become obsolete.

459 .

Chapter 9, C 4. Brands are recorded when purchased from other companies; therefore, Hilton's asset brands resulted from acquisition. However, if brands are internally developed or if a company only manages a brand for the owner, then no asset would be recorded for brands. For one or both of these reasons, Marriott has no asset on its balance sheet for brands. However, if another company wanted to buy Marriott's internally generated brands, the Marriott brands would certainly have great value. Both Marriott and Hilton benefit from their brands, but Hilton has an asset for brands on its balance sheet that is subject to an annual impairment test. Marriott has no asset for brands on its balance sheet. As a result, in measures of profitability such as return on assets, Marriott will appear to do relatively better than Hilton.

460 .

Chapter 9, C 5. 1. Property and equipment discussed In 2009, property and equipment, net constituted 12.9 percent ($7,923 ÷ $61,641) of total assets. The components of property and equipment were land, building and improvements, fixtures and equipment, leasehold improvements, and software. Fixtures and equipment at over $6.3 billion of investment is the largest component. Leasehold improvements are improvements to leased property that become the property of the lessor at the end of the lease. This is the second-largest category for CVS at almost $2.7 billion. The company leases most of its stores, which results in a demand for these types of improvements. Leasehold improvements are depreciated over the life of the leases and thus reduce income by the amount of the depreciation (excluding tax effects). 2. Depreciation discussed Property, equipment and improvements to leased premises are depreciated using the straight-line method over estimated useful lives of the assets or, when applicable, the term of the lease, whichever is shorter. Estimated useful lives generally range from 10 to 40 years for buildings, building improvements, and leasehold improvements and 3 to 10 years for fixtures and equipment. Major renewals and replacements that substantially extend the useful life of an asset are capitalized and depreciated. CVS capitalizes application development stage costs for significant internally developed software projects. These costs are amortized over the estimated useful lives of the software, which generally range from 3 to 5 years. CVS will have to remodel its stores several times over the life of the buildings because the fixtures and equipment have shorter useful lives than the buildings do. 3. Impairment discussed When evaluating assets for impairment, CVS first compares the carrying value of the asset to the asset's estimated future cash flows. If the estimated future cash flows used in this analysis are less than the carrying amount of the asset, an impairment loss calculation is prepared.

461 .

Chapter 9, C 6. 1. Expenditures on property and equipment analyzed (in millions) CVS

2009

2008

Property and equipment expenditures Net property and equipment Percentage

$ 2,548 $ 7,923 32.2% *

$ 2,180 $ 8,125 26.8% *

Southwest Airlines

2009

2008

Property and equipment expenditures Net property and equipment

Percentage

585 10,634 5.5% *

923 11,040 8.4% *

Southwest is increasing its long-term assets by additional expenditures by only 5 to 8 percent per year. CVS is growing much faster at the rate of about 27 to 32 percent per year. *Rounded 2. Free cash flow analyzed (in millions) Free Net Cash Flows from = – Dividends – Cash Flow Operating Activities

Purchases of Plant Assets

Sales of Plant Assets

CVS $4,035 $1,071

–

$439

–

$2,548

$23

$3,947 $1,403

–

$383

–

$2,180

$19

$985 $387

–

$13

–

$ 585** +

2008 = ($1,521) – = ($2,457)

$13

–

$ 923** +

2009 = = 2008 = = Southwest 2009 = =

** Purchases are net of sales Except for the negative operating cash flows and thus negative free cash flow for Southwest Airlines in 2008, both companies have had positive free cash flows. However, CVS has had substantially higher free cash flow for boths years analyzed. CVS is able to fund its expansion of plant assets and dividends from operations and does not have to look for outside funding, while Southwest must look to other sources aside from operations to fund part of its expansion. 462

Chapter 9, C 7. Depreciation in and of itself does not affect cash flows because it is an allocation of the cost of purchase and does not require a cash outlay when it is recorded. However, cash flows are affected by the decision in that depreciation is deductible for tax purposes. Thus, the decision that results in the higher level of annual depreciation (the controller's plan) will have a possible effect on cash flows in that it will reduce income taxes by $32,400 compared to the CFO's plan. This is an ethical dilemma to the extent that one or the other of the plans is a false representation of the true situation. In cases like this, the true allocation between land and building is unlikely to be precise and is a matter of judgment. However, some reasonable allocation can usually be made based on separate appraisals of the land and the building. The company and therefore the people who have a stake in it, such as the stockholders and management, would probably benefit from the approach that would save income taxes. Thus, to the extent that an appraisal of the relative values of the land and building would support a lower land value, the company would benefit. The government would not benefit from this approach.

463 .

Chapter 9, C 8. 1.

Present value computed for each type of equipment

Type A $1,000,000

Immediate Cash Outlay = Present Value

Type B Amount of Non-Interest-Bearing Note × $1,346,000

Factor

= Present Value

0.743

$1,000,078

(factor from Table 1 in Appendix B = 2 years at 16%) 2.

Net present value computed for each type of equipment

Type A Annual Net Cash Receipts ×

Factor

$340,000 × 3.274 (factor from Table 2 in Appendix B = 5 years at 16%) Net Present Value =

$1,113,160

–

= Present Value =

$1,000,000

$1,113,160 =

$113,160

Type B Net Cash Receipts

—

Year 2

500,000

0.743

371,500

Year 3

600,000

0.641

384,600

Year 4

600,000

0.552

Year 5

200,000

0.476

331,200 95,200

Year 1

Factor*

$1,182,500

*Table 1 in Appendix B, 16%

464 .

—

$1,182,500

Total Present Value Net Present Value =

Present Value

–

$1,000,078

$182,422

Chapter 9, C 8. (Continued) 3.

Memorandum with recommendation Memorandum

Date: To: From: Re:

Today's Date Board of Directors Student Purchase Recommendation

We have two machines that will enable us to manufacture the parts for the new subcontract: Type A:

Conventional equipment that can be put into service immediately for $1,000,000

Type B:

Special equipment that will take a year to be put into service for $1,346,000

To compare these two options requires the use of present values to convert the cash flows from each to a comparable basis. On a present value basis, using 16 percent interest (rate of return), the investments both cost approximately $1,000,000, as shown in schedule 1 . When the net cash receipts are considered on a present value basis, as calculated in schedule 2 , Type B has a higher net present value: $182,422 versus $113,160 for Type A. This means that although both options will be profitable, I recommend choosing Type B because it will have a higher rate of return. If you have any further questions, please let me know.

465 .

CHAPTER 10—Solutions LONG-TERM LIABILITIES

Chapter 10, SE 1. 1. Advantage 2. Disadvantage 3. Disadvantage 4. Advantage 5. Advantage Chapter 10, SE 2. a. 4 b. 7 c. 1 d. 3 e. 2 f. 6 g. 5 Chapter 10, SE 3.

Month 0 1 2 3

Monthly Payment $1,200 1,200 1,200

* 8% ÷ 12 ** Rounded

Interest for 1 Month at 0.6667%* on Unpaid Balance $1,000 999 ** 997 **

= 0.006667

466 .

Reduction in Debt

Unpaid Balance at End of Period

$200 201 203

$150,000 149,800 149,599 149,396

Chapter 10, SE 4.

Monthly Payment

Month 0 1 2 3

$1,800 1,800 1,800

Interest for 1 Month at 0.75%* on Unpaid Balance $1,688 ** 1,687 ** 1,686 **

Reduction in Debt $112 113 114

Unpaid Balance at End of Period $225,000 224,888 224,775 224,661

* 9% ÷ 12 = 0.0075 ** Rounded Chapter 10, SE 5. 2011 Dec.

31 Income Taxes Expense Deferred Income Taxes Income Taxes Payable To record income taxes expense, income

35,000 5,000 30,000

Income Taxes Expense appears on the income statement and Income Taxes Payable is a current liability on the balance sheet. Deferred Income Taxes is a longterm liability because it is associated with a long-term asset (buildings). Chapter 10, SE 6. Choice A Present value of 40 periodic payments at 6% (from Table 2*) $32,000 × 15.046 Present value of a single payment at the end of 40 periods at 6% (from Table 1*) $600,000 × 0.097 Total present value of Choice A

$481,472

58,200 $ 539,672

Choice B Present value of 30 periodic payments at 6% (from Table 2*) $30,000 × 13.765 Present value of a single payment at the end of 30 periods at 6% (from Table 1*) $600,000 × 0.174 Total present value of Choice B

104,400 517,350 $1,057,022

Total present value of both bonds *From Appendix B

$412,950

467

Chapter 10, SE 7. 2011 Apr. 1 Cash Unamortized Bond Discount

7,840,000 160,000

Bonds Payable

8,000,000

Issued 8.5%, 5-year bonds at 98 $8,000,000 × 0.98 = $7,840,000 Oct. 1 Bond Interest Expense Unamortized Bond Discount

356,000 16,000 340,000

Cash To pay semiannual interest and amortize discount $160,000 = $16,000 $8,000,000

(

5 years ×

2 )

× 0.085 × 6 / 12

= $340,000 2012 Apr. 1 Bond Interest Expense Unamortized Bond Discount

356,000 16,000

Cash

340,000

To pay semiannual interest and amortize discount $160,000 ÷ ( 5 years × 2 ) = $16,000 $8,000,000 × 0.085 × 6 / 12 = $340,000

468 .

Chapter 10, SE 8. 2011 Apr. 1 Cash Unamortized Bond Premium

10,200,000 200,000

Bonds Payable

10,000,000

Issued 8%, 5-year bonds at 102 $10,000,000

× 1.02

= $10,200,000 Oct. 1 Bond Interest Expense Unamortized Bond Premium

380,000 20,000

Cash

400,000

To pay semiannual interest and amortize premium $200,000

= $20,000 $10,000,000

( 5 ×

years

0.080

2 )

× 6 / 12

= $400,000 2012 Apr. 1 Bond Interest Expense Unamortized Bond Premium

380,000 20,000

Cash

400,000

To pay semiannual interest and amortize premium $200,000 = $20,000 $10,000,000

( 5 ×

years

0.080

2 )

× 6 / 12

= $400,000

469 .

Chapter 10, SE 9. 2011 Mar.

1 Cash Unamortized Bond Premium Bonds Payable Sold 9.5%, 20-year bonds at 106 $200,000 × 1.06 =

212,000 12,000 200,000 $212,000

Aug. 31 Bond Interest Expense Unamortized Bond Premium Bond Interest Payable Recorded accrued semiannual interest and amortized premium on 9.5%, 20-year bonds ( $200,000 × 0.095 × 6 / 12 ) – ( $212,000 × 0.089 × 6 / 12 ) = $9,500 – $9,434 = $66

9,434 66

Sept.

9,500

1 Bond Interest Payable Cash Paid semiannual interest

9,500

Chapter 10, SE 10. Dec.

1 Bonds Payable Loss on Retirement of Bonds Unamortized Bond Discount Cash Retired 8% bonds at call price of 104 $240,000 × 1.04 = $249,600 $240,000 $400,000

$10,500

240,000 15,900

$6,300

Chapter 10, SE 11. a.

Amount paid: $100,000 × 1.03 = $103,000

There is a loss on retirement of $500, computed as follows: Cash paid – Book value: $103,000 – ($100,000 + $2,500) = $500

470 .

6,300 249,600

Chapter 10, SE 12. 2011 Mar.

1 Bonds Payable Unamortized Bond Discount Common Stock Additional Paid-In Capital Converted $1,200,000 of 6% bonds into common stock at the rate of 20 shares for each $1,000 bond 1,200 × 20 shares = 24,000 shares 24,000 shares × $10 = $240,000 $1,200,000

$40,000

$24,000

$1,200,000 – (

$24,000

$240,000 )

$2,000,000

1,200,000 24,000 240,000 936,000

= $936,000 Chapter 10, SE 13. 2011 June

1 Bonds Payable Unamortized Bond Discount Common Stock Additional Paid-In Capital Converted $1,800,000 of 8% bonds into common stock at the rate of 30 shares for each $1,000 bond 1,800 × 30 shares = 54,000 shares 54,000 shares × $10 = $540,000 $1,800,000

$60,000

$36,000

$1,800,000 – (

$36,000

$540,000

$3,000,000

= $1,224,000

471 .

)

1,800,000 36,000 540,000 1,224,000

Chapter 10, E 1. 1.

The lender reviews the enterprise’s current earnings and cash flows as well as its debt to equity and interest coverage ratios. The analysis may also include a historical comparison that reflects both good and poor economic times. The lender can then judge how well the company has met its past debt obligations. The company would most likely issue a secured bond because rather than being issued on the company’s general credit, certain assets are pledged as a guarantee of repayment. A company may choose to lease rather than buy a long-term asset because the amount paid on a lease is immediately tax-deductible as opposed to depreciation on the purchased asset over the asset’s life. Further, a lease does not require the purchase of the asset for either cash or debt. Callable and convertible bonds are considered to add to management’s future flexibility in financing a business because they offer options for management to refinance or call the bonds if interest rates change.

Chapter 10, E 2. 1. 2.

3. 4.

The relationship between the prevailing market rate of interest and the face interest rate on the issue date is the determinant. The market price of a bond varies over time because the market interest rate varies in relation to the face interest rate and the market interest rate is used to determine the market price of the bond. The straight-line method is acceptable only when it does not produce a result materially different from that produced by the effective interest method. Bond interest expense must be accrued at the close of each accounting period to ensure proper matching of all the borrowing costs associated with bonds payable. Interest payment dates rarely coincide with the end of the accounting period.

472 .

Chapter 10, E 3. Interest Coverage Ratio =

2011 =

2012 =

Income Before Income Taxes + Interest Expense Interest Expense +

$7,580

$1,650

$1,650 $9,230

= 5.6 Times

$1,650

$9,045

$2,900

$2,900 $11,945 $2,900

= 4.1 Times

The interest coverage ratio declined from 2011 to 2012 from 5.6 to 4.1 times. The reason for the decline is that interest expense grew faster than income before income taxes.

473 .

Chapter 10, E 4. 1. Monthly payment schedule prepared

Month 0 1 2 3

Monthly Payment $4,000 4,000 4,000

Interest for 1 Month at 1% on Unpaid Balance

Reduction in Debt

Unpaid Balance at End of Period

$1,000 1,010 1,020

$300,000 299,000 297,990 296,970

$3,000 2,990 2,980

2. Entries prepared in journal form

Month 1

Month 2

Building Mortgage Payable Purchased building by signing a mortgage

300,000

Mortgage Interest Expense Mortgage Payable Cash Made first monthly payment on mortgage

3,000 1,000

Mortgage Interest Expense Mortgage Payable Cash Made second monthly payment on mortgage

2,990 1,010

474 .

300,000

4,000

Chapter 10, E 5. 1.

Present value calculated

Periodic Payment × Factor (Table 2 in Appendix B: 15%, 12 periods) = Present Value of Lease $86,000 5.421 × = $466,206 2.

Journal entry prepared to record the lease agreement

Capital Lease Equipment Capital Lease Obligations Recorded the lease contract 3.

466,206 466,206

Journal entry prepared to record depreciation for the first year

Depreciation Expense—Capital Lease Equipment Accumulated Depreciation—Capital Lease Equipment Recorded depreciation on leased equipment for first year $466,206 ÷ 12 years = $38,851 4.

38,851 38,851

Journal entries prepared to record lease payments

Year 1 Interest Expense Capital Lease Obligations Cash Made lease payment for first year $466,206 × 0.15 = $69,931

69,931 16,069

Year 2 Interest Expense Capital Lease Obligations Cash Made lease payment for second year ( $466,206 – $16,069 ) × 0.15 = $67,521

67,521 18,479

475 .

86,000

Chapter 10, E 6. 2011 Dec. 31 Income Taxes Expense Deferred Income Taxes Income Taxes Payable To record income taxes expense, income taxes payable, and related deferred taxes liability

120,000 40,000 80,000

Income Taxes Expense appears on the income statement and Income Taxes Payable is a current liability on the balance sheet. Deferred Income Taxes is a longterm liability because it is associated with a long-term asset (equipment). Chapter 10, E 7. Choice A Present value of 40 periodic payments at 6% (from Table 2*): $32,000 × 15.046 Present value of a single payment at the end

$481,472

of 40 periods at 6% (from Table 1*): $400,000

38,800

× 0.097

Issue price (total present value) of Choice A

$ 520,272

Choice B Present value of 30 periodic payments at 6% (from Table 2*): $30,000 × 13.765 Present value of a single payment at the end of 30 periods at 6% (from Table 1*): $400,000 × 0.174 Issue price (total present value) of Choice B Issue price (total present value) of both bonds *From Appendix B

476 .

$412,950

69,600 482,550 $1,002,822

Chapter 10, E 8. a.

Present value of 20 periodic payments at 5% (from Table 2*): $6,000 × 12.462 Present value of a single payment at the end of 20 periods at 5% (from Table 1*): $150,000 × 0.377 Issue price (total present value) of bond issue

Present value of 20 periodic payments at 3% (from Table 2*): $6,000 × 14.878 Present value of a single payment at the end of 20 periods at 3% (from Table 1*): $150,000 × 0.554 Issue price (total present value) of bond issue

Present value of 20 periodic payments at 4% (from Table 2*): $7,500 × 13.590 Present value of a single payment at the end of 20 periods at 4% (from Table 1*): $150,000 × 0.456 Issue price (total present value) of bond issue

Present value of 40 periodic payments at 6% (from Table 2*): $7,500 × 15.046 Present value of a single payment at the end of 40 periods at 6% (from Table 1*): $150,000 × 0.097 Issue price (total present value) of bond issue

Present value of 40 periodic payments at 3% (from Table 2*): $7,500 × 23.115 Present value of a single payment at the end of 40 periods at 3% (from Table 1*): $150,000 × 0.307 Issue price (total present value) of bond issue

* From Appendix B ** Rounded

477 .

$ 74,772 56,550 $131,322

$ 89,268 83,100 $172,368

$101,925 68,400 $170,325

$112,845 14,550 $127,395

$173,363** 46,050 $219,413

Chapter 10, E 9. Face value of 30-year, 10% zero coupon bonds, compounded annually: Present value of a single payment at the end of 30 periods at 10% (from Table 1*): Face value × Face value = Face value =

0.057 = $50,000,000 $50,000,000 ÷ 0.057 $877,192,983 or about $877 million

Face value of 50-year, 10% zero coupon bonds, compounded annually: Present value of a single payment at the end of 50 periods at 10% (from Table 1*): Face value × Face value = Face value =

0.009 = $50,000,000 $50,000,000 ÷ 0.009 $5,555,555,556 or about $5.56 billion

Face value of 30-year, 8% zero coupon bonds, compounded annually: Present value of a single payment at the end of 30 periods at 8% (from Table 1*): Face value × Face value = Face value =

0.099 = $50,000,000 $50,000,000 ÷ 0.099 $505,050,505 or about $505 million

Face value of 50-year, 8% zero coupon bonds, compounded annually: Present value of a single payment at the end of 50 periods at 8% (from Table 1*): Face value × Face value = Face value =

0.021 = $50,000,000 $50,000,000 ÷ 0.021 $2,380,952,381 or about $2.38 billion

*From Appendix B

478 .

Chapter 10, E 10. 1. a. Cash received: $8,000,000

b. Bonds payable:

1.04

= $8,320,000

$8,000,000

c. The difference of $320,000 is called unamortized bond premium. 2. a. Cash paid in interest: $8,000,000

0.105

× 6 / 12 = $420,000

b. Amortization of bond premium: (

$320,000

÷ 10 years ) ÷

c. Interest expense: $420,000 – $16,000

= $16,000

= $404,000

3. a. Cash paid in interest: $8,000,000

0.105

× 6 / 12 = $420,000

b. Amortization of bond premium: (

$320,000

÷ 10 years ) ÷

= $16,000

c. Interest expense: $420,000

–

$16,000

= $404,000

Note: Part 2 and part 3 are identical.

479 .

Chapter 10, E 11. 2011 Mar.

1 Cash Unamortized Bond Discount Bonds Payable Issued 8.5%, 5-year bonds at 96 $4,000,000 × 0.96 = $3,840,000

3,840,000 160,000

Sept. 1 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount $160,000 ÷ ( 5 years × 2 ) = $16,000 $4,000,000 × ( 0.085 ÷ 2 ) = $170,000 $170,000 + $16,000 = $186,000

186,000

2012 Mar.

1 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount $160,000 ÷ ( 5 years × 2 ) = $16,000 $4,000,000 × ( 0.085 ÷ 2 ) = $170,000 $170,000 + $16,000 = $186,000

480 .

4,000,000

16,000 170,000

186,000 16,000 170,000

Chapter 10, E 12. 2011 Mar.

1 Cash Unamortized Bond Premium Bonds Payable Issued 7.0%, 5-year bonds at 103 $5,000,000 × 1.03 = $5,150,000

5,150,000

Sept. 1 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized premium $150,000 ÷ ( 5 years × 2 ) = $15,000 $5,000,000 × 0.070 × 6 / 12 = $175,000

160,000 15,000

2012 Mar.

1 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized premium $150,000 ÷ ( 5 years × 2 ) = $15,000 $5,000,000 × 0.070 × 6 / 12 = $175,000

481 .

150,000 5,000,000

175,000

160,000 15,000 175,000

Chapter 10, E 13. 1. a. Cash received: $250,000

b. Bonds payable:

1.06

$265,000

$250,000

c. The difference of $15,000 is called unamortized bond premium. 2. a. Cash paid in interest: $250,000

× 0.095 ×

6 / 12 = $11,875

b. Amortization of bond premium: ( $250,000

× 0.095 ×

6 / 12 )

–

( $265,000

× 0.089 ×

6 / 12 )

–

= $82

$11,875

$11,793

c. Interest expense: $11,875 – $82

$11,793

3. a. Cash paid in interest: $250,000

× 0.095 ×

6 / 12 = $11,875

b. Amortization of bond premium: ( $250,000

× 0.095 ×

[( $265,000

–

$11,875

6 / 12 )

) ×

$82

– $11,789

0.089

= $86

c. Interest expense: $11,875

–

$86

$11,789

482 .

– × 6 / 12 ] =

Chapter 10, E 14. 2011 Mar.

1 Cash Unamortized Bond Discount Bonds Payable Sold 10%, 5-year bonds at a discount

2,302,660 97,340

Aug. 31 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 10%, 5-year bonds $2,302,660 ( × 0.11 × 6 / 12 ) – $2,400,000 ( × 0.10 × 6 / 12 ) = $126,646 – $120,000 = $6,646

126,646

2012 Feb. 28 Bond Interest Expense Unamortized Bond Discount Cash Recorded accrued semiannual interest and amortized the discount on 10%, 5-year bonds $2,302,660 [( + $6,646 ) × 0.11 × 6 / 12 ] – ( $2,400,000 × 0.10 × 6 / 12 ) = $127,012 – $120,000 = $7,012

483 .

2,400,000

6,646 120,000

127,012 7,012 120,000

Chapter 10, E 15. 1. Cash paid to retire bonds calculated Cash paid: $480,000

× 1.04 = $499,200

2. Gain or loss calculated Unamortized discount attributable to retired bonds: (

$480,000

$800,000

)

$21,000

= $12,600

$499,200

–

(

$480,000

–

$12,600

)

Loss: = $31,800

Chapter 10, E 16. 1.

There is no gain or loss on the conversion because the stock issued for the bonds will be recorded at the carrying value of the bonds.

The number of shares issued for the bonds is calculated as follows: (

$600,000

$1,000

)

× 20 shares

12,000 shares

Effects of bond conversion: Total liabilities are reduced by $570,000, as follows: Bonds payable Unamortized bond discount*

$600,000 30,000

Decrease in total liabilities

$570,000

$40,000 × (

$600,000

$800,000

)

Total stockholders’ equity will be increased by $570,000, as follows: Common stock

12,000 shares

× $10

Additional paid-in capital

$120,000 450,000

Increase in stockholders’ equity

$570,000

484 .

Chapter 10, E 17. 1. Current market value of the bonds calculated Present value of 20 periodic payments at 8% (16% ÷ 2) (from Table 2*): $28,000** × 9.818

$274,904

Present value of a single payment at the end of 20 periods with interest compounded semiannually at 8% (16% ÷ 2) (from Table 1*):

$700,000

150,500

0.215

Issue price (total present value) of bond issue

$425,404

* From Appendix B ** $700,000 × 8% × 6 / 12 = $28,000 2. Gain or loss determined Face value Cash paid

$700,000 425,404

Gain

$274,596

485 .

Chapter 10, P 1. 1.

Lease option examined

Present value calculated

Periodic Payment x Factor (Table 2 in the appendix on present value tables: 9%, 12 periods) = Present Value of Lease $12,000 7.161 x = $85,932 b.

Entry prepared in journal form to record the lease agreement

Capital Lease Equipment Capital Lease Obligations To record the lease contract c.

85,932 85,932

Entry prepared in journal form to record depreciation for the first year

Depreciation Expense, Capital Lease Equipment Accumulated Depreciation, Capital Lease Equipment To record depreciation on leased equipment for first year $85,932 12 years = $7,161  d.

7,161 7,161

Entries prepared in journal form to record lease payments

Year 1 Interest Expense Capital Lease Obligations Cash Made lease payment for first year $85,932 x 0.09 = $7,734

7,734 4,266

Year 2 Interest Expense Capital Lease Obligations Cash Made lease payment for second year ( $85,932 – $4,266 ) x 0.09 = $7,350

7,350 4,650

12,000

486 .

Chapter 10, P 1. (Continued) 2. Purchase option examined a. Monthly payment schedule prepared

Month 0 1 2 3

Monthly Payment $1,000 1,000 1,000

Interest for 1 Month at 0.75% on Unpaid Balance

Reduction in Debt

Unpaid Balance at End of Period

$400 403 406

$80,000 79,600 79,197 78,791

$600 597 * 594 *

*Rounded. b. Entries prepared in journal form

Month 1

Month 2

Building Mortgage Payable Purchased building by signing a mortgage

80,000

Mortgage Interest Expense Mortgage Payable Cash Made first monthly payment on mortgage

600 400

Mortgage Interest Expense Mortgage Payable Cash Made second monthly payment on mortgage

597 403

487 .

80,000

1,000

Chapter 10, P 1. (Continued) 3. Options discussed Based on the calculation it appears that the purchase is best because the cost of $80,000 is less than the net present value of the lease, which is $85,932. Both options result in an increase in assets and in liabilities. An advantage of the lease is that it has a limited term and the company has no more responsibility after completing the lease. A disadvantage is that if the company still needs customer parking after 12 years, it will have to make arrangements for new parking facilities, which could be releasing the current facility, if it is still used. Also, the owner of the facility may want to use the space for other purposes. An advantage of purchasing the building is that Shen has control over the property and can renovate, rebuild, or sell it, as the need arises. A disadvantage is that Shen assumes the responsibilities of ownership, which can include repairs, taxes, and other costs. In conclusion, the decision to lease or purchase depends both on financial and non-financial considerations.

488 .

Chapter 10, P 2. 1. Bond terminology identified 1.

10.

11.

12.

13.

14.

15.

16.

17.

2. User Insight: Effect of market interest rates A decrease in the market interest rate will increase the price of the bond, therefore issuing it at a premium. The amount of cash received will exceed face value. The interest expense will decrease because the amortization of the premium will reduce the face rate to the lower market rate. The amount of cash paid for interest will remain the same because cash paid equals the face interest rate times the face value.

489 .

Chapter 10, P 3. 1. Bonds issued at 103.5 on May 1, 2009 a.

Calculation of cash received: $4,000,000

1.035

= $4,140,000

Amount of Bonds Payable: $4,000,000

Difference between a and b explained: The difference of $140,000 between a and b is the bond premium.

Interest components (1) Cash paid in interest: $4,000,000

0.095

x 6 /

x 2

) =

$190,000

(2) Amortization computed: $140,000

÷ ( 25 years

2,800

(3) Interest expense computed: Interest expense

$190,000

–

$2,800

$187,200

2. Bonds issued at 96.5 on May 1, 2009 a.

Calculation of cash received: $4,000,000

0.965

= $ 3,860,000

Amount of Bonds Payable:

$4,000,000

Difference between a and b explained: The difference of $140,000 between a and b is the bond discount.

Interest components (1) Cash paid in interest: $4,000,000

0.095

x 6 /

$190,000

(2) Amortization computed: $140,000

÷ ( 25 years

x 2 )

2,800

(3) Interest expense computed: Interest expense

$190,000 +

$2,800

$192,800

490 .

Chapter 10, P 3. (Continued) 3. Bonds called and retired ten years later a. Cash to retire bonds: Call amount = $4,000,000

x 1.03

$4,120,000

b. Gain or loss calculated: Carrying value: $4,000,000 +

(

$140,000

–

$56,000 )

4,084,000

Since the call takes place after 10 years of a 25-year period, 40 percent or $56,000 of the $140,000 premium has been amortized. A loss exists because the call amount exceeds $

the carrying value of the bonds. Loss amount =

36,000

4. Bonds converted to common stock ten years later a. No gain or loss occurs in a bond conversion because the issued stock is recorded at the carrying value of the bonds that are converted. b. Numbers of shares of common stock computed: $4,000,000 ÷

$1,000

bonds

160,000 shares

c. Effects of liabilities and stockholders' equity shown: Bonds payable and its accompanying unamortized discount will be reduced in the liabilities. Common stock and additional paid-in capital will be increased in stockholders' equity. Decrease in liabilities Bonds payable Unamortized bond discount

$140,000

0.6

$4,000,000 ( 84,000) $3,916,000

Bond carrying value

Since the call takes places after 10 years of a 25-year period, 60 percent or $84,000 of the $140,000 discount remains to be amortized. Increase in stockholders' equity Common stock

160,000 shares

$10

Additional paid-in capital

$1,600,000 2,316,000

Total common stock issue amount

$3,916,000

491 .

Chapter 10, P 3. (Continued) 5. User Insight: Strategy of calling bonds when stock price has risen The company can improve its debt to equity ratio without using cash by calling the bonds. Since the price of the company's stock has risen, the bondholders will be better off electing to convert the bonds into common stock (the result in requirement 4) than selling them back to the company at the call price. The bondholders then have the option of keeping or selling the stock in the general market. A disadvantage of this approach is that it would increase the number of shares outstanding and increase the amount of stockholders' equity. The result would have the effect of reducing the key ratios of earnings per share and return on equity. Also, the current shareholders' share of the business would be diluted or reduced.

492 .

Chapter 10, P 4. 1. Journal entries prepared for bonds issued at more than face value 2011 Mar.

1 Cash Unamortized Bond Premium Bonds Payable Sold 9.5%, 25-year bonds at 102.5

2,050,000

Aug. 31 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 9.5%, 25-year bonds $50,000 ÷ ( 25 years × 2 ) = $1,000 $2,000,000 × 0.095 × 6 / 12 = $95,000

94,000 1,000

2012 Feb. 28 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 9.5%, 25-year bonds $50,000 ÷ ( 25 years × 2 ) = $1,000 $2,000,000 × 0.095 × 6 / 12 = $95,000

493 .

50,000 2,000,000

95,000

94,000 1,000 95,000

Chapter 10, P 4. (Continued) 2. Journal entries prepared for bonds issued at less than face value 2011 Mar.

1 Cash Unamortized Bond Discount Bonds Payable Sold 9.5%, 25-year bonds at 97.5

1,950,000 50,000

Aug. 31 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds $50,000 ÷ ( 25 years × 2 ) = $1,000 $2,000,000 × 0.095 × 6 / 12 = $95,000

96,000

2012 Feb. 28 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds $50,000 ÷ ( 25 years × 2 ) = $1,000 $2,000,000 × 0.095 × 6 / 12 = $95,000 3.

2,000,000

1,000 95,000

96,000 1,000 95,000

User Insight: Role of market interest rates

Market interest rates play a role in creating the premium and discount in the previous example. When market rates are below the face interest rate, a premium exists. When market rates are above the face interest rate, a discount exists.

494 .

Chapter 10, P 5. 1. Journal entries prepared for bonds issued at more than face value 2011 Mar.

1 Cash Unamortized Bond Premium Bonds Payable Sold 9.5%, 25-year bonds at 102.5

Aug.

2012 Feb.

50,000 2,000,000

31 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 9.5%, 25-year bonds ( $2,000,000 × 0.095 × 6 / 12 ) – ( $2,050,000 × 0.092 × 6 / 12 ) = $95,000 – $94,300 = $700

94,300 700

28 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 9.5%, 25-year bonds ( $2,000,000 × 0.095 × 6 / 12 ) – ( $2,049,300 * × 0.092 × 6 / 12 ) = $95,000 – $94,268 = $732

94,268 732

* $2,050,000

–

$700

$2,049,300

495 .

2,050,000

95,000

Chapter 10, P 5. (Continued) 2. Journal entries prepared for bonds issued at less than face value 2011 Mar.

1 Cash Unamortized Bond Discount Bonds Payable Sold 9.5%, 25-year bonds at 97.5

1,950,000 50,000

Aug. 31 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds ( $1,950,000 × 0.098 × 6 / 12 ) – ( $2,000,000 × 0.095 × 6 / 12 ) = $95,550 – $95,000 = $550

95,550

2012 Feb. 28 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds ( $1,950,550 * × 0.098 × 6 / 12 ) – ( $2,000,000 × 0.095 × 6 / 12 ) = $95,577 – $95,000 = $577 * $1,950,000

$550

2,000,000

550 95,000

95,577 577 95,000

= $1,950,550

3. User Insight: Role of market interest rates Market interest rates play a role in creating the premium and discount in the previous example. When market rates are below the face interest rate, a premium exists. When market rates are above the face interest rate, a discount exists.

496 .

Chapter 10, P 6. 1. Lease option examined a.

Present value calculated Periodic Payment × Factor (Table 2 in Appendix B: 8%, 15 periods) = Present Value of Lease $18,000 × 8.559 = $154,062

Journal entry prepared to record the lease agreement Capital Lease Equipment Capital Lease Obligations Recorded the lease contract

154,062 154,062

Journal entry prepared to record depreciation for the first year Depreciation Expense—Capital Lease Equipment Accumulated Depreciation—Capital Lease Equipment Recorded depreciation on leased equipment for first year $154,062 ÷ 15 years = $10,271

10,271 10,271

Journal entries prepared to record lease payments

Year 1 Interest Expense Capital Lease Obligations Cash Made lease payment for first year $154,062 × 0.08 = $12,325

12,325 5,675

Year 2 Interest Expense Capital Lease Obligations Cash Made lease payment for second year ( $154,062 – $5,675 ) × 0.08 = $11,871

11,871 6,129

497 .

18,000

Chapter 10, P 6. (Continued) 2. Purchase option examined a. Monthly payment schedule prepared

Month 0 1 2 3

Monthly Payment

Interest for 1 Month at 0.67% on Unpaid Balance

$1,500 1,500 1,500

Reduction in Debt

Unpaid Balance at End of Period

$696 701 705

$120,000 119,304 118,603 117,898

$804 799 795

*Rounded b. Journal entries prepared

Month 1

Month 2

Warehouse Building Mortgage Payable Purchased building by signing a mortgage

120,000

Mortgage Interest Expense Mortgage Payable Cash Made first monthly payment on mortgage

804 696

Mortgage Interest Expense Mortgage Payable Cash Made second monthly payment on mortgage

799 701

498 .

120,000

1,500

Chapter 10, P 6. (Continued) 3. Options discussed Based on the calculation, it appears that the purchase is best because the cost of $120,000 is less than the net present value of the lease, which is $154,062. Both options result in an increase in assets and in liabilities. An advantage of the lease is that it has a limited term and the company has no more responsibility after completing the lease. A disadvantage is that if the company still needs storage space after 15 years, it will have to make arrangements for new storage facilities, which could be accomplished by releasing the current facility if it is still used. Also, the owner of the facility may want to use the space for other purposes. An advantage of purchasing the building is that Fender has control over the property and can renovate, rebuild, or sell it as the need arises. A disadvantage is that Fender assumes the responsibilities of ownership, which can include repairs, taxes, and other costs. In conclusion, the decision to lease or purchase depends on both financial and nonfinancial considerations.

499 .

Chapter 10, P 7. 1. Bonds issued at 103 on June 1, 2010 a.

Calculation of cash received: $20,000,000

1.03

= $20,600,000

Amount of Bonds Payable: $20,000,000

Difference between a and b explained: The difference of

$600,000

between a and b is the bond premium.

Interest components (1) Cash paid in interest: $20,000,000

x 0.105 x

/ 12 =

)

$1,050,000

–

$15,000

$1,050,000

(2) Amortization computed: $600,000

( 20 years

15,000

(3) Interest expense computed: Interest expense =

$1,035,000

2. Bonds issued at 97 on June 1, 2010 a.

Calculation of cash received: $20,000,000

0.97

= $19,400,000

Amount of Bonds Payable: $20,000,000

Difference between a and b explained: The difference of

$600,000

between a and b is the bond discount.

Interest components (1) Cash paid in interest: $20,000,000

x 0.105 x

/ 12 =

)

$1,050,000

$15,000

$1,050,000

(2) Amortization computed: $600,000

( 20 years

15,000

(3) Interest expense computed: Interest expense =

500 .

$1,065,000

Chapter 10, P 7. (Continued) 3. Bonds called and retired ten years later a. Cash to retire bonds: Call amount = $20,000,000

1.04

$20,800,000

–

$300,000 ) =

20,300,000

b. Gain or loss calculated: Carrying value: $20,000,000

( $600,000

Since the call takes place after 10 years of a 20-year period, 50 percent or $300,000 of the $600,000 premium has been amortized. A loss exists because the call amount exceeds the carrying $

value of the bonds. Loss amount =

500,000

500,000 shares

$600,000

x 0.5

$20,000,000 ( 300,000) $19,700,000

Bond carrying value Since the call takes place after 10 years of a 20-year period, 50 percent or $300,000 of the $600,000 discount remains to be amortized. Increase in stockholders' equity Common stock 500,000 shares Additional paid-in capital Total common stock issue amount

501 .

$20

$10,000,000 9,700,000 $19,700,000

Chapter 10, P 7. (Continued) 5. User Insight: Strategy of calling bonds when stock price has risen The company can improve its debt to equity ratio without using cash by calling the bonds. Since the price of the company's stock has risen, the bondholders will be better off electing to convert the bonds into common stock (the result in requirement 4) than selling them back to the company at the call price. The bondholders then have the option of keeping or selling the stock in the general market. A disadvantage of this approach is that it would increase the number of shares outstanding and increase the amount of stockholders' equity. The result would have the effect of reducing the key ratios of earnings per share and return on equity. Also, the current shareholders' share of the business would be diluted or reduced.

502 .

Chapter 10, P 8. 1. Journal entries prepared for bonds issued at more than face value 2011 June

1 Cash Unamortized Bond Premium Bonds Payable Sold 10.5%, 20-year bonds at 103

Nov. 30 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 10.5%, 20-year bonds $300,000 ÷ ( 20 years × 2 ) = $7,500 $10,000,000 × 0.105 × 6 / 12 = $525,000 2012 May 31 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 9.5%, 25-year bonds $300,000 ÷ ( 20 years × 2 ) = $7,500 $10,000,000 × 0.105 × 6 / 12 = $525,000

503 .

10,300,000 300,000 10,000,000 517,500 7,500 525,000

517,500 7,500 525,000

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Chapter 10, P 8. (Continued) 2. Journal entries prepared for bonds issued at less than face value 2011 June

1 Cash Unamortized Bond Discount Bonds Payable Sold 10.5%, 20-year bonds at 97

9,700,000 300,000

Nov. 30 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds $300,000 ÷ ( 20 years × 2 ) = $7,500 $10,000,000 × 0.105 × 6 / 12 = $525,000

532,500

2012 May 31 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds $300,000 ÷ ( 20 years × 2 ) = $7,500 $10,000,000 × 0.105 × 6 / 12 = $525,000

10,000,000

7,500 525,000

532,500 7,500 525,000

504 .

Chapter 10, P 9. 1. Journal entries prepared for bonds issued at more than face value 2011 June

1 Cash Unamortized Bond Premium Bonds Payable Sold 8%, 25-year bonds at 103

10,300,000

Nov. 30 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 8%, 25-year bonds $300,000 ÷ ( 25 years × 2 ) = $6,000 $10,000,000 × 0.080 × 6 / 12 = $400,000

394,000 6,000

2012 May 31 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 8%, 25-year bonds $300,000 ÷ ( 25 years × 2 ) = $6,000 $10,000,000 × 0.080 × 6 / 12 = $400,000

505 .

300,000 10,000,000

400,000

394,000 6,000 400,000

Chapter 10, P 9. (Continued) 2. Journal entries prepared for bonds issued at less than face value 2011 June

Nov.

1 Cash Unamortized Bond Discount Bonds Payable Sold 8%, 25-year bonds at 97 30 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds $300,000 ÷ ( 25 years × 2 ) = $6,000 $10,000,000 × 0.080 × 6 / 12 = $400,000

2012 May 31 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.5%, 25-year bonds $300,000 ÷ ( 25 years × 2 ) = $6,000 $10,000,000 × 0.080 × 6 / 12 = $400,000

9,700,000 300,000 10,000,000 406,000 6,000 400,000

406,000 6,000 400,000

506 .

Chapter 10, P 10. 1. Journal entries prepared for bonds issued at more than face value 2011 Apr.

1 Cash Unamortized Bond Premium Bonds Payable Sold 9.6%, 10-year bonds at 102

15,300,000

Sept. 30 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 9.6%, 10-year bonds ( $15,000,000 × 0.096 × 6 / 12 ) – ( $15,300,000 × 0.093 × 6 / 12 ) = $720,000 – $711,450 = $8,550

711,450 8,550

2012 Mar.

31 Bond Interest Expense Unamortized Bond Premium Cash Paid semiannual interest and amortized the premium on 9.6%, 10-year bonds ( $15,000,000 × 0.096 × 6 / 12 ) – ( $15,291,450 * × 0.093 × 6 / 12 ) = $720,000 – $711,052 = $8,948

* $15,300,000

–

$8,550

= $15,291,450

507 .

300,000 15,000,000

720,000

711,052 8,948 720,000

Chapter 10, P 10. (Continued) 2. Journal entries prepared for bonds issued at less than face value 2011 Apr.

1 Cash Unamortized Bond Discount Bonds Payable Sold 9.6%, 10-year bonds at 96

14,400,000 600,000

Sept. 30 Bond Interest Expense Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 9.6%, 10-year bonds ( $14,400,000 × 0.102 × 6 / 12 ) – ( $15,000,000 × 0.096 × 6 / 12 ) = $734,400 – $720,000 = $14,400

734,400

2012 Mar.

31 Bond Interest Expense * Unamortized Bond Discount Cash Paid semiannual interest and amortized the discount on 10.5%, 20-year bonds ( $14,414,400 * × 0.102 × 6 / 12 ) – ( $15,000,000 × 0.096 × 6 / 12 ) = $735,134 – $720,000 = $15,134

* $14,400,000

$14,400

15,000,000

14,400 720,000

735,134 15,134 720,000

= $14,414,400

3. User Insight: Role of market interest rates Market interest rates play a role in creating the premium and discount in the previous example. When market rates are above the face interest rate, a discount exists. When market rates are below the face interest rate, a premium exists.

508 .

Chapter 10, C 1. Future commitments for operating leases, such as those described for Walgreens, do not appear on the balance sheet. The $2.0 billion for the current year will appear as an operating expense on the income statement. Often these operating leases represent commitments on the part of the company to make payments for five years or more in the future. Since these commitments for future payments do not appear on the balance sheet as liabilities, any ratio that includes debt, such as the debt to equity or interest coverage ratio, looks better than it would if the company recognized the future lease payments as liabilities. Further, free cash flow is improved because the company is not making expenditures to purchase the assets it is leasing. Walgreens’ operating lease commitments are greater than the liabilities shown on the balance sheet. A capital lease is a long-term lease that cannot be canceled, has a duration that is about the same as the useful life of the asset, and stipulates that the lessee has the option to buy the asset at a nominal price at the end of the lease. Even though the asset is leased, under a capital lease, it must be recorded as a long-term asset with a corresponding long-term liability. The lease payments are then considered to be partly interest and partly repayment of the debt. If the lease commitments were shown on the balance sheet, a more realistic picture of the company’s assets, debt, and interest expense and debt to equity, interest coverage, and free cash flow ratios would be provided in the company’s financial health.

509 .

Chapter 10, C 2. Unsecured notes (also called debenture bonds ) are bonds issued on the general credit of the organization. Because there are no specific assets as security in case the company does not pay, unsecured bonds involve more risk to the creditor. Notes with higher risks usually carry higher interest rates to entice the creditor to loan the money. Convertible securities are bonds that may be converted into shares of common stock at the option of the bondholder. These bonds are favorable to the bondholder because they pay interest and are scheduled to be paid at a specified time. At the same time, if the company is successful and the price of its stock goes up, the bondholder can convert the bonds into stock to hold or sell for a gain. Convertible bonds are also advantageous to the company because if the company is successful and the price of its stock goes up, management can elect to pay off the bonds; more likely, however, management will allow them to be converted into common stock, which will increase the company’s stockholders’ equity and will not require any cash to repay the debt. Further, convertible bonds usually carry lower interest rates because of the possibility of gains from the rise in stock prices. The callable feature on a bond means that the company must pay a specified price to buy it back from the holder and retire it. This feature gives management flexibility in managing its debt. For instance, if interest rates go down, management may want to call bonds on which it is paying higher rates and issue new bonds at lower rates.

510 .

Chapter 10, C 3. The Wal-Mart bond sold for a premium because the market price of 108 was greater than the face value of 100. Interest rates have declined since the date of issue because the bond is selling at a premium. As a result, the market rate of interest will be less than the face interest rate of 4.875, or approximately 4.51 percent (4.875 ÷ 1.08). The current market value of the bond did not affect either the interest expense or the interest payment. These amounts depend on the original issue price of the bond. Since the original issue price was face value or 100, both the interest expense and the interest payment were 4.875 percent of the face value of the bond. If the bond had originally been issued at a premium or a discount, the interest expense would be different. Chapter 10, C 4. Leverage is a corporation’s ability to increase earnings by earning more on its assets than it is paying in interest on its debt. This plan results in higher leverage because it involves issuing debt and reducing the amount of stock outstanding by buying it back. The ratio that reflects leverage and financial risk is the debt to equity ratio. The higher the debt to equity ratio, the more leverage and the more financial risk. The stock buyback will reduce the number of shares outstanding, reducing the denominator in computing earnings per share. Thus, earnings per share increases without an increase in earnings. This strategy for increasing the value of the stock by increasing earnings per share through leverage may not work if investors perceive the company as being a bigger risk.

511 .

Chapter 10, C 5. There are several good reasons for issuing convertible notes instead of nonconvertible notes or common stock. First, the effective interest rate of 6.875 percent is much lower than the company would have to pay if the notes were nonconvertible. The investors are willing to give up some current interest in return for the prospect that the value of the underlying stock will increase and therefore the value of the bonds will also increase. Second, by issuing convertible notes, the company does not have to give up any current control of the company. Noteholders do not have voting rights; only stockholders do. A third advantage of this approach is tax savings. Interest paid on notes is fully deductible for income tax purposes, whereas cash dividends on common stock are not deductible. Fourth, the company’s income will be favorably affected if the company earns a return that exceeds the interest cost of the notes. For example, if the company uses the funds for a purpose that earns 10 percent, the return is greater than the interest cost of 6.875 percent. Fifth, the convertible feature offers financial flexibility. If the price of the stock rises, the noteholders may convert their notes into common stock, thereby relieving the company of the need to repay the debt. Finally, it may be the only way the company can raise funds in light of its high risk of never having earned a profit. One major disadvantage of convertible notes is that interest must be paid semiannually. If the company is unable to meet an interest payment, it could be forced into bankruptcy. Common stock dividends are declared and paid only when the board of directors decides to do so. This is an important consideration in light of the company’s unprofitability. Another disadvantage is that when the notes are converted, they become new outstanding common stock, lose the advantage of notes, and may dilute ownership. With a conversion price of $112 per share, the entire issue represents 4,464,286 ($500,000,000 ÷ $112) shares of common stock. At $146 per share, the theoretical market value would be $651,785,756. The holders would have a theoretical gain of $151,785,756. Since the price of the stock is above $112 per share and the holders elect to convert the notes into common stock, which is a likely scenario, the debt to equity ratio would improve because the debt would decrease and the stockholders’ equity would increase. However, the percentage ownership of the company by the other stockholders would decrease.

512 .

Chapter 10, C 6. 1. From the note on property and equipment, it may be seen that CVS has a small amount of land and buildings and improvements in relation to fixtures and equipment and leasehold improvements. This would indicate that the company leases most of its buildings. 2. Under an operating lease the risks of ownership lie with the lessor and typically the life of the lease is shorter than the life of the asset being leased. In contrast, a capital lease is more like an installment purchase where the life of the lease is roughly the life of the asset. Companies like CVS find it advantageous to structure their leases as operating leases because operating leases do not appear on the balance sheet as an asset and a liability. The obligation appears only in a note to the financial statements. This is referred to as off-the-balance sheet financing. Capital leases, on the other hand, must appear on the balance sheet as an asset and show the corresponding liability. The liability is much more visible to investors. 3. Under a defined benefit plan the employer pays an amount in the current year to fund employees’ future pension benefits. CVS’ plan is underfunded by $240 million ($612 million – $372 million) which means CVS has a long-term obligation that must be paid in the future. (Note: The instructor may want to point out that underfunded pension plans are a major problem of federal, state, and local governments including school districts.)

513 .

Chapter 10, C 7. (dollars in millions) CVS’s Debt to Equity Ratio: Total Liabilities

Debt to Equity Ratio =

Total Stockholders’ Equity $25,873

2009:

= 72.3%

$35,768 $26,386

2008:

= 76.3%

$34,574

CVS’s Interest Coverage Ratio: Interest Coverage Ratio =

2009:

Income Before Income Taxes + Interest Expense Interest Expense $5,913

$525 $5,537

= + $509

$6,046 $509

514 .

$525

$525 $6,438

2008:

12.3 Times $509

11.9 Times

Chapter 10, C 7. (Continued) (dollars in millions) Southwest’s Debt to Equity Ratio: Debt to Equity Ratio = 2009: 2008:

Total Liabilities Total Stockholders’ Equity $8,803 $5,466 $9,115 $4,953

= 161.1% = 184.0%

Southwest’s Interest Coverage Ratio: Interest Coverage Ratio = 2009:

Income Before Income Taxes + Interest Expense Interest Expense $164

$186

$186 $350 $186

2008:

$278

1.9 Times

$130

$130 $408 $130

3.1 Times

CVS’s debt to equity ratio decreased from 76.3 percent in 2008 to 72.3 percent in 2009. Southwest’s debt to equity was higher. Its ratio decreased from 184.0 percent in 2008 to 161.1 percent in 2009. CVS has higher interest coverage ratios (12.3 in 2009 and 11.9 in 2008), whereas Southwest’s interest coverage ratios are lower (1.9 in 2009 and 3.1 in 2008). However, these figures do not tell the whole story. Both companies leased a substantial portion of their assets on long-term leases. CVS’s total lease commitments were $26,913 million compared to Southwest’s $2,659 million. If the present value of these leases were to be considered as long-term debt, the debt to equity ratios of both companies, especially CVS, would increase dramatically. Further, if the lease expense for 2008 and 2009 ($1,724 million and $1,899 million, respectively, in the case of CVS) were considered in addition to interest expense, both companies’ interest (and lease) coverage ratios would decline sharply. These examples illustrate why long-term operating leases are considered "offbalance-sheet" financing. 515 .

Chapter 10, C 8. Kwak’s proposal is not considered acceptable accounting practice because no sale has taken place. Following through with this proposal would be a violation of the revenue recognition principle. In addition, the proposal would not be ethical because it would result in fraudulent financial reporting. Although the company might be saved in the short run, there is no guarantee that the FDA will approve the drug. Even if the drug is approved, the company might ultimately be in worse condition than it would be if its problem in meeting the bond indenture requirements were brought out now. The bondholders would be harmed if their investment was not protected. The stockholders, although in a probable loss situation, might lose more in the long run. Management’s best course of action is to ask for a meeting with the bondholders to explain the facts of the situation. The bondholders may be willing to wait if they see that approval of the new drug is imminent. Chapter 10, C 9. Memorandum To: From: Date: Re:

Megan Russ Student’s Name Today’s Date Issuance of long-term bonds versus leasing to finance the new plant

At our meeting to discuss whether to issue long-term bonds and purchase the new fertilizer plant or to use a capital lease, the following issues should be considered: 1. Cash flow requirements 2. The market interest rates of the two alternatives 3. The income tax effects 4. Effects on the financial structure (balance sheet) of the business and financial ratios 5. Effects on the earnings of the business (interest expense and depreciation expense) 6. Effects on the company’s future financing plans and interest rates

516 .

CHAPTER 11—Solutions STOCKHOLDERS’ EQUITY Chapter 11, SE 1. 1. c 2. a 3. b

4. d 5. e 6. a

Chapter 11, SE 2. 1. Advantage 2. Disadvantage 3. Advantage

4. Advantage 5. Disadvantage 6. Advantage

Chapter 11, SE 3. 5/15

Dividends Dividends Payable Declaration of dividends: 140,000 shares outstanding × $0.20 per share

6/1

28,000 28,000

No entry necessary on record date

6/15

Dividends Payable Cash Payment of dividends

28,000 28,000

Chapter 11, SE 4. Start-up and organization costs: Legal services, 24,000 shares of $1 par value common stock Incorporation fees

$40,000 24,000

Total start-up and organization costs

$64,000

Income Statement Effect: ($64,000)

Start-up and organization costs Balance Sheet Effect: Cash Common Stock Additional Paid-In Capital Retained Earnings

($24,000) 24,000 16,000 ( 64,000) 517

Chapter 11, SE 5. Fina Corporation Balance Sheet December 31, 2011 Stockholders’ Equity Contributed capital Common stock, $10 par value, 30,000 shares authorized, 20,000 shares issued, and 19,500 shares outstanding

$200,000 100,000

Additional paid-in capital Total contributed capital

$300,000 15,000

Retained earnings Total contributed capital and retained earnings Less: Treasury stock, common (500 shares, at cost)

$315,000 7,500

Total stockholders’ equity

$307,500

Chapter 11, SE 6. Preferred Stock Dividends

Common Stock Dividends

Per Share —

Dividends Allocated —

$0.20

$40,000

$1.60

$80,000

Amount —

2010

Amount —

Total

2011 2010 dividends in arrears ( $200,000 ×

$16,000

0.08 )

2011 dividends ( $200,000 × (

$40,000

–

Totals

0.08 )

16,000

$32,000 ) _______ $32,000

$ 8,000 $16.00

$ 8,000

2012 2012 dividends ( $200,000 × (

$80,000

Totals

–

0.08 )

$16,000

$16,000 ) _______ $16,000

518 .

$64,000 $ 8.00

$64,000

Chapter 11, SE 7. 1.

Cash Common Stock Additional Paid-In Capital Issued 2,500 shares of $5 par value common stock at $12 per share

30,000

Cash Common Stock Additional Paid-In Capital Issued 2,500 shares of $1 stated value common stock at $12 per share

30,000

12,500 17,500

2,500 27,500

Chapter 11, SE 8. 1.

Land Common Stock Additional Paid-In Capital Issued 16,000 shares of $1 par value common stock for land; market value of common stock used to value transaction 16,000 shares at $7 = $112,000

112,000

Land Common Stock Additional Paid-In Capital Issued 16,000 shares of $1 par value common stock for land; market value of land used to value transaction

100,000

519 .

16,000 96,000

16,000 84,000

Chapter 11, SE 9. Oct.

1 Treasury Stock, Common Cash Acquired 2,000 shares of company’s common stock for $40,000 ( 2,000 × $20 per share )

40,000

17 Cash Treasury Stock, Common Paid-In Capital, Treasury Stock Sold 500 shares of treasury stock for $12,500 ( 500 × $25 per share); cost was $10,000 ( 500 × $20 per share)

12,500

40,000

10,000 2,500

Chapter 11, SE 10. Oct. 28 Common Stock Additional Paid-In Capital Retained Earnings Treasury Stock, Common Retired 1,500 shares of $2 par value common stock that cost $20 per share and were originally issued at $5 per share

520 .

3,000 4,500 22,500 30,000

Chapter 11, SE 11. Feb. 15 Stock Dividends Common Stock Distributable Additional Paid-In Capital Declaration of a stock dividend of 4,400 shares (2% × 220,000 shares) on $10 par value common stock, to be distributed on March 15 at the market value of stock of $66,000 (4,400 shares × $15 per share)

66,000 44,000 22,000

1 No entry required

Mar.

15 Common Stock Distributable Common Stock Distribution of a stock dividend of 4,400 shares declared on February 15

44,000

30 Dividends Dividends Payable Declaration of a cash dividend $0.50 × 224,400 shares = $112,200

112,200

44,000

112,200

Chapter 11, SE 12. After Stock Split Pearl International Stockholders’ Equity August 10, 2011 Contributed capital Common stock, $3 par value, 400,000 shares authorized, 375,000 shares issued and outstanding Additional paid-in capital Total contributed capital

$1,125,000 3,000,000

Retained earnings

$4,125,000 3,250,000

Total stockholders’ equity

$7,375,000

No entry is required, but a memorandum entry for informational purposes should be prepared.

521 .

Chapter 11, SE 13. 1. 2. 3. 4.

$50 per share ( * $33.33 per share ( $50 per share ( $48 per share (

$500,000 $200,000 $380,000 $ 48,000

÷ ÷ ÷ ÷

10,000 6,000 7,600 1,000

shares ) shares ) shares ) shares )

Chapter 11, SE 14.

1. 2. 3. 4.

Total Assets

Total Liabilities

Total Stockholders’ Equity

No effect No effect No effect Decrease

No effect Increase No effect No effect

No effect Decrease No effect Decrease

Chapter 11, SE 15. Preferred Stock Book = Value per Share =

1,000

shares ×

$100

Common Stock Book = Value per Share =

(

1,000

)

$8,000 *

1,000 shares $116,000

1,000 0.08

)

$2,482,000

$116

per share

= $8,000 –

$116,000

80,000 shares $2,366,000 80,000

*Rounded.

522 .

× $108

$29.58 * per share

Chapter 11, E 1. 1.

Most large companies are formed as corporations rather than partnerships because corporations offer limited liability, ease of capital generation, ease of transfer of ownership, lack of mutual agency, continuous existence, centralized authority and responsibility, and professional management.

Companies like to give stock options as compensation because even though under new rules stock options create an expense when issued, they do not require a cash outflow. Also, the ownership of stock options gives the employees an interest in the future success of the business.

No. If an investor sells shares after the declaration date but before the date of record, the seller will not receive the dividend because the date of record is the date at which ownership of the stock of a company and the right to receive a dividend is determined. However, the dividend will usually be reflected in the price for the stock. After the declaration date, the stock price adjusts upward to include the dividend declared. After the date of record, the price of the stock will drop by the amount of the dividend.

A company usually does not want to issue all of its authorized shares because doing so dilutes the ownership and the company wants the option of being able to offer shares at a later date.

Chapter 11, E 2. 1.

Callable preferred stock gives the company greater flexibility. The company can eliminate the related dividends at some future date by redeeming the shares at a specified call price.

The argument that could be given in treating preferred stock as debt instead of equity consists of its higher priority over common stock in case of liquidation (as in the case of debt) and its fixed dividend payment (as in the case of debt).

Return on equity and debt to equity are computed using total stockholders’ equity, which includes the total issue price of the stock. Financial analysis does not generally find par or stated value of any relevance.

Treasury stock is not considered an investment because it is stock that has been issued and then reacquired. The company does not own the stock in the sense that an outside investor does. For instance, no dividends are paid on treasury stock because the company would be paying itself. By buying and holding its own stock, the company is in effect reducing its stockholders’ equity.

523 .

Chapter 11, E 3. Dividends Yield =

Price/Earnings (P/E) Ratio =

Dividends per Share Market Price per Share $2.00 $66.00

= 3.0%

Market Price per Share Earnings per Share $66.00 $4.40

15.0 Times

Chapter 11, E 4. 6/5

Dividends

17,500

Dividends Payable

17,500

Declaration of dividends 70,000 shares outstanding × $0.25 per share 6/15 6/25

Record date: No entry necessary Dividends Payable

17,500

Cash

17,500

Payment of dividends Chapter 11, E 5. 10/15 Dividends Dividends Payable Declaration of dividends 180,000 shares outstanding × $0.50 per share 11/1

90,000

Record date: No entry necessary

11/15 Dividends Payable Cash Payment of dividends

90,000 90,000

524 .

90,000

Chapter 11, E 6. Quest Corporation Balance Sheet December 31, 2011 Stockholders’ Equity Contributed capital Preferred stock, $100 par value, 9 percent cumulative, 20,000 shares authorized, 6,000 shares issued and outstanding

$ 600,000

Common stock, $12 par value, 90,000 shares authorized, 30,000 shares issued, and 28,500 shares outstanding

$360,000 194,000

Additional paid-in capital Total contributed capital

554,000 $1,154,000 23,000

Retained earnings Total contributed capital and retained earnings Less: Treasury stock, common (1,500 shares, at cost)

$1,177,000 30,000

Total stockholders’ equity

$1,147,000

Chapter 11, E 7. 1. 2. 3.

P C P

4. 5. 6.

P C P

7. 8. 9.

525 .

C P P

Chapter 11, E 8. 1.

Transactions recorded in T accounts Cash

Mar. 1

Preferred Stock

450,000

Mar.

400,000

400,000 Common Stock

Additional Paid-In Capital

Mar. 1

150,000

Mar.

300,000

Stockholders’ equity section of the balance sheet prepared Rich Supply Corporation Balance Sheet March 1, 2011 Stockholders’ Equity

Contributed capital Preferred stock, $100 par value, 6 percent noncumulative, 20,000 shares authorized, 4,000 shares issued and outstanding

$400,000

Common stock, $5 stated value, 100,000 shares authorized, 30,000 shares issued and outstanding

$150,000 300,000

Additional paid-in capital Total contributed capital Retained earnings

$850,000 —

Total stockholders’ equity

$850,000

526 .

450,000

Chapter 11, E 9. Preferred Stock Dividends Per Amount Share —

2009

—

Common Stock Dividends Per Amount Share

Total Dividends Allocated

—

$60,000

$1.00

$70,000

$1.40

$70,000

2010 2009 dividends in arrears ( $500,000 × 0.07 )

$35,000

2010 dividends (

$60,000

– $35,000 )

25,000 $60,000

Totals

$12.00

2011 2010 dividends in arrears (

$35,000

– $25,000 )

$10,000

2011 dividends ( $500,000 × 0.07 ) (

$70,000

– $45,000 )

35,000 — $45,000

Totals

$25,000 $ 9.00

$25,000

2012 2012 dividends ( $500,000 × 0.07 ) (

$70,000

Totals

– $35,000 )

$35,000 — $35,000

$35,000 $ 7.00

527 .

$35,000

Chapter 11, E 10. Preferred Stock Dividends 1. 2009 dividends

$40,000

Common Stock Dividends —

2010 dividends

$30,000

—

$30,000

$ 30,000

$90,000

$ 5,000

$40,000

—

$30,000

Total $40,000

2011 dividends (

$1,000,000

× 0.06 )

(

$90,000

–

$60,000

$60,000 )

2. 2009 dividends (

$500,000

× 0.07 )

(

$40,000

–

$35,000

$35,000 ) $30,000

2010 dividends 2011 dividends 2010 dividends in arrears (

$35,000

–

$30,000

)

$ 5,000

0.07

)

35,000

$40,000

)

2011 (

$500,000

(

$90,000

× –

$50,000 $40,000

Totals

528 .

$50,000

$90,000

Chapter 11, E 11. 1.

Entry prepared—$25 par value

Aug.

1 Cash Common Stock Issued 5,000 shares of $25 par value common stock for $25 per share

1 Cash Common Stock Additional Paid-In Capital Issued 5,000 shares of $10 par value common stock for $25 per share

125,000 50,000 75,000

Entry prepared—no par value

Aug.

125,000

Entry prepared—$10 par value

Aug.

125,000

1 Cash Common Stock Issued 5,000 shares of no-par common stock for $25 per share

125,000 125,000

Entry prepared—$1 stated value

Aug.

1 Cash Common Stock Additional Paid-In Capital Issued 5,000 shares of $1 stated value common stock for $25 per share

529 .

125,000 5,000 120,000

Chapter 11, E 12. 1.

Entry prepared—$10 par value

2011 July

400,000 800,000

1 Building Common Stock Issued 40,000 shares of no-par common stock for a building with a fair market value of $1,200,000

1,200,000 1,200,000

Entry prepared—$4 stated value

2011 July

1 Building Common Stock Additional Paid-In Capital Issued 40,000 shares of $4 stated value common stock for a building with a fair market value of $1,200,000

530 .

1,200,000

Entry prepared—no par value

2011 July

1 Building Common Stock Additional Paid-In Capital Issued 40,000 shares of $10 par value common stock for a building with a fair market value of $1,200,000

1,200,000 160,000 1,040,000

Chapter 11, E 13. Cash May 17

52,800 2

32,000 5

45,600

Treasury Stock, Common

May

128,000 1

May

128,000

May 17 48,000 3 21 32,000 28 48,000 7

—

Bal.

Paid-In Capital, Treasury Stock May 28

3,200 shares ×

$40

$128,000

1,200 shares ×

$44

$52,800

1,200 shares ×

$40

$48,000

1,200 shares × ($44 – $40)

$4,800

800 shares ×

$40

$32,000

1,200 shares ×

$38

$45,600

1,200 shares ×

$40

$48,000

1,200 shares × ($38 – $40)

$2,400

531 .

2,400 8

May 17

4,800 4

Bal.

2,400

Chapter 11, E 14. Cash June 10 20

10,000 2 10,150 5

June

Treasury Stock, Common 1 35,000 1

June 1 35,000

—

Bal. Retained Earnings June 20

850 7

5,600 11

Paid-In Capital, Treasury Stock June 20

Common Stock June 30 1 2 3 4 5 6 7 8 9 10 11

1,250

June 10

1,250 4

Bal.

—

Additional Paid-In Capital

6,000 9

June 30

1,000 shares × $35 = $35,000 250 shares × $40 = $10,000 250 shares × $35 = $8,750 250 shares × ( $40 – $35 ) = $1,250 350 shares × $29 = $10,150 350 shares × $35 = $12,250 $12,250 – $10,150 – $1,250 = $850 400 shares × $35 = $14,000 400 shares × $15 par value = $6,000 400 shares × ( $21 – $15 ) = $2,400 $14,000 – $6,000 – $2,400 = $5,600

532 .

June 10 8,750 3 20 12,250 6 30 14,000 8

2,400 10

Chapter 11, E 15. July

17 Stock Dividends Common Stock Distributable Additional Paid-In Capital Declaration of a 6,000-share stock dividend (60,000 shares × 0.10) on $1 par value common stock, to be distributed on August 10 at the market value of stock of $30,000 ( 6,000 shares × $5 per share)

30,000 6,000 24,000

31 No entry required Aug.

Sept.

10 Common Stock Distributable Common Stock Distribution of a stock dividend of 6,000 shares declared on July 17

6,000

1 Dividends Dividends Payable Declaration of a cash dividend 66,000 shares × $0.50 = $33,000

33,000

533 .

6,000

33,000

Chapter 11, E 16. Before Stock Split Agat Company Stockholders’ Equity May 15, 2011 Contributed capital Common stock, $1 par value, 250,000 shares authorized, 100,000 shares issued and outstanding Additional paid-in capital Total contributed capital

$100,000 10,000

Retained earnings

$110,000 350,000

Total stockholders’ equity

$460,000

After Stock Split Agat Company Stockholders’ Equity May 15, 2011 Contributed capital Common stock, $0.50 par value, 250,000 shares authorized, 200,000 shares issued and outstanding Additional paid-in capital Total contributed capital

$100,000 10,000

Retained earnings

$110,000 350,000

Total stockholders’ equity

$460,000

No entry is required, but a memorandum entry for informational purposes should be prepared.

534 .

Chapter 11, E 17. Before Stock Split Mendoza International Stockholders’ Equity January 15, 2011 Contributed capital Common stock, $12 par value, 1,600,000 shares authorized, 400,000 shares issued and outstanding Additional paid-in capital Total contributed capital

$ 4,800,000 8,000,000

Retained earnings

$12,800,000 16,000,000

Total stockholders’ equity

$28,800,000

After Stock Split Mendoza International Stockholders’ Equity January 15, 2011 Contributed capital Common stock, $4 par value, 1,600,000 shares authorized, 1,200,000 shares issued and outstanding Additional paid-in capital Total contributed capital

$ 4,800,000 8,000,000

Retained earnings

$12,800,000 16,000,000

Total stockholders’ equity

$28,800,000

No entry is required, but a memorandum entry for informational purposes should be prepared.

535 .

Chapter 11, E 18. Ruff Corporation Statement of Stockholders’ Equity For the Year Ended December 31, 2012 9%, $100

Other

Par Value Cumulative

$2 Par Value

Additional

Preferred Stock

Common Stock

Paid-In Capital

Retained Earnings

$400,000

$600,000

$2,100,000

Balance, December 31, 2011

Accumulated CompreTreasury Stock

hensive Income

Total

$3,100,000

a. Issued 5,000 shares of preferred stock

$500,000

b. Conversion of bonds into 20,000 shares of common stock

500,000 40,000

260,000

8,800

52,800

300,000

c. Issued 4,400 common shares in a stock dividend*

(

61,600)

d. Purchased 5,000 treasury shares, common

($80,000)

e. Net income

(

230,000

80,000) 230,000

f. Cash dividends: Preferred ($500,000 × 0.09)

(

45,000)

(

45,000)

(

87,760)

(

87,760)

(

50,000)

Common (219,400 × $0.40) g. Foreign currency translation ($50,000)

adjustment Balance, December 31, 2012 *( 200,000

20,000 ) × 0.02 ×

$500,000

$448,800

$912,800

$14 per share 536

$2,135,640

($80,000)

($50,000)

$3,867,240

Chapter 11, E 19. Preferred Stock = Book Value per Share =

* ( 400

( 400

) +

$2,400*

400 Shares $44,400 400

$111 per Share

shares × $100 × 0.06 ) = $2,400 Common Stock = Book Value per Share =

–

$356,000

$44,400

18,000 Shares $311,600 18,000

537 .

$105

$17.31 per Share

Chapter 11, P 1. 1. Transactions recorded in T accounts Cash Mar. 1 Apr. 10

100,000 65,000

Common Stock Mar. 2 Apr. 15

165,000 Bal.

12,000 25,000

Mar. Apr.

37,000

Bal.

Mar. 1 Apr. 10

40,000

Mar. 2

12,000

39,000

Bal.

12,000

Bal.

79,000 Dividends Payable

Apr. 15

25,000

May

Bal.

25,000

Bal.

Dividends May 31

3,800 3

Bal.

3,800

15,000 shares x 6,500 shares x 19,000 shares x

$4 $4

par value par value

= =

$60,000 $26,000

$0.20

par value

$3,800

538 .

86,000

Start-up and Organization Costs

Treasury Stock, Common

60,000 1 26,000 2

128,000 Additional Paid-in Capital

1 10

3,800 3,800

Chapter 11, P 1. (Continued) 2. Stockholders' equity section of balance sheet prepared Dora Corporation Balance Sheet May 31, 2010 Stockholders' Equity Contributed capital Common stock, $4 par value, 50,000 shares authorized, 21,500 shares issued and 19,000 shares outstanding Additional paid-in capital Total contributed capital

$ 86,000 79,000 $165,000 11,200

Retained earnings* Total contributed capital and retained earnings Less treasury stock, common (2,500 shares, at cost)

$176,200 25,000

Total stockholders' equity

$151,200

* $15,000

–

$3,800

$11,200

3. User Insight: Effects of cash dividend declaration discussed The cash dividend declaration on May 31 will not affect net income and will not affect cash flows in the current period since the cash will be paid out in the next period. It will, however, reduce retained earnings in the current period.

539 .

Chapter 11, P 2. 1. Dividends calculated for cumulative preferred stock and common stock

2009

Cumulative Preferred Stock Dividends

Common Stock Dividends

Amount

Per Share

Amount

Per Share

Dividends Allocated

$ 30,000

$ 6.00

—

$ 30,000

$ 6.00

—

$ 30,000

Total

2010 Dividends in arrears, 2009 2010 dividends Totals

$ 10,000 20,000 $ 30,000

2011 Dividends in arrears, 2010 2011 dividends Totals 2012

$ 20,000 40,000

$ 34,000

$ 60,000

$12.00

$ 34,000

$ 0.34

$ 94,000

$ 40,000

$ 8.00

$ 90,000

$ 0.90

$130,000

2. Dividends calculated for noncumulative preferred stock and common stock Noncumulative Preferred Stock Dividends

Common Stock Dividends

Amount

Per Share

Amount

Per Share

Dividends Allocated

2009

$ 30,000

$ 6.00

—

$ 30,000

2010

$ 30,000

$ 6.00

—

$ 30,000

2011

$ 40,000

$ 8.00

$ 54,000

$ 0.54

$ 94,000

2012

$ 40,000

$ 8.00

$ 90,000

$ 0.90

$130,000

540 .

Total

Chapter 11, P 2. (Continued) 3.

The 2011 and 2012 dividends yield for common stock calculated

Dividends Yield =

Dividends per Share Market Price per Share 2011 $0.54 $7.25

= 7.4%

2012 $0.90 $8.00 4.

= 11.3%

User Insight: Preferred stock compared to long-term bonds

Both cumulative and noncumulative preferred stock have a fixed level of dividends and are thus similar in this way to long-term bonds, which have a fixed level of interest. However, cumulative preferred stock would be more similar to long-term bonds in the sense that if dividends are declared in any given year, past dividends not paid must be made up. Likewise, any past interest missed on long-term bonds would have to be made up. The difference is that with noncumulative preferred stock, if no dividends are ever declared, then the past dividends do not need to be made up; however, any past interest on bonds becomes a liability of the company and is not under the control of the board of directors. Also, missing the payment of interest on long-term bonds will usually result in a default and possible bankruptcy of the company, whereas skipping a preferred dividend in any one year does not have this result.

541 .

Chapter 11, P 3. 1. Account numbers and dollar amounts provided Account Debited Account Number Jan.

Credited

Dollar Amount

19 110

$ 31,500

21 510 Feb.

Mar.

July

Sept.

310

5,000

312

6,000

310

30,000

350

30,000

110

30,000

310

5,000

312

10,000

350

7,500

15,000

110

10,000

313

2,500

341

7,125 *

220

7,125

220

no entry 7,125

4,000 8,000

110

110,000

305

110,000

30,000 (10,000) 5,000 2,500 $0.15

310 312

5,000

7,125

12,000

Common Shares

47,500

110

120

15,000 shares

= $7,125

542 .

16,500

48,000

312

no entry

Dec.

$ 15,000

312

15 Oct.

310

78,000

1 1

Dollar Amount

121

110 Aug.

11,000

Account Number

Chapter 11, P 3. (Continued) 2. User Insight: Stockholders’ equity section of balance sheet discussed The stockholders’ equity section of the balance sheet is an important factor in analyzing a company’s performance because it represents the ownership interest of the stockholders. For instance, a key performance measure is return on equity, which measures the earnings of the company against the ownership interest.

543 .

Chapter 11, P 4. 1. T accounts set up and transactions recorded in the accounts Cash Aug.

3 22 Oct. 4

110,000 250,000 30,000

Additional Paid-In Capital

Oct. 10 31

390,000 Bal.

3,250 4,775

Aug.

3 15 Oct. 4

100,000 40,000 25,000

8,025

Bal.

165,000

381,975 Common Stock

Preferred Stock

Aug. 3 15

10,000 8,000

Oct.

5,000

Bal.

48,000

Oct. 10

3,250

Bal.

48,000

Bal.

3,250

Dividends 4,775 *

Oct. 31

= =

$3,750 1,025 $4,775

Note: No entry necessary for October 25.

544 .

250,000

Dividends Payable

Bal.

Total

Bal.

Treasury Stock, Common

Aug. 15

4,775 * * $250,000 × 0.06 × 3/12 10,250 shares × $0.10

250,000

23,000

Land

Oct. 15

Aug. 22

4,775

Oct. 15

4,775

Bal.

—

Chapter 11, P 4. (Continued) 2. Stockholders’ equity section of the balance sheet prepared Stas Corporation Balance Sheet October 31, 2011 Stockholders’ Equity Contributed capital Preferred stock, $100 par value, 6 percent, 5,000 shares authorized, 2,500 shares issued and outstanding

$250,000

Common stock, $2 stated value, 25,000 shares authorized, 11,500 shares issued, and 10,250 shares outstanding

$ 23,000 165,000

Additional paid-in capital Total contributed capital

188,000 $438,000 6,725

Retained earnings* Total contributed capital and retained earnings Less: Treasury stock, common (1,250 shares, at cost)

$444,725 3,250

Total stockholders’ equity

$441,475

* $11,500

–

$4,775

= $6,725

545 .

Chapter 11, P 4. (Continued) 3. User Insight: Performance ratios computed for the quarter Dividends per Share

Dividends Yield =

Market Price per Share $0.10

Market Price per Share

Price/Earnings = (P/E) Ratio =

Earnings per Share $25.00 $1.97

= $110,000

$48,000

= 12.7 Times Net Income

Return on Equity =

= 0.4%

$25.00

Average Stockholders’ Equity $11,500 $441,475

(

$11,500 $424,738 +

$408,000* )

÷ 2

= 2.7%

$250,000

$408,000

4. User Insight: Investors’ return discussed Stas Corporation’s dividends yield is only 0.4 percent, which means that investors must also consider changes in the price of the company’s stock. A return on equity of only 2.7 percent is low and will not encourage a rise in the company’s stock or an expansion of the company’s price/earnings ratio of 12.7 times net income.

546 .

Chapter 11, P 5. 1.

Transactions recorded in T accounts Common Stock

Common Stock Distributable

Bal.

240,000

5/1 Bal.

5/1

12,000

3/25

12,000

12/15

25,200

252,000

Bal.

25,200

Additional Paid-In Capital

Retained Earnings

Bal.

75,000

3/25

72,000

12/15

201,600

Bal.

348,600

Bal.

Stock Dividends 3/25

84,000 1

12/15

226,800 2

Bal.

310,800

80,000

0.05

$21

$84,000

252,000

0.10

$226,800

Shares outstanding before split:

80,000

4,000

Shares outstanding after split:

84,000

April 20—no entry September 10—no entry

547 .

84,000 252,000

240,000

Chapter 11, P 5. (Continued) 2. Stockholders’ equity section of the balance sheet prepared Rigby Storage, Inc. Stockholders’ Equity December 31, 2012 Contributed capital Common stock, $1 par value, 1,000,000 shares authorized, 252,000 shares issued and outstanding

$ 252,000

Common stock distributable, 25,200 shares

25,200 348,600

Additional paid-in capital Total contributed capital Retained earnings*

$ 625,800 423,200

Total stockholders’ equity

$1,049,000

* $240,000

–

$310,800

$494,000

= $423,200

3. User insight: Effect of stock transactions determined If you owned 2,000 shares of Rigby Storage stock on March 1, 2012, you would own 6,930 shares on February 15, 2013 (calculation below). Your proportionate share would be the same because other shareholders would receive the same proportionate distributions. Mar. 1, 2012:

Original holding

2,000 shares

Apr. 20, 2012: Stock dividend

100

Sept. 10, 2012: Stock split Jan. 15, 2013: Stock dividend

4,200 630

Feb. 15, 2013: Total owned

6,930 shares

548 .

Chapter 11, P 6. 1. T accounts set up and transactions recorded in the accounts Cash Sept. Oct.

1 2

250,000 480,000

Additional Paid-in Capital

Sept. 1 Oct. 15

730,000 Bal.

16,000 75,000

Sept. Oct.

91,000

Bal.

Sept. Oct.

210,000

Dividends Payable 1 2

Bal.

200,000 320,000

Bal.

16,000

Nov.

16,000

Bal.

Treasury Stock, Common 15

75,000

Bal.

75,000

*60,000 shares x $0.40 = $24,000

549 .

Nov. 30

24,000

Bal.

24,000

520,000

Start-up and Organization Costs

Oct.

50,000 160,000

639,000 Common Stock

Sept.

1 2

Dividends 24,000 * * 24,000

Chapter 11, P 6. (Continued) 2. Stockholders' equity section of the balance sheet prepared Glass Corporation Balance Sheet November 30, 2010 Stockholders' Equity Contributed capital Common stock, $8 par value, 150,000 shares authorized, 65,000 shares issued and 60,000 shares outstanding

$520,000 210,000

Additional paid-in capital Total contributed capital

$730,000 16,000

Retained earnings* Total contributed capital and retained earnings Less treasury stock, common (5,000 shares at cost)

$746,000 75,000

Total stockholders' equity

$671,000

* $40,000

–

$24,000

= $16,000

3. User Insight: Effects of cash dividend declaration discussed The cash dividend declaration on November 30 will not affect net income and will not affect cash flows in the current period since the cash will be paid out in the next period. It will, however, reduce retained earnings in the current period.

550 .

Chapter 11, P 7. 1. Dividends calculated for cumulative preferred stock and common stock Cumulative Preferred Stock Dividends

2010

Common Stock Dividends

Amount

Per Share

$ 30,000

$ 6.00

Amount —

$ 6.00

—

Total

Per Share —

Dividends Allocated

—

$ 30,000

2011 Dividends in arrears, 2010 2011 dividends Totals

$ 10,000 20,000 $ 30,000

2012 Dividends in arrears, 2011 2012 dividends Totals 2013

$ 20,000 40,000

$ 34,000

$ 60,000

$12.00

$ 34,000

$ 0.34

$ 94,000

$ 40,000

$ 8.00

$ 90,000

$ 0.90

$130,000

2. Dividends calculated for noncumulative preferred stock and common stock Noncumulative Preferred Stock Dividends

Common Stock Dividends

Amount

Per Share

Amount

2010

$ 30,000

$ 6.00

2011

$ 30,000

2012 2013

Dividends Allocated

—

Per Share —

$ 6.00

—

$ 30,000

$ 40,000

$ 8.00

$ 54,000

$ 0.54

$ 94,000

$ 40,000

$ 8.00

$ 90,000

$ 0.90

$130,000

551 .

Total

$ 30,000

Chapter 11, P 7. (Continued) 3.

The 2012 and 2013 dividends yield for common stock calculated Dividends Yield =

Dividends per Share Market Price per Share 2012 $0.54 $7.25

= 7.4% 2013

$0.90 $8.00 4.

= 11.3%

User Insight: Preferred stock compared to long-term bonds

552 .

Chapter 11, P 8. 1. Journal entries prepared July

1 Cash Common Stock

110,000 50,000

Additional Paid-In Capital Issued 10,000

60,000

shares of

value common stock at

stated

$11 per share

1 Start-up and Organization Costs Common Stock

5,500 2,500

Additional Paid-In Capital Issued

500

3,000

shares of

value common stock at

stated

$11 per share for

legal services to organize the corporation 2 Cash Preferred Stock Issued

100,000 100,000

1,000

shares of

$100 par value

preferred stock at par 10 Land Common Stock

30,000 12,500

Additional Paid-In Capital Issued

2,500

17,500

shares of

stated

value common stock with a market value of Aug.

$12 per share for land

2 Treasury Stock, Common Cash Purchased

1,500

19,500 19,500 shares of common

stock for the treasury at

$13 per share

10 Dividends Dividends Payable

980 980

Declaration of preferred and common stock dividends $100,000 11,500

× 0.09 shares

× 1 ×

/ 12 = $750 $0.02 = 230 $980

Total 12 No entry required 22 Dividends Payable Cash

980 980

Payment of preferred and common stock cash dividends 553 .

Chapter 11, P 8. (Continued) 2. Stockholders’ equity section of the balance sheet prepared Java, Inc. Balance Sheet August 31, 2011 Stockholders’ Equity Contributed capital Preferred stock, $100 par value, 9 percent, 5,000 shares authorized, 1,000 shares issued and outstanding

$100,000

Common stock, no-par $5 stated value, 50,000 shares authorized, 13,000 shares issued, and 11,500 shares outstanding

$65,000 80,500

Additional paid-in capital Total contributed capital

$245,500 10,520

Retained earnings* Total contributed capital and retained earnings Less: Treasury stock, common (1,500 shares, at cost)

$256,020 19,500

Total stockholders’ equity

$236,520

$11,500

–

$980

= $10,520

554 .

145,500

Chapter 11, P 8. (Continued) 3. User Insight: Performance ratios computed Dividends per Share

Dividends Yield =

Market Price per Share $0.02

Market Price per Share

Price/Earnings = (P/E) Ratio =

Earnings per Share $20.00

20.0 Times

Net Income Average Stockholders’ Equity $11,500

* $110,000

$1.00

Return on Equity =

= 0.1%

$20.00

( $236,520 $11,500 $241,010

$5,500

$245,500* ) ÷

= 4.8%

$100,000

$30,000

= $245,500

4. User Insight: Investors’ return discussed Java’s dividends yield is only 0.1 percent, which means that investors must also consider changes in the price of the company’s stock. A return on equity of only 4.8 percent is low and will not encourage a rise in the company’s stock or an expansion of the company’s price/earnings ratio of 20 times net income.

555 .

Chapter 11, P 9. 1. Journal entries prepared 2012 Jan. 4 No entry required

Mar.

14 Cash Preferred Stock Sold 24,000 shares of $40 par value preferred stock at $40

960,000

14 Building Preferred Stock Issued 4,000 shares of preferred stock in exchange for a building valued at $160,000

160,000

4 Cash Treasury Stock, Common Paid-In Capital, Treasury Stock Sold 2,000 shares of treasury stock for $16 per share; originally purchased for $12 per share

July 15 Dividends Dividends Payable Declared a cash dividend of $4 per share on 28,000 shares of preferred stock and $0.40 per share on 236,000 shares of common stock $112,000 + $94,400 = $206,400 25 No entry required

556 .

160,000

8 Memo: The 120,000 shares of $8 par value common stock that are issued and outstanding were split 2 for 1, resulting in 240,000 shares of $4 par value common stock issued and outstanding.

Apr. 20 Treasury Stock, Common Cash Purchased 6,000 shares of common stock for the treasury at $12 per share May

960,000

72,000 72,000

32,000 24,000 8,000

206,400 206,400

Chapter 11, P 9. (Continued) 2012 Aug. 15 Dividends Payable Cash Paid cash dividends to preferred and common stockholders Nov. 28 Stock Dividends Common Stock Distributable Additional Paid-In Capital Declared a 15 percent stock dividend on 236,000 shares of common stock; market value was $20 per share; par value is $4 per share 35,400 shares × $20 = $708,000 Dec. 15 No entry required

557 .

206,400 206,400

708,000 141,600 566,400

Chapter 11, P 9. (Continued) T accounts for stockholders’ equity Preferred Stock

Common Stock

1/14/12 1/14/12

960,000 160,000

Bal.

1,120,000

Bal.

Common Stock Distributable 11/28/12

Additional Paid-In Capital

141,600

Bal. 2,560,000 11/28/12 566,400 Bal.

Paid-In Capital, Treasury Stock 5/4/12

960,000

3,126,400

Retained Earnings

8,000

7/15/12 11/28/12 12/31/12

206,400* Bal. 708,000*

1,648,000

436,000 Bal.

297,600

Treasury Stock, Common 4/20/12

72,000

Bal.

48,000

5/4/12

24,000

*Cash dividends declared and stock dividends declared reduce Retained Earnings.

558 .

Chapter 11, P 9. (Continued) 2. Stockholders’ equity section of the balance sheet prepared Sophia Company Balance Sheet December 31, 2012 Stockholders’ Equity Contributed capital Preferred stock, $40 par value, $4 dividend, 40,000 shares authorized, 28,000 shares issued and outstanding Common stock, $4 par value, 400,000 shares authorized, 240,000 shares issued, 236,000 shares outstanding

$1,120,000

Common stock distributable, 35,400 shares Additional paid-in capital

141,600 3,126,400 8,000

Paid-in capital, treasury stock Total contributed capital

960,000

$5,356,000 297,600

Retained earnings Total contributed capital and retained earnings Less: Treasury stock, common (4,000 shares, at cost)

$5,653,600 48,000

Total stockholders’ equity

$5,605,600

3. User Insight: Book value per share computed December 31, 2011 Common stock: $5,168,000 * ÷

120,000 shares

$43.07** per share

December 31, 2012 Preferred stock: Call price of $42 equals book value per share Common stock: ( =

$5,605,600 $4,429,600

– ÷

$1,176,000 ) ÷ ( 236,000 shares + 35,400 shares) 271,400 shares = $16.32** per share

Book value per share usually does not affect market price, which is affected by many other factors.

* 28,000 shares of preferred stock × $42 per share ** Rounded. 559 .

Chapter 11, P 10. 1.

Journal entries prepared

2012 Mar.

5 Dividends Dividends Payable Declaration of a cash dividend 1,000,000 shares × $0.40 = $400,000

400,000 400,000

20 No entry required Apr.

6 Dividends Payable Cash Payment of cash dividend declared on March 5

June 17 Stock Dividends Common Stock Distributable Additional Paid-In Capital Declaration of a stock dividend of 100,000 shares (1,000,000 shares × 0.10) on $2 par value common stock, to be distributed on August 17 at the market value of the stock of 100,000 shares × $14 = $1,400,000 Aug.

1,400,000 200,000 1,200,000

200,000 200,000

2 Memo: The 1,100,000 shares of $2 par value common stock that are issued and outstanding were split 2 for 1, resulting in 2,200,000 shares of $1 par value common stock issued and outstanding.

Dec. 27 Dividends Dividends Payable Declaration of a cash dividend 2,200,000 shares × $0.20 = $440,000

560 .

400,000

5 No entry required 17 Common Stock Distributable Common Stock Distribution of stock dividend of 100,000 shares declared on June 17

Oct.

400,000

440,000 440,000

Chapter 11, P 10. (Continued) 2. Stockholders’ equity section of the balance sheet prepared Jet Moving Company Balance Sheet December 31, 2012 Stockholders’ Equity Contributed capital Common stock, $1 par value, 6,000,000 shares authorized, 2,200,000 shares issued and outstanding

$2,200,000 2,000,000

Additional paid-in capital Total contributed capital Retained earnings*

$4,200,000 720,000

Total stockholders’ equity

$4,920,000

* $2,160,000 – $400,000 – $1,400,000

– $440,000 + $800,000

= $720,000 3. User Insight: Effect of stock transactions on share price If you owned shares in Jet, you would expect the total value of your shares to remain about the same, although the price per share would be less because there are more shares outstanding. An intangible that might cause the total value to increase is that it is usually considered a positive sign to the market when a company declares stock dividends or stock splits. These actions often accompany positive views on the part of management about the future of the company.

561 .

Chapter 11, C 1. An advantage of issuing common stock is that it improves the company’s debt to equity ratio by increasing the amount of common stock outstanding in relation to long-term debt. Another advantage is that issuing stock is less risky than issuing bonds because dividends do not have to be paid on stock and there is no debt to be repaid. These are effects that could improve DreamWorks’ bond rating and lower the interest it might pay on future bond issues. A disadvantage of issuing stock is that it dilutes the share of the company owned by the current stockholders unless they buy more shares. In addition, when the company is profitable, it reduces the company’s ability to use financial leverage to increase the return on equity over the return on assets. Also, the interest paid on bonds is tax-deductible, whereas dividends paid on common stock are not. Chapter 11, C 2. Even though preferred stocks have some characteristics of bonds, such as a fixed dividend rate, they are classified on the balance sheet as equity. This is very important to companies that have suffered losses resulting in decreased stockholders’ equity and to banks, which must maintain minimum ratios of capital to total assets. From the investor’s standpoint, the dividend is fixed, like bond interest. The value of the preferred stock varies with changes in the market rate of interest, also like bond prices. If the preferred stock is convertible and the price of the common stock rises above the conversion price, the price of the preferred stock will then rise with the common price (in which case the investor has a capital gain). PERCs are popular with companies because they provide great flexibility. If the interest rates decline and a company wishes to refinance the stock, it can call the stock and retire it. If a company does not have the cash to redeem the shares, it can simply wait; they will be converted into common stock after three years. From the investor’s viewpoint, PERCs pay a high fixed rate and may result in a capital gain if the shares are converted into common stock.

562 .

Chapter 11, C 3. A company may have several reasons for buying back its own shares. One reason is that it may have uses for the shares for employee stock purchase plans or employee pension plan contributions. A second reason would be to increase the value of the company’s stock. A third reason is to increase earnings per share: with fewer shares outstanding, earnings per share should be higher. When the economy has been growing slowly, this is a way to accelerate the growth in earnings per share. A fourth reason would be to reduce the cash that will have to be paid in the future for cash dividends. With fewer shares outstanding, less cash will have to be paid. A fifth reason is that management feels that investing in the company’s own stock is a sound idea because it is a good value. Sometimes a company is so successful that it has no better investment opportunity at the time. A sixth reason is to have sufficient shares to purchase other companies. The effects of buybacks are as follows: Favorable or Unfavorable

Ratio

Effect

Earnings per share

Increase

Favorable

Return on equity

Increase

Favorable

Return on assets

Increase

Favorable

Debt to equity

Increase

Unfavorable

Current ratio

Decrease

Unfavorable

Chapter 11, C 4. A stock split is an increase in the number of outstanding shares accompanied by a proportionate reduction in the par or stated value. Thus, a stock split does not affect amounts in the stockholders’ equity section. The stock split will cause the market value of the stock to drop. A stock split often occurs after the price of a company’s stock has risen and thus is a positive signal to the market that management is confident about the company’s future.

563 .

Chapter 11, C 5. 1. Stock issue recorded as journal entry Cash Common Stock Additional Paid-In Capital Issued 22,500,000 shares of $0.001 par value common stock at net proceeds of $1,800,000,000

1,800,000,000 22,500 1,799,977,500

2. Stockholders’ equity section of the balance sheet prepared Google, Inc. Balance Sheet After Stock Offering Stockholders’ Equity (in thousands) Contributed capital Common stock, $0.001 par value, 700,000,000 shares authorized, 183,500,000 shares issued and outstanding Additional paid-in capital Total contributed capital

184 2,525,197

Retained earnings

$2,525,381 191,352

Total stockholders’ equity

$2,716,733

3. Google’s need to increase the authorized shares discussed Google did not have to increase its authorized shares because management knew the 700,000,000 previously authorized shares and the 161,000,000 previously issued shares left a sufficient number of authorized but unissued shares to cover the new issue. 4. Underwriters’ fee discussed The total proceeds were $1,912,500,000 ($85 × 22,500,000 shares). Google received $80 ($1,800,000,000 ÷ 22,500,000 shares) per share. The underwriters received a total of $112,500,000 ($1,912,500,000 – $1,800,000,000), or $5 ($85 – $80) per share, to assist in issuing the shares. The underwriters find investors to buy the stock at the offering price.

564 .

Chapter 11, C 6. 1. Explanations of transactions (1) To transfer 2011 net income of $18,753,000 to retained earnings (2) To adjust available-for-sale securities to market: $12,000,000 (3) To redeem and retire 27,560 shares of preferred stock at par value of $100 for $2,756,000 (4) Purchase of 89,000 shares of $1 par value common stock at an average price of $10.52 for a total of $936,000 (including additional paid-in capital of $847,000 by employees under stock option plan) (5) Purchase of 501,412 shares of common stock at an average price of $25.03 per share ($12,552,000 ÷ 501,412 shares) for the treasury (6) Conversion of convertible debentures into 148,000 shares of common stock at an exchange rate of $25.56 per share ($3,783,000 ÷ 148,000 shares) (7) Issuance of 715,000 shares of common stock for cash at $35.31 per share ($25,250,000 ÷ 715,000 shares) (8) Exchange of 500,000 shares of common stock for shares in Miti Company as an investment; the value of the transaction is $35.53 per share ($17,763,000 ÷ 500,000 shares) (9) To transfer 2011 cash dividends to retained earnings in the amount of $3,086,000 2. Comprehensive income discussed Comprehensive income is the change in a company’s equity during a period from sources other than owners and includes net income, change in unrealized investment gains and losses, and other items affecting equity. Thus, Spencer’s comprehensive income is net income of $18,753,000 plus the unrealized gain on availablefor-sale securities of $12,000,000, or a total of $30,753,000.

565 .

Chapter 11, C 7. 1.

CVS has preferred stock, preference stock, and common stock. The preferred stock ($0.01 par value) has 0.1 million authorized but none issued or outstanding. It is available if management wants to use it for some purpose. The preference stock ($1.00 par value) has 50 million shares authorized but none issued or outstanding at the end of fiscal 2009. The common stock has a par value of $0.01 per share. There are 3.2 billion authorized shares, of which 1.612 billion shares have been issued and 1.391 billion shares are outstanding; 219 million shares are in the treasury.

The dividends yield for 2009 is as follows: Dividends Yield =

Dividends per Share

* Stock prices from Note 15. ( $38.27 + $27.38 ) ÷

Market Price

$0.305 $32.83 * *

= 0.9%

= $32.83

This yield is less than 1 percent. As a result, the stockholders’ total return is dependent on share price changes. Since retained earnings makes up about 46 percent of stockholders’ equity, the company relies more on earnings than stock for its stockholders’ equity. 3.

CVS has an employee stock ownership plan (ESOP) described in Note 8, which applies to full-time employees with at least one year of service. This plan relates to the preference stock. In addition, the company has a stock option plan (called a stock incentive plan) described in Note 10. These options apply to executive officers and other officers and employees of the company and its subsidiaries. The options are exercisable at an average price of $29.14. With fourth-quarter shares ranging from $27.38 to $38.27, only some of the holders have gains, but holders of the options have an incentive to keep their options and help the company to succeed in order to make significant profits from the options (Note 15).

Aside from net earnings and dividends on preference and common stock, several items appear on each of the three years of CVS’s statement of shareholders’ equity. These items include conversion of preference stock to common stock, conversion of preference stock to treasury stock, common stock issued, employee stock purchases, reduction of guaranteed ESOP obligation, stock option activity and awards (and related tax effects), treasury stock purchases, and a minimum pension liability adjustment. 566

Chapter 11, C 8. 1. Return on equity computed (dollars in millions) CVS’s Return on Equity Ratio: Net Income

Return on Equity =

2009 =

Average Stockholders’ Equity $3,696 (

$35,768

$34,574

) ÷ 2

$3,696

$35,171

= 10.5% 2008 =

$3,212 (

$34,574

$31,322

) ÷ 2

$3,212

$32,948

= 9.7% Southwest’s Return on Equity Ratio: Net Income

Return on Equity =

2009 =

Average Stockholders’ Equity $99 (

$5,466

$4,953

) ÷ 2

$6,941

) ÷ 2

$99

$5,210

= 1.9% 2008 =

$178 (

$4,953

$178 $5,947

= 3.0%

567 .

Chapter 11, C 8. (Continued) 2. Treasury stock purchases discussed According to the statement of cash flows, CVS purchased treasury stock of $2.477 billion in 2009, but about $7.87 billion over the past three years. In contrast, Southwest repurchased no treasury stock in 2009, but a total of approximately $1.055 billion over three years. The purchases of treasury shares will have the effect of increasing return on equity (because the cost of the treasury shares will reduce stockholders’ equity) and earnings per share (because treasury shares reduce the number of shares outstanding). 3. Stock issues discussed Neither company raised significant funds through stock issues. It may be seen in the statement of cash flows that the only types of stock issued by both companies during the three-year period were those associated with employee stock plans. The proceeds from these issues were greater in the case of CVS ($250 million in 2009). The proceeds for Southwest were lower than CVS’s, at $20 million in 2009. 4. Dividend policies discussed From their income statements, statements of cash flows, and statements of stockholders’ equity, it may be seen that both companies pay cash dividends, but the amounts are small ($0.305 per share for CVS and $0.018 per share for Southwest). Thus, stockholders for both companies must get most of their return from increases in the stock price.

568 .

Chapter 11, C 8. (Continued) 5. Book values per share computed CVS’s Book Value per Share (in millions except per share): 2009

2008

Less equity allocated to preference shareholders

$35,768 —

$34,574 191

Stockholders’ equity related to common stock

$35,768

$34,383

Common stock outstanding

1,391

1,436

Book value per common share

$25.71

$23.94

Average stock price per share*

$32.83

$29.05

2009

2008

$5,466

$4,953

Common stock outstanding

808

Book value per common share

$6.76

$ 6.13

Average stock price per share

$9.94

$11.01

Total stockholders’ equity

* ( $38.27 + ( $34.90 +

$27.38 ) ÷ 2 = $32.83 $23.19 ) ÷ 2 = $29.05

Southwest’s Book Value per Share (in millions except per share): Stockholders’ equity related to common stock

6. Book values per share and their relationship to market prices discussed In both cases, book value per share bears little relationship to market value per share. If a company is successful, as both CVS and Southwest are, market price will usually far exceed book value as it does in these cases. Although CVS’s 2009 stockholders’ equity is roughly 6.5 times as much as Southwest’s, its book value is only about 3.8 times that of Southwest. Book value per share is a function of the number of shares outstanding. CVS has roughly two times as many shares outstanding as Southwest does.

569 .

Chapter 11, C 9. Some may argue that if management were not prohibited from taking such action, then its actions might be judged as acceptable. Others will clearly see that owners are harmed by this action in at least two ways. Buying treasury stock is not unethical in and of itself. It is the borrowing to do it that is questionable. First, cash bonuses were paid as a result of borrowing to buy back shares, not because management improved the operating success of the firm. Second, the risk of stock ownership increased because debt to equity is now higher. In this case, the share buyback increased management’s wealth but not the owners’ wealth. Conflicts of interest between owners and managers often arise. If compensation measures are not carefully selected, management can actually destroy shareholder value. If yearend bonuses were based on measures adjusted as if the borrowing and share repurchase had not occurred, then management would not be rewarded for actions that are not in the best interests of shareholders.

570 .

CHAPTER 12—Solutions THE STATEMENT OF CASH FLOWS

Chapter 12, SE 1. 1. b

4. d

2. c

5. c

3. a

6. c

Chapter 12, SE 2. Cash Flow Yield =

Cash Flows to Sales =

Cash Flows to Assets =

Net Cash Flows from Operating Activities Net Income $90,000 $45,000

2.0 Times

Net Cash Flows from Operating Activities Sales $90,000 $395,000

= 22.8%

Net Cash Flows from Operating Activities Average Total Assets $90,000 ( $275,000 + $250,000 ) ÷ 2

= 34.3%

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets = $90,000 –

$20,000

= $20,000

571 .

–

$60,000 + $10,000

Chapter 12, SE 3. Cash Flow Yield =

Cash Flows to Sales =

Cash Flows to Assets =

Net Cash Flows from Operating Activities Net Income $270,000 $135,000

2.0 Times

Net Cash Flows from Operating Activities Sales $270,000

= 22.8%

$1,185,000

Net Cash Flows from Operating Activities Average Total Assets $270,000 ( $825,000

$750,000 ) ÷

= 34.3%

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets = $270,000

–

$60,000

= $60,000

572 .

–

$180,000 +

$30,000

Chapter 12, SE 4. The cash flow yield is 0.7 times, which indicates that cash flows from operations are only 70 percent of earnings. A yield of less than 1 signals potential problems. Titan Corporation experienced this unfavorable yield primarily because of a $50,000 decrease in accounts payable. The cash flows to assets is slightly larger than cash flows to sales because the asset turnover is slightly more than 1. Because cash flow yield is less than 1, we know that profit margin and return on assets are higher than the cash flows to sales and cash flows to assets. The key to improving all three efficiency ratios is better management of inventory, accounts payable, and accounts receivable, all of which affect cash flows from operations. Free cash flow is positive, which indicates that the company was able to finance its net expenditures for land and equipment from its cash flows from operations after paying dividends. Although the company did not replace its depreciable assets, as indicated by a decline in the gross amount of equipment, it did reduce liabilities by approximately 25 percent. Overall, the company improved its liquidity and its ability to borrow for possible future expansion. Chapter 12, SE 5. Express Corporation Schedule of Cash Flows from Operating Activities For the Year Ended December 31, 2011 Cash flows from operating activities Net income

$66,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$28,000

Changes in current assets and current liabilities Increase in accounts receivable

( 22,000) 10,000

Increase in accounts payable

$82,000

Net cash flows from operating activities

573 .

16,000

Chapter 12, SE 6. Minh Corporation Schedule of Cash Flows from Operating Activities For the Year Ended December 31, 2011 Cash flows from operating activities Net income

$144,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$16,000

Amortization

1,800

Changes in current assets and current liabilities Decrease in accounts receivable Increase in inventories

(

5,400)

Decrease in prepaid expenses

1,000

Decrease in accounts payable

( 14,000) ( 1,700)

Decrease in accrued liabilities Net cash flows from operating activities

574 .

8,200

5,900 $149,900

Chapter 12, SE 7. Pilch Corporation Schedule of Cash Flows from Operating Activities For the Year Ended December 31, 2011 Cash flows from operating activities Net income

$216,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$24,000

Amortization

2,700

Changes in current assets and current liabilities Decrease in accounts receivable

12,300

Increase in inventories

(

8,100)

Decrease in prepaid expenses

1,500

Decrease in accounts payable

( 21,000) ( 2,550)

Decrease in accrued liabilities

8,850 $224,850

Net cash flows from operating activities Chapter 12, SE 8. Cash flows from investing activities Sale of equipment Purchase of land (see below)

$143,000 ( 188,000)

Net cash flows from investing activities

($ 45,000)

Schedule of Noncash Investing and Financing Transactions $375,000

Issue of mortgage in partial payment for land

(Note: Under the indirect method, the gain of $113,000 would appear as a deduction in the cash flows from operating activities section.)

575 .

Chapter 12, SE 9. Cash flows from investing activities Sale of building Purchase of land (see below)

$ 95,000 ( 125,000)

Net cash flows from investing activities

($ 30,000)

Schedule of Noncash Investing and Financing Transactions $250,000

Issue of mortgage in partial payment for land

(Note: Under the indirect method, the gain of $75,000 would appear as a deduction in the cash flows from operating activities section.) Chapter 12, SE 10. Cash flows from financing activities Issuance of bonds*

$480,000

Repayment of bonds

( (

Payment of dividends

75,000) 25,000) $380,000

Net cash flows from financing activities

(Note: Interest paid appears in the cash flows from operating activities section.) *$500,000 × 96% = $480,000

576 .

Chapter 12, SE 11. Cash flows from financing activities Issuance of bonds*

$735,000

Repayment of bonds

( 113,000) ( 38,000)

Payment of dividends

$584,000

Net cash flows from financing activities

(Note: Interest paid appears in the cash flows from operating activities section.) *$750,000 × 98% = $735,000 Chapter 12, SE 12. 1.

577 .

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Chapter 12, E 1. 1. The statements are equally useful. The income statement relates most directly to the goal of profitability, whereas the statement of cash flows is more closely tied to the goal of liquidity. 2. The change in cash from year to year, while important, can easily be obtained from the comparative balance sheets. What is important from the statement of cash flows are the details of the changes. For instance, cash flows from operating activities is a very important figure that cannot be seen on any other statement. 3. Cash flows to sales and cash flows to assets would be less than profit margin and return on assets, respectively, because a cash flow yield of less than 1.0 means that cash flows from operations are less than net income. Both are numerators in ratios that have the same denominators. Chapter 12, E 2. 1. If a company has large gains, large increases in current assets, or decreases in current liabilities, the results could overwhelm the earnings and create negative cash flows from operating activities. 2. Gains and losses from operating activities are directly related to the cash flows from the sale of assets reported in the investing activities section. 3. Both purchases of treasury stock and dividend payments represent payments to stockholders. Each diverts cash from productive use in the business (as assets), and thus each reduces free cash flow. Chapter 12, E 3. 1. c

6. d

11. a

2. b

7. a

12. e

3. a

13. b

4. a

8. c 9. d

5. b and a

10. c

578 .

Chapter 12, E 4. Cash Flow Yield =

Cash Flows to Sales =

Net Cash Flows from Operating Activities Net Income $98,000

1.4 Times

Net Cash Flows from Operating Activities Sales $98,000

Cash Flows to = Assets

$70,000

= 11.9%

$825,000

Net Cash Flows from Operating Activities Average Total Assets $98,000 (

$600,000

$525,000

) ÷

= 17.4%

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets =

$98,000

–

$30,000

= ($34,000)

579 .

–

$125,000

+ $23,000

Chapter 12, E 5. Sunderland Chemical Company Schedule of Cash Flows from Operating Activities For the Year Ended December 31, 2011 Cash flows from operating activities Net income

$1,200,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$820,000

Changes in current assets and current liabilities Increase in accounts receivable

( 700,000)

Decrease in inventory

180,000

Increase in prepaid expenses

(

Increase in accounts payable Decrease in accrued liabilities

80,000) 240,000

(

Increase in income taxes payable

40,000) 20,000

440,000 $1,640,000

Net cash flows from operating activities Chapter 12, E 6. Lambda Corporation Schedule of Cash Flows from Operating Activities For the Year Ended December 31, 2011 Cash flows from operating activities Net income

$82,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$ 4,600

Amortization

600

Changes in current assets and current liabilities Increase in accounts receivable Decrease in inventories

6,800) 3,800

Decrease in prepaid expenses

400

Increase in accounts payable

10,000 ( 900)

Decrease in accrued liabilities Net cash flows from operating activities

580 .

(

11,700 $93,700

Chapter 12, E 7. Freed Corporation Schedule of Cash Flows from Operating Activities For the Year Ended June 30, 2011 Cash flows from operating activities Net income

$14,800

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$ 4,000

Changes in current assets and current liabilities Increase in accounts receivable

(

Increase in inventories

( 14,000)

Decrease in prepaid rent

2,800

Increase in accounts payable

28,000

Increase in salaries payable

2,000 1,200)

Decrease in income taxes payable

(

8,800)

12,800 $27,600

Net cash flows from operating activities Chapter 12, E 8. Cash flows from investing activities Purchase of investments

($116,000) (a)

Sale of investments

65,000 (b)

T account shows purchases of investments to be $116,000, which is an outflow of cash.

T account shows $78,000 of investments sold. There was a $13,000 loss on the sale. The net cash flow from the sale is computed as follows: Book value of investment sold Less loss on sale

$78,000 13,000

Net cash inflow from sale

$65,000

581 .

Chapter 12, E 9. Cash flows from investing activities ($67,200) (a)

Purchase of plant assets

25,400 (b)

Sale of plant assets a.

T account shows total purchases of plant assets of $67,200, which is an outflow of cash.

T accounts show disposal of plant assets that cost $46,000 and had accumulated depreciation of $29,400. The income statement shows a $8,800 gain on the sale of the plant assets. The net cash inflow from the disposal is computed as follows: Plant assets

$46,000 29,400

Less accumulated depreciation Book value Add gain on sale

$16,600 8,800

Net cash inflow from sale of plant assets

$25,400

Chapter 12, E 10. Cash flows from financing activities Issue of notes payable

$36,000

Repayment of notes payable

( 10,000)

Schedule of Noncash Investing and Financing Transactions $60,000

Issue of note payable for patent

Note: Interest expense of $1,000 would be included in the operating activities section and would not have to be adjusted further.

582 .

Chapter 12, E 11. Bristol Corporation Statement of Cash Flows For the Year Ended June 30, 2011 Cash flows from operating activities Net income

$17,900

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$19,300

Changes in current assets and current liabilities Decrease in accounts receivable

5,000

Decrease in inventory

5,000

Increase in prepaid expenses

(

600)

Decrease in accounts payable

( (

1,000) 600)

Decrease in income taxes payable Net cash flows from operating activities

27,100 $45,000

Cash flows from investing activities Sale of furniture*

11,700

Cash flows from financing activities Repayment of notes payable

($20,000)

Issue of common stock

25,000 ( 4,300)

Payment of dividends

700

Net cash flows from financing activities Net increase in cash Cash at beginning of year

$57,400 12,500

Cash at end of year

$69,900

Schedule of Noncash Investing and Financing Transactions $22,000

Issue of note payable for furniture *

$27,000

–

$15,300

$11,700

583 .

Chapter 12, P 1. Cash Flow Classification Transaction 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

Increased accounts payable. Decreased inventory. Increased prepaid insurance. Earned a net income. Declared and paid a cash dividend. Issued stock for cash. Retired long-term debt by issuing stock. Purchased a long-term investment with cash. Sold trading securities at a gain. Sold a machine at a loss. Retired fully depreciated equipment. Decreased interest payable. Purchased available-for-sale securities (long-term). Decreased dividends receivable. Decreased accounts receivable. Converted bonds to common stock. Purchased 90-day Treasury bill.

Operating Activity

Investing Activity

Financing Noncash Activity Transaction

X X X X

Increase

Decrease

X X X X

X X X

No Effect

X X

X X X

X X

X X X X*

*Cash equivalent 584 .

Effect on Cash Flows

X X

Chapter 12, P 2. 1. Using the "law of large numbers," the primary reasons for the difference between net income and cash flows from operating activities in 2009 are increases in inventory, accounts receivable, and depreciation. The first two are the result of building up inventories and receivables in the retail division. Depreciation is a noncash expense on the income statement. In 2010, in addition to depreciation, the company decreased its accounts receivable and inventories in its retail division due to the closed outlets, which is evident from the loss on closure of retail outlets. In addition, the company increased its payables to suppliers. The latter may be a sign of financial difficulties. 2. Free Cash Flow 2009: ($ 38,472) –

$19,973

–

$33,112

= ($ 91,557)

–

$22,924

–

$16,145

= $145,158

2010:

$184,227

In 2009, the company did not have sufficient free cash flow for expansion and thus had to obtain funds externally. In 2010, free cash flow was large but came mostly from the downsizing of failed outlets and expansion of accounts payable, as explained in 1 above. The total cost of the acquisition consists of cash of $201,000 and a bond issue of $50,000. (See significant noncash investing and financing transactions.) 3. The most significant financing activity by far was the increase in short-term bank financing. The company also paid dividends, purchased treasury stock, and reduced long-term debt. It is not a good idea to finance expansion mostly using short-term debt. In addition, it is questionable whether the company should be paying dividends and buying treasury stock when it is using so much cash. 4. The company immediately began to lose money after the acquisition and had to close outlets to reduce inventory and receivables to raise cash to pay off the short-term bank notes. The entire strategy of diversification was not well thought out. The company's regular sales probably declined due to its traditional customers resenting the competition from one of their suppliers. The company had no experience running a retail business.

585 .

Chapter 12, P 3. 1.

Statement of cash flows prepared Arif Fabrics, Inc. Statement of Cash Flows For the Year Ended December 31, 2010

Cash flows from operating activities Net income

$ 28,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation, building

$ 15,000

Depreciation, equipment

3,000

Amortization, patent

3,000

Gain on sale of equipment

(

5,300)

(

27,000)

Changes in current assets and current liabilities Increase in accounts receivable Decrease in inventory

25,000

Decrease in prepaid expenses

20,000

Decrease in accounts payable

( (

Decrease in accrued liabilities

26,000) 12,300)

Net cash flows from operating activities

(

4,600)

$ 23,400

Cash flows from investing activities Purchase of equipment

($ 12,500)

Sale of equipment (

Purchase of patent

6,300 1,000)

Net cash flows from investing activities

(

7,200)

Cash flows from financing activities Issue of notes payable

$ 25,000

Repayment of notes payable

(

15,000)

(

50,000 9,000)

Issue of common stock Payment of dividends

51,000

Net cash flows from financing activities Net increase in cash Cash at beginning of year

$ 67,200 27,360

Cash at end of year

$ 94,560

Schedule of Noncash Investing and Financing Transactions Issue of mortgage for land

$ 25,000

Issue of mortgage for building

137,000 $162,000 586

Chapter 12, P 3. (Continued) 2. User Insight: Causes of increase in cash identified Although net income of $28,000 generated only $23,400 of cash flows from operating activities, and $7,200 was used by investing activities, Arif Fabrics, Inc., managed to increase cash by $67,200. Net cash flows (or increases) from financing activities were $51,000. Arif Fabrics has increased its cash balance through these financing activities by borrowing from the bank and issuing common stock. Its investing activities were relatively small. Next year's statement of cash flows will reveal what management did with the cash. 3. User Insight: Computation and assessment of cash flow yield and free cash flow

Cash Flow Yield =

Net Cash Flows from Operating Activities Net Income $23,400 $28,000

0.8 times

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets =

$23,400

$8,200

–

$9,000

–

$12,500

$6,300

Arif Fabrics does not generate sufficient cash from operating activities; nor does it have strong free cash flow. Most companies should have net cash flows from operating activities that exceed net income. Also, if free cash flow is low, growth must be financed by borrowing or issuing stock. As was seen in requirement 2, the company has raised cash through debt and stock issuance, which may enable the company to invest and improve its performance.

587 .

Chapter 12, P 4. 1. Statement of cash flows prepared Lopez Ceramics, Inc. Statement of Cash Flows For the Year Ended December 31, 2010 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash

$ 48,000

flows from operating activities Depreciation, building Depreciation, equipment

$ 40,000

Amortization, intangibles Gain on sale of investments

(

Changes in current assets and current liabilities Decrease in accounts receivable Increase in inventory Decrease in prepaid expenses Decrease in accounts payable Decrease in accrued liabilities Net cash flows from operating activities

( ( (

30,000 10,000 17,000) 10,000 80,000) 6,000 95,000) 5,000)

( 101,000) ($ 53,000)

Cash flows from investing activities Purchase of investments Sale of investments Net cash flows from investing activities

($ 58,000) 75,000 17,000

Cash flows from financing activities Issue of bonds Repayment of notes payable Repayment of mortgage

$120,000 ( (

Issue of notes payable

90,000) 20,000) 30,000

Purchase of treasury stock

( (

Payment of dividends

10,000) 18,000) 12,000

Net cash flows from financing activities Net (decrease) in cash Cash at beginning of year

($ 24,000) 152,800

Cash at end of year

$128,800

Schedule of Noncash Investing and Financing Transactions Issue of mortgage for land Issue of mortgage for warehouse

$ 20,000 140,000 $160,000 588

Chapter 12, P 4. (Continued) 2. User Insight: Causes of decrease in cash identified Lopez Ceramics, Inc., had a net decrease in cash as a result of large outflows of cash used by operating activities. The company used significant amounts of cash in 2010 to increase inventory and decrease accounts payable. These payments were large enough to more than offset the increase in cash through investing and financing activities. 3. User Insight: Computation and assessment of cash flow yield and free cash flow

Cash Flow Yield =

Net Cash Flows from Operating Activities Net Income ($53,000) $48,000

not meaningful

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets = ($53,000)

–

$18,000

–

= ($71,000) Despite a net income in 2010, Lopez Ceramics' cash flows from operations were negative. The cash flow yield was not meaningful because a positive net income is divided into negative cash flow. The major uses of cash were to increase inventory and pay accounts payable. Further, this contributed to the company's negative free cash flow of $71,000. To bolster its cash balance, the company sold investments and issued bonds. Overall, the situation warrants investigation. Why did inventory grow so rapidly? Are the company's suppliers requiring faster payment? The focus should be on increasing cash flows from operating activities and, secondarily, on a positive free cash flow.

589 .

Chapter 12, P 5. 1. Statement of cash flows prepared Wu Corporation Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities Net income

$ 11,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$ 46,800

Gain on sale of furniture and fixtures

(

7,000)

Changes in current assets and current liabilities Decrease in accounts receivable

34,800

Decrease in merchandise inventory

100,000

Decrease in prepaid rent

1,000

Decrease in accounts payable

( (

Decrease in income taxes payable

57,000) 3,000)

Net cash flows from operating activities

115,600 $126,600

Cash flows from investing activities Sale of furniture and fixtures*

$ 13,800 ( 39,600)

Purchase of furniture and fixtures Net cash flows from investing activities

(

25,800)

Cash flows from financing activities Repayment of notes payable

($ 20,000)

Issue of notes payable (

Payment of dividends

40,000 6,000) 14,000

Net cash flows from financing activities Net increase in cash Cash at beginning of year

$114,800 50,000

Cash at end of year

$164,800

Schedule of Noncash Investing and Financing Transactions $100,000

Conversion of bonds into common stock * $35,600

–

$28,800

$7,000

= $13,800

590 .

Chapter 12, P 5. (Continued) 2. User Insight: Causes of increase in cash identified Wu had net income of only $11,000, but a net increase in cash of $114,800. The most important causes of this difference were the decrease in accounts receivable ($34,800), the decrease in merchandise inventory ($100,000), and depreciation expense ($46,800). These flows were partially offset by the decrease in accounts payable ($57,000). Net cash inflows from financing activities ($14,000) and net cash outflows from investing activities ($25,800) were relatively unimportant factors. 3. User Insight: Computation and assessment of cash flow yield and free cash flow

Cash Flow Yield =

2011 =

Net Cash Flows from Operating Activities Net Income $126,600 $11,000

11.5 times

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets 2011 =

$126,600

$94,800

–

$6,000

–

$39,600

$13,800

Despite a low net income in 2011, Wu Corporation's cash flows from operations held up, as revealed by its excellent cash flow yield of 11.5 times net income. Also, the free cash flow is positive even though the company had a moderate amount of net capital expenditures for the year. Assuming that the company can improve its profitability in 2012, cash flows do not currently seem to be a problem.

591 .

Chapter 12, P 6. Cash Flow Classification Transaction 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

Paid a cash dividend. Decreased accounts receivable. Increased inventory. Incurred a net loss. Declared and issued a stock dividend. Retired long-term debt with cash. Sold available-for-sale securities at a loss. Issued stock for equipment. Decreased prepaid insurance. Purchased treasury stock with cash. Retired a fully depreciated truck (no gain or loss). Increased interest payable. Decreased dividends receivable on investment. Sold treasury stock. Increased income taxes payable. Transferred cash to money market account. Purchased land and building with a mortgage.

Operating Activity

Investing Activity

Financing Noncash Activity Transaction

Increase

Decrease

X X X

X X X X

X X

No Effect

X X

X X X

X X

*Cash equivalent 592 .

Effect on Cash Flows

Chapter 12, P 7. 1. Statement of cash flows prepared Zagloba Materials, Inc. Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash flows from operating activities Depreciation—building Depreciation—equipment Amortization—patent Gain on sale of equipment Changes in current assets and current liabilities Increase in accounts receivable Decrease in inventory Decrease in prepaid expenses Decrease in accounts payable Decrease in accrued liabilities Net cash flows from operating activities Cash flows from investing activities Purchase of equipment Sale of equipment* Purchase of patent

$ 28,000

$15,000 3,000 3,000 ( 5,300) ( 27,000) 25,000 20,000 ( 26,000) ( 12,300)

(

4,600) $ 23,400

($12,500) 6,300 ( 1,000)

Net cash flows from investing activities

(

Cash flows from financing activities Issue of notes payable Repayment of notes payable Issue of common stock Payment of dividends

7,200)

$25,000 ( 15,000) 50,000 ( 9,000) 51,000

Net cash flows from financing activities Net increase in cash Cash at beginning of year

$ 67,200 27,360

Cash at end of year

$ 94,560

Schedule of Noncash Investing and Financing Transactions Issue of mortgage for land

$ 25,000 137,000

Issue of mortgage for building

$162,000 *

$13,500

–

$12,500

$5,300 593

$6,300

Chapter 12, P 7. (Continued) 2. User Insight: Causes of increase in cash identified Although net income of $28,000 generated only $23,400 of cash flows from operating activities and $7,200 was used by investing activities, Zagloba Materials, Inc., managed to increase cash by $67,200. Net cash flows (or increases) from financing activities were $51,000. Zagloba Materials has increased its cash balance through these financing activities by borrowing from the bank and issuing common stock. Its investing activities were relatively small. Next year's statement of cash flows will reveal what management did with the cash. 3. User Insight: Computation and assessment of cash flow yield and free cash flow Cash Flow Yield =

Net Cash Flows from Operating Activities Net Income $23,400 $28,000

0.8 Times

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets =

$23,400

$8,200

–

$9,000

–

$12,500

$6,300

Zagloba Materials does not generate sufficient cash from operating activities; nor does it have strong free cash flow. Most companies should have net cash flows from operating activities that exceed net income. Also, if free cash flow is low, growth must be financed by borrowing or issuing stock. As was seen in requirement 2, the company has raised cash through debt and stock issuance, which may enable the company to invest and improve its performance.

594 .

Chapter 12, P 8. 1.

Statement of cash flows prepared

Sharma Fabrics, Inc. Statement of Cash Flows For the Year Ended December 31, 2011 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash flows from operating activities Depreciation—building $ 30,000 Depreciation—equipment 6,000 Amortization—patent 6,000 Gain on sale of equipment ( 10,600) Changes in current assets and current liabilities Increase in accounts receivable ( 54,000) Decrease in inventory 50,000 Decrease in prepaid expenses 40,000 Decrease in accounts payable ( 52,000) ( 24,600) Decrease in accrued liabilities

$ 56,000

(

Net cash flows from operating activities

9,200) $ 46,800

Cash flows from investing activities Purchase of equipment Sale of equipment* Purchase of patent Net cash flows from investing activities

($ 25,000) 12,600 ( 2,000) (

Cash flows from financing activities Issue of notes payable Repayment of notes payable Issue of common stock Payment of dividends

14,400)

$ 50,000 ( 30,000) 100,000 ( 18,000) 102,000

Net cash flows from financing activities Net increase (decrease) in cash Cash at beginning of year

$134,400 54,720

Cash at end of year

$189,120

Schedule of Noncash Investing and Financing Transactions Issue of mortgage for land Issue of mortgage for building

$ 50,000 274,000 $324,000

* .

$27,000

–

$25,000

$10,600 595

$12,600

Chapter 12, P 8. (Continued) 2. User Insight: Causes of increase in cash identified Although net income of $56,000 generated only $46,800 of cash flows from operating activities and $14,400 was used by investing activities, Sharma Fabrics, Inc., managed to increase cash by $134,400. Net cash flows (or increases) from financing activities were $102,000. Sharma Fabrics has increased its cash balance through these financing activities by borrowing from the bank and issuing common stock. Its investing activities were relatively small. Next year's statement of cash flows will reveal what management did with the cash. 3. User Insight: Computation and assessment of cash flow yield and free cash flow Cash Flow Yield =

Net Cash Flows from Operating Activities Net Income $46,800 $56,000

0.8 Times

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets =

$46,800

$16,400

–

$18,000

–

$25,000

$12,600

Sharma Fabrics does not generate sufficient cash from operating activities; nor does it have strong free cash flow. Most companies should have net cash flows from operating activities that exceed net income. Also, if free cash flow is low, growth must be financed by borrowing or issuing stock. As was seen in requirement 2, the company has raised cash through debt and stock issuance, which may enable the company to invest and improve its performance.

596 .

Chapter 12, P 9. 1. Statement of cash flows prepared Karidis Ceramics, Inc. Statement of Cash Flows For the Year Ended December 31, 2012 Cash flows from operating activities Net income

$ 96,000

Adjustments to reconcile net income to net cash flows from operating activities Depreciation—building

$ 80,000 60,000 20,000

Depreciation—equipment Amortization—intangibles Gain on sale of investments

(

34,000)

20,000 ( 160,000) 12,000 ( 190,000) ( 10,000)

Cash flows from investing activities Purchase of investments Sale of investments Net cash flows from investing activities

($116,000) 150,000

Cash flows from financing activities Issue of bonds Repayment of notes payable

$240,000

( 202,000) ($106,000)

34,000

( 180,000) ( 40,000)

Repayment of mortgage Issue of notes payable Purchase of treasury stock

( (

Payment of dividends

60,000 20,000) 36,000) 24,000

Net cash flows from financing activities Net increase (decrease) in cash Cash at beginning of year

($ 48,000) 305,600

Cash at end of year

$257,600

Schedule of Noncash Investing and Financing Transactions Issue of mortgage for land Issue of mortgage for warehouse

$ 40,000 280,000 $320,000 597

Chapter 12, P 9. (Continued) 2. User Insight: Causes of decrease in cash identified Karidis Ceramics, Inc., had a net decrease in cash as a result of large outflows of cash used by operating activities. The company used significant amounts of cash in 2012 to increase inventory and decrease accounts payable. These payments were large enough to more than offset the increase in cash through investing and financing activities. 3. User Insight: Computation and assessment of cash flow yield and free cash flow Cash Flow Yield =

Net Cash Flows from Operating Activities Net Income ($106,000) $96,000

not meaningful

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets = ($106,000)

–

$36,000

–

= ($142,000) Despite a net income in 2012, Karidis Ceramics' cash flows from operations were negative. The cash flow yield was not meaningful because a positive net income is divided into negative cash flow. The major uses of cash were to increase inventory and pay accounts payable. Further, this contributed to the company's negative free cash flow of $142,000. To bolster its cash balance, the company sold investments and issued bonds. Overall, the situation warrants investigation. Why did inventory grow so rapidly? Are the company's suppliers requiring faster payment? The focus should be on increasing cash flows from operating activities and, secondarily, on a positive free cash flow.

598 .

Chapter 12, P 10. 1. Using the "law of large numbers," the primary reasons for the difference between net income and cash flows from operating activities in 2010 are depreciation and increases in inventory and accounts receivable. The last two are the result of building up inventories and receivables in the Retail Division. Depreciation is a noncash expense on the income statement. In 2011, in addition to depreciation, the company decreased its accounts receivable and inventories in its Retail Division due to the closed outlets, which is evident from the loss on closure of retail outlets. In addition, the company increased its payables to suppliers. The latter may be a sign of financial difficulties. 2. Free Cash Flow 2010: ($ 38,472) –

$19,973

–

$33,112

= ($ 91,557)

–

$22,924

–

$16,145

= $145,158

2011:

$184,227

In 2010, the company did not have sufficient free cash flow for expansion and thus had to obtain funds externally. In 2011, free cash flow was large but came mostly from the downsizing of failed outlets and expansion of accounts payable, as explained in requirement 1. The total cost of the acquisition consists of cash of $201,000 and a bond issue of $50,000. (See significant noncash investing and financing transactions.) 3. The most significant financing activity by far was the increase in short-term bank financing. The company also paid dividends, purchased treasury stock, and reduced long-term debt. It is not a good idea to finance expansion using mostly short-term debt. In addition, it is questionable whether the company should be paying dividends and buying treasury stock when it is using so much cash. 4. The company immediately began to lose money after the acquisition and had to close outlets to reduce inventory and receivables to raise cash to pay off the short-term bank notes. The entire strategy of diversification was not well thought out. The company's regular sales probably declined due to its traditional customers resenting the competition from one of their suppliers. The company had no experience running a retail business.

599 .

Chapter 12, C 1. EBITDA (earnings before interest, taxes, depreciation, and amortization) is often used in the financial press as a shortcut for cash flows from operating activities on the statement of cash flows. It is not a good approximation because it leaves out many factors that affect cash flow from operations. First, it is true that in the operating activities section, depreciation and amortization are added back to earnings (net income), but interest and taxes require cash and are unavoidable. Second, there may be one-time items in net income, such as gains and losses, write-offs, and restructuring charges, that affect cash flows from operating activities. Third, EBITDA ignores the effects of changes in current assets and current liabilities, which can have a significant effect on cash flows from operating activities. The financial press would give a better picture of a company's cash position by focusing on cash flows from operating activities and cash flow yield.

600 .

Chapter 12, C 2. 1. Make required computations and label the document "Attachment" Attachment All dollar amounts are in millions. Cash Flow Yield = 2001 =

2000 =

Cash Flows to Sales = 2001 =

2000 =

Cash Flows to Assets = 2001 =

2000 =

Net Cash Flows from Operating Activities Net Income ($753)

= not meaningful

$225 $127

= 0.2 Times

$797

Net Cash Flows from Operating Activities Net Sales ($753) $133,762 $127 $55,494

= -0.6%

= 0.2%

Net Cash Flows from Operating Activities Total Assets ($753) $61,783 $127 $64,926

= -1.2%

= 0.2%

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets 2001 = ($753)

–

$394

–

$1,584

= ($2,731)

2000 =

–

$396

–

$1,539

= ($1,808)

$127

601 .

Chapter 12, C 2. (Continued) 2.

Prepare a memorandum to the investment analyst Memorandum

Date: To: From: Re:

Today's Date Investment Analyst Student Assessment of Enron's Statements of Cash Flows

At your request, I have prepared an analysis of Enron Corporation's statement of cash flows. Enron's statement of cash flows and the computation on which this analysis is based are presented in attachments. Mr. Lay, Chairman of Enron, referred to a 26 percent increase in recurring earnings. In fact, the net income, or "bottom line," decreased from $797 million in 2000 to $225 million in 2001 (nine-month period). Also, the statement of cash flows tells a very different story. First, net cash provided by operating activities was only $127 million in 2000 and declined to a negative $753 million in 2001. The largest items accounting for the negative cash flows in 2001 were the net margin deposit activity (in connection with derivatives trading—$2,349 million) and the decline in payables ($1,764 million). These amounts were partially offset by the decline in receivables ($987 million). The result is that cash flow yield is a very meager 0.2 times in 2000 and not meaningful in 2001 because of the negative cash flow from operating activities. Cash flows to sales and cash flows to assets are also very low in 2000 (0.2 percent for both measures) and negative in 2001 (–0.6 percent cash flows to sales and –1.2 percent in 2001). It is clear that Enron's other activities, such as trading activities, have overwhelmed any positive effect from "recurring earnings." Second, an analysis of free cash flow also shows a very difficult situation for Enron. Free cash flow was negative in both years, by almost $2 billion in 2000 ($1,808 million) and almost $3 billion in 2001 ($2,731 million). Not counted in free cash flow were equity investments in both years of about $1 billion ($858 million and $1,172 million), putting a further strain on the company's cash situation. This means the company must provide cash from financing activities to cover these shortfalls in cash. In 2000, financing activities, mainly through increasing longterm and short-term borrowings, were able to make up for the shortfall. However, in 2001, issuance and repayments of long-term debt were basically a wash. This means the company relied heavily on short-term borrowings, which increased by $2,365 million. Further demands on cash were the $394 million the company paid in dividends and the $398 million in treasury stock acquired in 2001. In short, in spite of what the chairman says, Enron is in a very precarious financial situation because of its very poor cash flows from operating activities and its expenditures on long-term investing activities while borrowing short-term. In total, Enron's cash declined by $239 million in the nine months ended September 30, 2001. 602 .

Chapter 12, C 3. Panasonic:

Sony (amounts in billions of yen): Cash Flow Yield = 2009:

2008:

407 -99 758 369

2008:

-379 466

= 2.1 Times

407 7,730 758 8,871

407 12,284 758 12,135

282

= -0.3 Times

= 1.7 Times

Net Cash Flows from Operating Activities Sales 117

= 5.3%

7,766 466

= 8.5%

Cash Flows to Assets = 2009:

117

= -4.1 Times

Cash Flows to Sales = 2009:

Net Cash Flows from Operating Activities Net Income

9,069

= 1.5%

= 5.1%

Net Cash Flows from Operating Activities Average Total Assets 117

= 3.3%

6,924 466

= 6.2%

7,671

= 1.7%

= 6.1%

Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets 2009: 407

–

– 496 + 153 =

117

–

– 522 +

2008: 758

–

– 475 + 145 =

403

466

–

– 419 + 151

= (448) =

129

This is an interesting situation because both companies have a loss in fiscal 2009 while being profitable in 2008. Disregarding the ratios affected by the net loss, Sony has better results in all cash flow yield, cash flow to sales, and cash flow to assets. It also has positive free cash flow in both 2009 and 2008.

603 .

Chapter 12, C 4. 1.

Statement of cash flows prepared Roll Print Gallery, Inc. Statement of Cash Flows For the Year Ended December 31, 2011

Cash flows from operating activities $120,000

Net income Adjustments to reconcile net income to net cash flows from operating activities Depreciation

$20,000

Changes in current assets and current liabilities Increase in accounts receivable

( 32,000)

Increase in inventory

( 60,000)

Decrease in prepaid expenses

4,000

Decrease in accounts payable

( 22,000) 2,000

Increase in income taxes payable

(

Net cash flows from operating activities

88,000) $ 32,000

Cash flows from investing activities (

Payment of dividends Net (decrease) in cash

48,000)

Cash at beginning of year

($ 16,000) 40,000

Cash at end of year

$ 24,000

Schedule of Noncash Investing and Financing Transactions $400,000

Issue of mortgage for building 2.

Cash problem explained

Although Roll earned $120,000 and had $20,000 of depreciation during the year, operating activities generated only $32,000 in cash because of the large increases in accounts receivable ($32,000) and inventory ($60,000). In addition, accounts payable was reduced by $22,000. Minor changes occurred in other current accounts. As a result, the net cash flows from operating activities were dwarfed by the financing payments of $48,000 for cash dividends. To improve the situation next year, Roll might consider reducing accounts receivable and inventory, obtaining shortterm or long-term financing, or reducing the dividend. 604 .

Chapter 12, C 5. 1. No, CVS uses the direct method of reporting cash flows from operating activities. In order to understand the difference between net income and net cash provided by operating activities, it is necessary to look at the reconciliation at the bottom of the statement. This reconciliation uses the indirect method and should be used to understand CVS's cash flows from operations. The most important items affecting cash flows from operations other than net earnings are depreciation and amortization, which have been rising in each year and were $1,389 million in fiscal 2009. In addition to depreciation, several other adjustments contributed to cash flows from operations of $4,035 million, which exceeded net income of $3,696 million. Most important was a use of cash to fund an increase in inventories of $1,199 million. Accounts receivable also increased by $86 million. Accounts payable decreased by $4 million, and accrued expenses increased by $66 million. 2. CVS is definitely an expanding company. In each of the last two years, the company has had additions to property and equipment that exceeded $4.7 billion in total. In addition, acquisitions and other investments totaled more than $2.7 billion in the last two years. In total for those two years, about $5.6 billion was spent on investing. Although cash flows from operating activities of about $8.0 billion in the last two years exceeded the invested, CVS also made use of financing activities. 3. Indeed, CVS was active in its financing activities. In total in the last two years, the company had additions to long-term debt of $3.2 billion, while reductions totaled only $0.7 billion. Also, the increase in short-term debt totaled over $3.7 billion in the last two years. The other large item was the repurchase of common stock of $2.5 billion in 2009. Overall, net cash used in financing activities increased by a total of $4.1 billion from $0.9 billion provided in 2008 to $3.2 billion used in 2009.

605 .

Chapter 12, C 6. (dollars in millions) CVS's cash flow yield: Net Cash Flows from Operating Activities

Cash Flow Yield =

Net Income $4,035

2009:

$3,696 $3,947

2008:

$3,212

1.1 Times

1.2 Times

CVS's cash flows to sales: Net Cash Flows from Operating Activities

Cash Flows to Sales =

Sales $4,035

2009:

= 4.1%

$98,729 $3,947

2008:

= 4.5%

$87,472

CVS's cash flows to assets: Net Cash Flows from Operating Activities

Cash Flows to Assets = 2009:

Average Total Assets $4,035 (

$4,035

= 2008:

$61,641

$60,960

) ÷ 2

= 6.6%

$61,301

$3,947 (

$60,960 $3,947 $57,841

$54,722

) ÷ 2

= 6.8%

CVS's free cash flow: Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets 2009:

$4,035

–

$439

– $2,548 +

$23

= $1,071

2008:

$3,947

–

$383

– $2,180 +

$19

= $1,403

606 .

Chapter 12, C 6. (Continued) (dollars in millions) Southwest's cash flow yield: Net Cash Flows from Operating Activities

Cash Flow Yield =

Net Income $985

2009:

2008:

$99 ($1,521) $178

9.9 Times

not meaningful

Southwest's cash flows to sales: Net Cash Flows from Operating Activities

Cash Flows to Sales = 2009:

2008:

Sales $985 $10,350 ($1,521) $11,023

= 9.5%

= -13.8%

Southwest's cash flows to assets: Cash Flows from Operating Activities

Cash Flows to Assets = 2009:

Average Total Assets $985 (

$985

2008:

$14,269

$14,169

$14,068

) ÷ 2

= 7.0% ($1,521)

(

$14,068

($1,521) $15,420

$16,772

) ÷ 2

= -9.9%

Southwest's free cash flow: Free Cash Flow = Net Cash Flows from Operating Activities – Dividends – Purchases of Plant Assets + Sales of Plant Assets 2009: 2008:

$985

–

($1,521) –

$13

–

$585

= $387

$13

–

$923

= ($2,457)

607 .

Chapter 12, C 6. (Continued) CVS's cash flow yield exceeds 1.0 times but is not sufficient to generate high cash flows to sales or to assets. In addition, free cash flow was relatively low in both years in relation to asset growth. The company will need to continue borrowing to finance expansion. Southwest, on the other hand, had a high cash flow yield of 9.9 times in 2009, but the cash flow yield for 2008 is not meaningful due to negative cash flow from operating activities, partly caused by low net income in relation to high depreciation. Therefore, for 2009, Southwest has higher cash flows to sales and to assets than CVS does. These ratios are not meaningful and/or negative for Southwest's 2008 operations. CVS had greater free cash flows in both years. Both companies have decreased their cash balances during the year. Due to the negative ratios for Southwest in 2008, overall, it appears that CVS has stronger cash flows. Chapter 12, C 7. Students will disagree on this case. Some will think the president's order is tantamount to lying. Others will see it as the practical thing to do, especially given that the note is for only two years and is "close" to being a current liability. Allowances for judgment would permit the reclassification. Also, the 3.0 ratio requirement is quite arbitrary. Why risk a serious situation over such a small thing? Most will argue that the company benefits in the short term by changing the classification of the proceeds from the note payable. The bank is harmed because by not knowing that the company missed its ratio requirement, the bank does not receive early warning that the company's financial condition may be worsening. In fact, the president has said that the company needs an increase in its line of credit, which the bank may approve if it relies on the improperly prepared statement. But some will argue that the bank benefits as well because this small deviation is probably temporary. It would be better in the long run not to force the company into a difficult situation. Management's alternatives are to make the change and keep quiet, not make the change and accept the consequences, or be open with the bank and negotiate. The last alternative is the best for the long term because it is honest. If the company is just temporarily tight on cash because of successfully expanding operations, the bank officers are very likely to be understanding. They will work with management unless there is some compelling reason for them not to, such as poor prospects in a declining economy. It is not in the bank's best interest to cause the company to fail.

608 .

CHAPTER 13—Solutions FINANCIAL PERFORMANCE MEASUREMENT

Chapter 13, SE 1. 1. 2. 3. 4. 5.

b a b a b

Chapter 13, SE 2. 1. 2. 3. 4. 5.

c a d b c

Chapter 13, SE 3. 1. 2. 3. 4. 5. 6. 7.

a; LIFO is more conservative. c b; 10-year useful life is more conservative. a; accelerated method is more conservative. c c b; increase in percentage is more conservative.

609 .

Chapter 13, SE 4. Lincoln Company Income Statement For the Year Ended June 30, 2012 Net sales

$720,000 350,000

Cost of goods sold Gross margin

$370,000 130,000

Operating expenses Income from continuing operations before income taxes Income taxes expense

$240,000 60,000

Income from continuing operations

$180,000

Discontinued operations Loss from discontinued operations (net of taxes, $70,000)

($200,000)

Loss on disposal of discontinued operations (

(net of taxes, $16,000)

50,000) ( 250,000) ($ 70,000)

Net loss Chapter 13, SE 5.

Net sales Accounts receivable (net)

2013

2012

2011

141.1% 204.8%

121.4% 152.4%

100.0% 100.0%

These results show an unfavorable trend because the company is tying up increasing amounts of resources in accounts receivable without as high an increase in sales.

610 .

Chapter 13, SE 6. Otis, Inc. Comparative Income Statements For the Years Ended December 31, 2012 and 2011 Increase or Decrease 2012

2011

Amount

Percentage

$360,000 224,000

$290,000 176,000

$70,000 48,000

24.1%

$136,000 80,000

$114,000 60,000

$22,000 20,000

19.3%

$ 56,000 14,000

$ 54,000 10,000

$ 2,000 4,000

3.7%

Income taxes expense

$ 42,000 14,000

$ 44,000 16,000

($ 2,000) ( 2,000)

-12.5%

Net income

$ 28,000

—

0.0%

Earnings per share

—

0.0%

Net sales Cost of goods sold Gross margin Operating expenses Operating income Interest expense Income before income taxes

2.80

27.3% 33.3% 40.0% -4.5%

The percentage increase in cost of goods sold was greater than the increase in net sales (27.3 percent versus 24.1 percent). As a result, the increase in gross margin is limited to 19.3 percent. Also, although sales and gross margin have increased by a large percentage, operating income is up only 3.7 percent because of the 33.3 percent increase in operating expenses. Income before income taxes has decreased as a result of the 40.0 percent increase in interest expense. That increase, however, was offset by a decrease in income taxes expense, so that net income is the same in both years. Overall, the trend is negative because net income did not increase, despite the 24.1 percent increase in net sales.

611 .

Chapter 13, SE 7. Otis, Inc. Common-Size Balance Sheets December 31, 2012 and 2011 Assets

2012

2011

Current assets

15.6%

16.7%

Property, plant, and equipment (net)

84.4%

83.3%

Total assets

100.0%

Current liabilities

11.7%

18.3%

Long-term liabilities

58.4%

50.0%

Stockholders' equity

29.9%

31.7%

Total liabilities and stockholders' equity

100.0%

Liabilities and Stockholders' Equity

Otis has increased the percentage of its assets devoted to property, plant, and equipment and the percentage of its long-term debt. As a result, its capital structure contains lower percentages of current liabilities and stockholders' equity. It is usually acceptable to finance increases in plant assets by using long-term debt.

612 .

Chapter 13, SE 8. 2012

2011

Current ratio: Current Assets

$48,000

Current Liabilities

$36,000

$40,000

1.3 Times

$44,000

0.9 Times

Quick ratio: Cash + Marketable Securities + Receivables

$14,000* +

$20,000

$14,000** +

$36,000

Current Liabilities $34,000

$36,000

* $48,000

$16,000

$44,000

0.9 Times

–

$14,000

–

$30,000

= $20,000

$44,000

** $40,000

0.7 Times

–

$10,000

–

$16,000

Receivable turnover: $360,000

Net Sales Average Accounts Receivable

(

$20,000

$360,000 $18,000

$290,000

$16,000 ) ÷ 2

= 20.0 Times

(

$16,000

$290,000 $14,000

$12,000 ) ÷ 2

20.7 Times

17.6 Days

Days' sales uncollected: Days in Year

365 Days

Receivable Turnover

20.0 Times

= 18.3 Days 613

365 Days 20.7 Times

Chapter 13, SE 8. (Continued) 2012

2011

$224,000

$176,000

Inventory turnover: Cost of Goods Sold Average Inventory

(

$14,000 $224,000

$12,000

$10,000

) ÷ 2

18.7 Times

19.5 Days

(

$10,000 $176,000

$9,000

$8,000

) ÷ 2

19.6 Times

18.6 Days

Days' inventory on hand: Days in Year

365 Days

Inventory Turnover

18.7 Times

365 Days 19.6 Times

Payables turnover: Cost of Goods Sold +/–

$224,000

Change in Inventories Average

(

Accounts Payable =

$24,000 $228,000 $22,000

$4,000

$20,000

10.4 Times

35.1 Days

$176,000

) ÷ 2

(

$20,000 $178,000 $19,000

+ +

$2,000 $18,000

) ÷ 2

9.4 Times

38.8 Days

Days' payable: Days in Year

365 Days

Payables Turnover

10.4 Times

365 Days 9.4 Times

In most regards, Otis seems to have adequate liquidity. Both the current and quick ratios increased, the receivable and inventory turnovers show very little change, and the payables turnover increased.

614 .

Chapter 13, SE 9. 2012

2011

Profit margin: Net Income

$28,000

Net Sales

$360,000

$28,000

= 7.8%

$290,000

= 9.7%

Asset turnover: $360,000

Net Sales Average Total Assets

( =

$308,000 $360,000 $274,000

$290,000

$240,000 ) ÷ 2

(

1.3 Times

$240,000 $290,000 $220,000

$200,000 ) ÷ 2

1.3 Times

Return on assets: Net Income Average Total Assets

$28,000 $274,000

= 10.2%

$28,000 $220,000

= 12.7%

Profitability measures declined as a result of the decrease in profit margin from 9.7 percent to 7.8 percent.

615 .

Chapter 13, SE 10. 2012

2011

Debt to equity ratio: Total Liabilities

$36,000

$180,000

$44,000

$92,000

Stockholders' Equity =

$216,000 $92,000

$120,000

+ $76,000

2.3 Times

$164,000 $76,000

2.2 Times

Return on equity: $28,000

Net Income Average Stockholders' Equity

( =

$92,000 $28,000 $84,000

$76,000

= 33.3%

$28,000 ) ÷

$76,000

( =

$28,000 $68,000

$60,000 ) ÷

= 41.2%

Interest coverage ratio: Income Before Income Taxes + Interest Expense

$42,000

$14,000

Interest Expense =

$56,000 $14,000

$10,000

+ $10,000

4.0 Times

616 .

$44,000

$54,000 $10,000

5.4 Times

Chapter 13, SE 10. (Continued) Otis carries a large amount of debt in relation to stockholders' equity, as shown by the debt to equity ratio. Return on equity remains high because of the large amount of debt the company has in relation to stockholders' equity. For the time being, the company has adequate interest coverage, even though this ratio did decline from 2011 to 2012. This situation bears close attention because the company is in a risky position, especially in light of the decline in profitability.

617 .

Chapter 13, SE 11. 2012

2011

Cash flow yield: Net Cash Flows from Operating Activities

$32,000

Net Income

$28,000

$42,000

1.1 Times

$28,000

1.5 Times

Cash flows to sales: Net Cash Flows from Operating Activities

$32,000

Net Sales

$360,000

$42,000

= 8.9%

$290,000

= 14.5%

Cash flows to assets: Net Cash Flows from Operating Activities Average Total Assets

$32,000 ( $308,000 =

$32,000 $274,000

$42,000

$240,000 ) ÷ 2

= 11.7%

( $240,000 =

$42,000 $220,000

$200,000 ) ÷ 2

= 19.1%

Free cash flow: Net Cash Flows from Operating Activities – Dividends – Net Capital Expenditures

$32,000

–

$12,000

= ($60,000)

–

$80,000

$42,000

–

$12,000

–

$60,000

= ($30,000)

Otis' cash flow adequacy has deteriorated from 2011 to 2012. The cash flow yield declined from 1.5 to 1.1 times, and 618 .

the other ratios declined accordingly. Free cash flow was negative in 2011 and got worse in 2012. The negative free cash flow explains in part the increase in liabilities shown in the analysis in SE 10.

618 .

Chapter 13, SE 12. 2012

2011

Price/earnings (P/E) ratio: Market Price per Share

$20.00

Earnings per Share

$2.80

7.1 Times

$30.00 $2.80

= 10.7 Times

Dividends yield: Dividends per Share*

$1.20

Market Price per Share

$20.00

*Dividends per share =

$12,000

= 6.0%

10,000

shares =

$1.20 $30.00 $1.20

= 4.0% per share

Investor confidence in Otis has declined, as reflected by the decline in the price/ earnings (P/E) ratio. This may reflect investor awareness of Otis's deteriorating profitability and cash flow situation and its increasingly heavy debt load. The dividends yield increased as a result of the drop in the market value of the stock.

619 .

Chapter 13, E 1. 1.

If the overall financial plan is expected to increase the owners' wealth, then linking managers' compensation to financial targets encourages managers to act in their own and the owners' best interests.

A company's past performance indicates whether performance is improving, but industry norms tell how well a company is performing in relation to its peer group. A limitation of using past performance as a benchmark is that it may not be a good measure of present needs. A limitation of using industry norms is that the company may not be strictly comparable with other companies in the industry.

In a five-year trend analysis for a new five-year period, the base year changes. Unless two successive base years have exactly the same dollar values, the trend analysis will be different each year.

Chapter 13, E 2. 1.

When receivable turnover decreases, it means that the company has more days' receivable to finance. Consequently, the company needs more cash to cover the increase in receivables.

On quarterly financial statements, all numbers on the income statement and statement of cash flows are for less than one year, whereas the balance sheet figures are full values similar to those at year-end. Thus, any ratios that use data from the income statement or statement of cash flows as their basis will be less than they might be on a full-year basis.

A limitation of free cash flows is that it takes into account the use of cash flows from operating activities only for capital expenditures and dividends. It does not consider such other uses as treasury stock or repayment of debt.

620 .

Chapter 13, E 3. 1. 2. 3. 4.

b a c b

5. 6. 7. 8.

c a c d

Chapter 13, E 4. 1.

Net income determined under FIFO

Net income under average cost method

$68,000

Difference between FIFO and average cost inventory (

$190,000

–

$180,000

10,000

)

$78,000

Net income under FIFO 2.

Net income determined under LIFO

Net income under average cost method

$68,000

Difference between LIFO and average cost inventory (

$172,000

–

$180,000

(

)

$60,000

Net income under LIFO 3.

Most accountants would consider the LIFO method the more conservative procedure because it yields a lower asset value and a lower net income (in a period of rising prices).

No, the choice of LIFO will not violate the consistency convention. Because this is the company's first year of operation, there has been no change in methods.

Yes, the full-disclosure convention requires disclosure of the inventory method used in the financial statements.

621 .

8,000)

Chapter 13, E 5. Hugo Corporation Income Statement For the Year Ended June 30, 2011 Net sales Cost of goods sold

$950,000 525,000

Gross margin

$425,000

Operating expenses Selling expenses

($25,000) ( 40,000)

Administrative expenses Total operating expenses

(

Gain on sale of equipment Income from continuing operations before income taxes

65,000) 6,250

Income taxes expense

$366,250 150,000

Income from continuing operations

$216,250

Discontinued operations Loss from discontinued operations (net of taxes,

($25,000)

$15,000) Loss on disposal of discontinued operations (net of ( 17,500) (

taxes, $6,500)

$173,750

Net income

622 .

42,500)

Chapter 13, E 6. 2012

2011

2010

2009

2008

Net sales

113.7%

109.0%

110.0%

104.0%

100.0%

Cost of goods sold

123.0%

110.0%

111.0%

105.0%

100.0%

General and administrative expenses 110.0%

108.0%

106.0%

102.0%

100.0%

Operating income

106.1%

111.6%

102.6%

100.0%

94.4%

Comment: Although sales increased over the five-year period, operating income decreased because cost of goods sold increased faster than sales. This unfavorable trend was partially offset by the fact that general and administrative expenses did not increase as fast as sales.

623 .

Chapter 13, E 7. Davis Company Comparative Balance Sheets December 31, 2012 and 2011 Increase or Decrease 2012

2011

Amount

Percentage

Current assets Property, plant, and equipment (net)

$ 18,600 109,464

$ 12,800 97,200

$ 5,800 12,264

Total assets

$128,064

$110,000

$18,064

45.3% 12.6% 16.4%

$ 11,200 35,000 81,864

3,200 40,000 66,800

$ 8,000 ( 5,000) 15,064

250.0% -12.5% 22.6%

$128,064

$110,000

$18,064

16.4%

Assets

Liabilities and Stockholders' Equity Current liabilities Long-term liabilities Stockholders' equity Total liabilities and stockholders' equity

Comment: All asset categories and stockholders' equity increased from 2011 to 2012. The most significant increase was the 250.0 percent, or $8,000, increase in current liabilities. In contrast, long-term liabilities decreased by only 12.5 percent, or $5,000—less than the $8,000 increase in current liabilities. The increase in current liabilities is compensated for by the $15,064 increase in stockholders' equity and the 45.3 percent increase in current assets.

624 .

Chapter 13, E 8. Davis Company Common-Size Income Statements For the Years Ended December 31, 2012 and 2011 2012

2011

Net sales

100.0%

Cost of goods sold

60.0%

65.0%

Gross margin

40.0%

35.0%

Selling expenses

25.0%

20.0%

General expenses

12.0%

10.0%

Total operating expenses

37.0%

30.0%

Operating income

3.0%

5.0%

Comment: Operating income decreased from 5 percent to 3 percent of sales despite a decrease in cost of goods sold in relation to sales (from 65 percent to 60 percent) because selling expenses and general expenses each increased as a percentage of sales (from 30 percent to 37 percent in total).

625 .

Chapter 13, E 9. 2012 $120,000

Current ratio

$40,000

$13,600 +

2011 $112,800

3.0 Times $7,200

$28,200

$44,800

$10,400

+ $17,200

$40,000

Quick ratio =

(

1.6 Times

Days' sales uncollected

$44,800

$322,560 $40,200

365 Days 8.0 Times

2.2 Times

)÷ 2

8.0 Times

45.6 Days

( =

$35,600 $220,720 $34,000

365 Days 6.5 Times

$217,600 Inventory turnover

( =

Days' inventory on hand

$54,400 $217,600 $52,000

365 Days 4.2 Times

Payables turnover

( =

$40,000 $222,400 $34,100

365 Days

Days' payable

6.5 Times

)÷ 2

4.2 Times

86.9 Days

$217,600

+ +

$32,400 ) ÷ 2

6.5 Times

56.2 Days

$203,360

$49,600

$35,600

$220,720

$35,600

$28,200

$322,560 Receivable turnover

4.0 Times

( =

6.5 Times

56.2 Days

$50,400

4.0 Times

$51,200 ) ÷ 2

4.0 Times

91.3 Days

–

$203,360

)÷ 2

$203,360

365 Days

$4,800 $28,200

$49,600

( =

$28,200 $201,760 $29,400

365 Days 6.9 Times

$1,600

$30,600 ) ÷ 2

6.9 Times

52.9 Days

Comment: Although Sople Company’s receivable turnover, days’ sales uncollected, inventory turnover, and days’ inventory on hand improved, its operating asset management position deteriorated, probably because of decreases in the current ratio (from 4.0 to 3.0) and the quick ratio (from 2.2 to 1.6). Also, its payables turnover and days’ payable were less favorable in 2012 than in 2011. However, the operating cycle declined from 147.5 days (56.2 + 91.3) to 132.5 days (45.6 + 86.9). The required days of financing decreased from 94.6 days (147.5 – 52.9) to 76.3 days (132.5 – 56.2). This is a favorable development. 626 .

Chapter 13, E 10. (amounts in thousands) Receivable Turnover

Year 2009:

2010:

2011:

2012:

Net Sales Average Accounts Receivable $80 ( $12

$11 ) ÷ 2 $96

( $16

$12 ) ÷ 2

$112 ( $20

$16 ) ÷ 2

$144 ( $24

$20 ) ÷ 2

7.0 Times

6.9 Times

6.2 Times

6.5 Times

Inventory Turnover

Payables Turnover

Cost of Goods Sold Average Inventory

Cost of Goods Sold +/– Change in Inventory Average Accounts Payable

$48 ( $10

$11 ) ÷ 2 $60

( $16

$10 ) ÷ 2 $72

( $22

$16 ) ÷ 2 $90

( $28

$22 ) ÷ 2

4.6 Times

3.8 Times

3.6 Times

–

$48 (

$60 (

+ +

$72 ( $10

$5 +

$90 ( $13

$8 +

$1 ) ÷ 2 $6 ) ÷ 2 $6 ) ÷ 2 $6

$10 ) ÷ 2

= 10.4 Times

= 10.2 Times

8.7 Times

8.3 Times

Clearly, Ike Tuxedo Rental is carrying too much inventory for its level of business. The inventory turnover ratio has declined from 4.6 times to 3.6 times, which means the company has been investing increasing amounts of cash in inventory. The company can improve its cash flow by reducing inventory. Also, payables turnover decreased, which means the company is paying its bills more quickly. The receivable turnover, on the other hand, has remained relatively constant over the four years. Though it might be improved, it has not worsened significantly.

627 .

Chapter 13, E 11. 2012 Profit margin

$49,476 $798,000

2011 $38,556

= 6.2%

$612,000

= 6.3%

$798,000 Asset turnover

( $380,000 =

$798,000 $360,000

$612,000

+ $340,000 ) ÷ 2

( $340,000

= 2.2 Times

$612,000 $330,000

$49,476 Return on assets

( $380,000 =

$49,476 $360,000

( $228,000 =

$49,476 $216,000

= 1.9 Times $38,556

+ $340,000 ) ÷ 2

( $340,000

= 13.7%

$38,556 $330,000

$49,476 Return on equity*

+ $320,000 ) ÷ 2

+ $320,000 ) ÷ 2 = 11.7% $38,556

+ $204,000 ) ÷ 2

( $204,000

= 22.9%

$38,556 $198,000

+ $192,000 ) ÷ 2 = 19.5%

Comment: Return on assets increased from 11.7 percent to 13.7 percent despite a relatively stable profit margin (6.3 percent and 6.2 percent) because of an increase in asset turnover from 1.9 to 2.2 times. The return on equity is higher than the return on assets because the company is leveraged, with a debt to equity ratio of 0.7 times. * In each year, equity equals 60 percent (1.00 ÷ 1.67) of total assets because the debt to equity ratio is 0.67.

628 .

Chapter 13, E 12. Mayer Company $2,160,000 Debt to equity ratio

$2,640,000 * *

Interest coverage ratio Price/earnings (P/E) ratio

Dividends yield

$576,000

$1,188,000

0.8 Times –

$4,800,000

Matthews Company

$2,160,000

$194,400

$6.40 $8.00 $80.00

–

$259,200

$1,188,000

$106,920

4.0 Times $80.00

1.2 Times

$2,160,000

$194,400 =

* $972,000

= 12.5 Times

3.4 Times $95.00 $10.00 $8.00

10.0%

$95.00

9.5 Times

8.4%

Comment: Matthews Company has a greater debt to equity ratio (1.2 times versus 0.8 times) and a smaller interest coverage ratio (3.4 times versus 4.0 times) than does Mayer Company. Both of these measures indicate that investments in Matthews Company, either bonds or stocks, may be more risky than similar investments in Mayer Company. Matthews Company has a lower P/E ratio than does Mayer Company (9.5 compared to 12.5); thus, an investor in Matthews Company obtains more underlying earnings per dollar invested compared to an investor in Mayer Company. However, in other respects, Mayer Company is more acceptable. For example, even though both companies pay an $8.00 per share dividend, the dividends yield for Mayer Company (10.0 percent) is better than that for Matthews Company (8.4 percent) because the price of Mayer Company's stock ($80.00) is less than that of Matthew Company's ($95.00). To reach a final decision, the investor must weigh the relative risks and potential returns associated with each investment.

629 .

Chapter 13, E 13. Cash flow yield

Cash flows to sales

$456,000 $352,000 =

$456,000 $3,200,000

1.3 Times

= 14.3% $456,000

( $3,120,000

$2,890,000 ) ÷ 2

Cash flows to assets =

Free cash flow

$456,000 $3,005,000

$456,000

–

= 15.2% $120,000

= $38,000

630 .

– $298,000

Chapter 13, P 1. 1. Alternative income statements prepared Dot Company Alternative Income Statements For the Year Ended December 31, 2012 Income Statement Using FIFO and Straight-Line Methods Net sales

$1,300,000

Cost of goods sold Cost of goods available for sale

$947,600

Less ending inventory 300 units at $420

$126,000 82,400

200 units at $412

208,400 739,200

Cost of goods sold Gross margin

$ 560,800

Operating expenses Salaries expense

$200,000

Other expenses

80,000

Depreciation 90,000

$900,000 ÷ 10 years Total operating expenses

370,000 $ 190,800

Net income Income Statement Using LIFO and Double-Declining-Balance Methods Net sales

$1,300,000

Cost of goods sold Cost of goods available for sale

$947,600

Less ending inventory 400 units at $400

$160,000 40,800

100 units at $408

200,800 746,800

Cost of goods sold Gross margin

$ 553,200

Operating expenses Salaries expense

$200,000

Other expenses

80,000

Depreciation 180,000

$900,000 × 0.20

460,000

Total operating expenses $

Net income 631 .

93,200

Chapter 13, P 1. (Continued) 2. Schedule prepared Dot Company Schedule of Differences in Net Income For the Year Ended December 31, 2012 Difference in net income Net income using FIFO and straight-line methods

$190,800

Net income using LIFO and double-decliningbalance methods

93,200

Difference in net income

$ 97,600

Differences resulting from alternative methods Cost of goods sold $739,200 746,800

FIFO LIFO

7,600

Depreciation $ 90,000 180,000

Straight-line method Double-declining-balance method

90,000 $ 97,600

Difference in net income 3. User Insight: Inventory turnover computed and discussed Inventory Turnover Cost of Goods Sold Ending Inventory

FIFO Method $739,200

3.5 Times

$208,400

LIFO Method $746,800

3.7 Times

$200,800

In a period of rising prices, the LIFO method produces a more favorable inventory turnover because cost of goods sold is higher and inventory is lower than under the FIFO method.

632 .

Chapter 13, P 1. (Continued) 4.

User Insight: Return on assets computed and discussed

Return on Assets FIFO/Straight-Line Methods Net Income Total Assets

= $80,000 =

$190,800 $1,098,400

$190,800 $208,400 + $900,000

–

$90,000

= 17.4%

LIFO/Double-Declining-Balance Methods = $80,000 =

$93,200 $1,000,800

$93,200 $200,800 + $900,000

–

$180,000

= 9.3%

The LIFO and double-declining-balance methods produce a lower return on assets. This combination of accounting methods produces a more conservative net income figure than does the FIFO/straight-line methods because it charges higher cost of goods sold and depreciation costs against revenues in earlier years. Therefore, analysts would be more willing to accept a lower return on assets in the LIFO/ double-declining-balance case.

633 .

Chapter 13, P 2. 1. Schedules showing amount and percentage changes prepared Whale Corporation Comparative Income Statements For the Years Ended December 31, 2012 and 2011 Increase or Decrease 2012

2011

Amount

Percentage

$3,146,400 2,008,400

$130,400 80,400

4.1

Cost of goods sold

$3,276,800 2,088,800

Gross margin

$1,188,000

$1,138,000

$ 50,000

4.4

$ 518,000 423,200

($ 41,200) 24,000

(8.0)

Administrative expenses

$ 476,800 447,200

Total operating expenses

$ 924,000

$ 941,200

($ 17,200)

(1.8)

$ 264,000 65,600

$ 196,800 39,200

$ 67,200 26,400

34.1

$ 157,600 56,800

$ 40,800 5,600

25.9

Income taxes expense

$ 198,400 62,400

Net income

$ 136,000

$ 100,800

$ 35,200

34.9

$3.40

$2.52

$0.88

34.9

Net sales

4.0

Operating expenses Selling expenses

Income from operations Interest expense Income before income taxes

Earnings per share

634 .

5.7

67.3 9.9

Chapter 13, P 2. (Continued) Whale Corporation Comparative Balance Sheets December 31, 2012 and 2011 Increase or Decrease 2012

2011

Amount

Percentage

40,800

$ 40,400

99.0

6,400

2.8

20,000)

(3.4)

Assets Cash

81,200

Accounts receivable (net)

235,600

229,200

Inventory

574,800

594,800

750,000

720,000

30,000

4.2

$1,641,600

$1,584,800

$ 56,800

3.6

$ 267,600

$ 477,200

($209,600)

(43.9)

Notes payable (short-term)

200,000

400,000

( 200,000)

(50.0)

Bonds payable

400,000

—

400,000

Common stock, $10 par value

400,000 374,000

400,000 307,600

— 66,400

— 21.6

$1,641,600

$1,584,800

$ 56,800

3.6

(

Property, plant, and equipment (net) Total assets

Liabilities and Stockholders' Equity Accounts payable

Retained earnings Total liabilities and stockholders' equity *Infinite

635 .

Chapter 13, P 2. (Continued) 2.

Common-size income statements and balance sheets prepared Whale Corporation Common-Size Income Statements For the Years Ended December 31, 2012 and 2011

Net sales Cost of goods sold Gross margin Operating expenses Selling expenses Administrative expenses Total operating expenses Income from operations Interest expense Income before income taxes Income taxes expense Net income

2012

2011

100.0% 63.7% 36.3%

100.0% 63.8% 36.2%

14.6% 13.6% 28.2% 8.1% 2.0% 6.1% 1.9% 4.2%

16.5% 13.5% 29.9% 6.3% 1.2% 5.0% 1.8% 3.2%

2012

2011

4.9% 14.4% 35.0% 45.7% 100.0%

2.6% 14.5% 37.5% 45.4% 100.0%

16.3% 12.2% 24.4% 24.4% 22.8% 100.0%

30.1% 25.2% 0.0% 25.2% 19.4% 100.0%

Whale Corporation Common-Size Balance Sheets December 31, 2012 and 2011 Assets Cash Accounts receivable (net) Inventory Property, plant, and equipment (net) Total assets Liabilities and Stockholders' Equity Accounts payable Notes payable (short-term) Bonds payable Common stock, $10 par value Retained earnings Total liabilities and stockholders' equity

* In common-size statements, the addition and subtraction of percentages are sometimes inexact due to rounding. 636 .

Chapter 13, P 2. (Continued) 3. User Insight: Results commented on The major changes in the income statements of Whale Corporation occurred in the expense categories. Interest expense increased 67.3 percent, or $26.4 thousand; administrative expenses increased 5.7 percent, or $24 thousand; and income taxes expense increased 9.9 percent, or $5.6 thousand. The increase in administrative expenses was partially offset by a significant decrease of 8.0 percent ($41.2 thousand) in selling expenses. The result was an overall decrease in operating expenses of 1.8 percent, compared with a 4.4 percent increase in gross margin on sales. Even with the increases in interest expense and income taxes expense, net income increased by a respectable 34.9 percent. There was little change in the component percentages. There were significant amount, percentage, and component changes in the liability portion of the balance sheets. In a major refinancing, Whale Corporation increased bonds payable by $400 thousand and decreased accounts payable and notes payable by about $400 thousand total. As a result, long-term debt rose to 24.4 percent of total liabilities and stockholders’ equity, while accounts payable and notes payable dropped to 16.3 and 12.2 percent, respectively, of the same figure.

637 .

Chapter 13, P 3. Effect Transaction a.

Issued common stock for cash.

Ratio

None

Asset turnover

Declared cash dividend. Sold treasury stock. Borrowed cash by issuing

Current ratio Return on equity

x x

note payable.

Debt to equity ratio

Paid salaries expense.

Inventory turnover

Purchased merchandise for cash.

Current ratio

Receivable turnover

b. c. d.

g. h. i.

Sold equipment for cash. Sold merchandise on account.

Paid current portion of long-term debt. Gave sales discount.

Purchased marketable

l. m.

Quick ratio

Return on assets Profit margin

x x

securities for cash.

Quick ratio

Declared 5% stock dividend.

Current ratio

Purchased a building.

Free cash flow

638 .

Increase Decrease

Chapter 13, P 4.

Ratio Name

2012

6. Favorable (F) or Unfavorable (U) Change

2011

1. Profitability and total asset management analysis a. Profit margin

$136,000

$3,276,800

= 4.2%

$100,800

$3,146,400

$3,276,800 (

b. Asset turnover

$1,641,600

= 3.2%

$3,146,400

$1,584,800 ) ÷ 2

(

$1,584,800

$1,465,600 ) ÷ 2 Neutral

$3,276,800

$1,613,200

= 2.0 Times

$3,146,400

$1,525,200

$136,000 (

c. Return on assets

$1,641,600

= 2.1 Times $100,800

$1,584,800 ) ÷ 2

(

$1,584,800

$1,465,600 ) ÷ 2 F

$136,000 $1,613,200

= 8.4%

639 .

$100,800 $1,525,200

= 6.6%

Chapter 13, P 4. (Continued)

Ratio Name

2012

6. Favorable (F) or Unfavorable (U) Change

2011

2. Liquidity analysis ($196,000)

a. Cash flow yield

$136,000 ($196,000)

b. Cash flows to sales

$3,276,800

$144,000

= -1.4 Times

$100,800 $144,000

= -5.9%

$3,146,400

($196,000) ( $1,641,600

c. Cash flows to assets

= 1.4 Times

= 4.6%

$144,000

$1,584,800 ) ÷ 2

( $1,584,800

$1,465,600 ) ÷ 2 U

d. Free cash flows

($196,000) $1,613,200

($196,000) – = ($280,000)

= -12.1% $44,000

= –

$40,000

640 .

$144,000 $1,525,200

$144,000 – = $44,600

= 9.4% $34,400

–

$65,000

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Chapter 13, P 4. (Continued)

Ratio Name

2012

6. Favorable (F) or Unfavorable (U) Change

2011

3. Financial risk analysis $267,600

$200,000

$400,000

a. Debt to equity ratio

$400,000

$374,000

$477,200

$400,000

$307,600 Neutral

$867,600

$774,000

= 1.1 Times

$877,200

$707,600

$136,000 (

b. Return on equity

$774,000

= 1.2 Times $100,800

$707,600 ) ÷ 2

(

$707,600

$641,600 ) ÷ 2 F

$136,000

$198,400 c. Interest coverage ratio

= 18.4%

$740,800

$65,600

$100,800

$157,600

$65,600

= 14.9%

$674,600

$39,200

$39,200 U

$264,000 $65,600

= 4.0 Times

641 .

$196,800 $39,200

= 5.0 Times

Chapter 13, P 4. (Continued)

Ratio Name

6. Favorable (F) or Unfavorable (U) Change

2012

2011

$2,088,800

$2,008,400

4. Operating asset management analysis (

a. Inventory turnover

$574,800

$594,800

) ÷

(

$594,800

$547,200

) ÷ 2 Neutral

b. Days' inventory on hand

$2,088,800 $584,800 365

Days

3.6

Times

3.6 Times

101.4 Days

$3,276,800 (

c. Receivable turnover

$235,600

$2,008,400 $571,000 365

Days

3.5

Times

3.5 Times

104.3 Days

$3,146,400

$229,200 ) ÷

(

$229,200

$206,800 ) ÷ 2 U

d. Days' sales uncollected

$3,276,800 $232,400 365 Days 14.1 Times

14.1 Times

25.9 Days

$3,146,400 $218,000 365 Days 14.4 Times

14.4 Times

25.3 Days

Note: These analyses indicate the apparently favorable or unfavorable change in each ratio. Class discussion may focus on conditions that lead to different conclusions.

642 .

Chapter 13, P 4. (Continued)

Ratio Name

2012

(

e. Payables turnover

$267,600

Days' payable

$2,068,800 $372,400 365 Days 5.6 Times

$81,200

$267,600

2011

–

$2,088,800

$20,000

$2,008,400

$477,200 ) ÷ 2

(

6. Favorable (F) or Unfavorable (U) Change

5.6 Times

$40,800

$200,000

$477,200

$47,600 $384,600 ) ÷ 2 =

$430,900

4.8 Times

$574,800

$2,056,000

365 Days

65.2 Days

$235,600

$477,200

4.8 Times

76.0 Days

$229,200 +

$594,800 $400,000

g. Current ratio

F =

$891,600 $467,600

1.9 Times

$864,800 $877,200

1.0 Times

$81,200

$235,600

$40,800

$229,200

$267,600

$200,000

$477,200

$400,000

h. Quick ratio

F =

$316,800 $467,600

0.7 Times

643 .

$270,000 $877,200

0.3 Times

Chapter 13, P 4. (Continued)

Ratio Name

2012

2011

6. Favorable (F) or Unfavorable (U) Change

5. Market strength analysis $36.00

a. Price/ earnings (P/E) ratio

$3.40

$44,000

10.6 Times

40,000 Shares

$60.00 $2.52

$34,400

$36.00

b. Dividends yield

23.8 Times

40,000 Shares

$60.00 F

$1.10 $36.00

= 3.1%

644 .

$0.86 $60.00

= 1.4%

Chapter 13, P 5.

Ratio Name

6. Company with More Favorable Ratio

Style

Fast

1. Liquidity analysis $80,000 a. Current ratio

$203,400

$192,400

$84,600

$552,800

$629,800

$54,400

$985,400

$1,253,400

$114,000

$344,000

$150,000

$50,200

$572,600

$400,000

$73,400

$1,520,400 $544,200

2.8 times

$2,629,800

$1,046,000

2.5 times

$80,000

$203,400

$552,800

$192,400

$84,600

$985,400

$344,000

$150,000

$50,200

$572,600

$400,000

$73,400

b. Quick ratio

Fast =

c. Receivable turnover

$836,200

$544,200

$12,560,000 $552,800 365 days

d. Days' sales uncollected

Fast

22.7 times

1.5 times

22.7 times

16.1 days

$1,262,400 $1,046,000

$25,210,000 $985,400 365 days 25.6 times

1.2 times

25.6 times

14.3 days

Style

Style (continued)

645 .

Chapter 13, P 5. (Continued)

Ratio Name

Fast

e. Inventory turnover

$6,142,000

f. Days' inventory on hand

365 days

g. Payables turnover

$6,142,000

h. Days' payable

$629,800

9.8 times

37.4 days

$344,000 365 days 17.9 times

Style

+ $0

6. Company with More Favorable Ratio

$14,834,000 $1,253,400 365 days 11.8 times

$14,834,000

17.9 times

11.8 times

30.8 days

+ $0

$572,600 365 days

20.4 days

25.9 times

14.1 days

Style

Style (continued)

646 .

Chapter 13, P 5. (Continued)

Ratio Name

Fast

6. Company with More Favorable Ratio

Style

2. Profitability analysis a. Profit margin

$215,400 $12,560,000

b. Asset turnover

$12,560,000

c. Return on assets

$215,400

$4,987,200

$305,800

= 1.7%

$25,210,000 $25,210,000

2.5 times

$9,326,600 $305,800

= 4.3%

$9,326,600

= 1.2%

Fast

Style

= 3.3%

$215,400 d. Return on equity

$1,000,000

$609,800

2.7 times

Fast

$305,800 +

$833,200

$600,000

$3,568,600

$2,112,000 Fast

$215,400 $2,443,000

= 8.8%

$305,800 $6,280,600

= 4.9% (continued)

647 .

Chapter 13, P 5. (Continued)

Ratio Name

Fast

6. Company with More Favorable Ratio

Style

3. Long-term solvency analysis $344,000 a. Debt to equity ratio

$572,600

$150,000

$50,200

$2,000,000

$400,000

$73,400

$2,000,000

$1,000,000

$609,800

$833,200

$600,000

$3,568,600

$2,112,000

$2,544,200 $2,443,000

$415,400 b. Interest coverage ratio

1.0 times

$194,000

$3,046,000 $6,280,600

$605,800

$194,000

Style

0.5 times

$228,000

$228,000 Style

$609,400 $194,000

3.1 times

$833,800 $228,000

3.7 times (continued)

648 .

Chapter 13, P 5. (Continued)

Ratio Name

Fast

6. Company with More Favorable Ratio

Style

4. Cash flow adequacy analysis a. Cash flow yield

$271,500

b. Cash flows to sales

$271,500

c. Cash flows to assets d. Free cash flow

$215,400

$12,560,000

$271,500 $4,987,200

$271,500

–

$492,500

1.3 times

$492,500

= 2.2%

$25,210,000

$492,500

= 5.4%

$50,000

$305,800

$9,326,600

–

$625,000

$492,500

= ($403,500)

–

= ($671,500)

1.6 times

= 2.0%

Fast

= 5.3%

$114,000

Style

Neutral

–

$1,050,000

Fast (continued)

649 .

Chapter 13, P 5. (Continued)

Ratio Name

Fast

Style

6. Company with More Favorable Ratio

5. Market strength analysis $60.00

a. Price/ earnings (P/E) ratio

$4.31

13.9 times

50,000 shares

$50,000

$76.00 $10.19

7.5 times

30,000 shares

$114,000

$60.00

b. Dividends yield

Fast

$76.00 Style

$1.00 $60.00

= 1.7%

$3.80 $76.00

= 5.0%

7. Use of information from prior years Information from prior years could be used to improve the analysis in at least two ways. First, the turnover and return ratios and the cash flows to assets could be based on average amounts. Second, a trend analysis could be performed for each company.

650 .

Chapter 13, P 6. 1. Alternative income statements prepared Zeigler Corporation Alternative Income Statements For the Year Ended December 31, 2012 Income Statement Using FIFO and Straight-Line Methods Net sales

$450,000

Cost of goods sold Goods available for sale

$118,450

Less ending inventory 150 units at $105

$15,750 10,300

100 units at $103

26,050 92,400

Cost of goods sold Gross margin

$357,600

Operating expenses Salaries expense

$ 70,000

Other expenses

25,000

Depreciation 30,000

$300,000 ÷ 10 years Total operating expenses

125,000 $232,600

Net income Income Statement Using LIFO and Double-Declining-Balance Methods Net sales

$450,000

Cost of goods sold Goods available for sale

$118,450

Less ending inventory 200 units at $100

$20,000 5,100

50 units at $102

25,100 93,350

Cost of goods sold Gross margin

$356,650

Operating expenses Salaries expense

$ 70,000

Other expenses

25,000

Depreciation 60,000

$300,000 × 0.20 Total operating expenses

155,000 $201,650

Net income 651 .

Chapter 13, P 6. (Continued) 2. Schedule prepared Zeigler Corporation Schedule of Differences in Net Income For the Year Ended December 31, 2012 Difference in net income Net income using FIFO and straight-line methods

$232,600

Net income using LIFO and double-decliningbalance methods

201,650

Difference in net income

$ 30,950

Differences resulting from alternative methods Cost of goods sold $92,400 93,350

FIFO LIFO

950

Depreciation $30,000 60,000

Straight-line method Double-declining-balance method

30,000 $ 30,950

Difference in net income 3. User insight: Inventory turnover computed and discussed Inventory Turnover Cost of Goods Sold Ending Inventory

FIFO Method $92,400

3.5 Times

$26,050

LIFO Method $93,350

= 3.7 Times

$25,100

In a period of rising prices, the LIFO method produces a more favorable inventory turnover because cost of goods sold is higher and inventory is lower than under the FIFO method.

652 .

Chapter 13, P 6. (Continued) 4.

User insight: Return on assets computed and discussed

Return on Assets FIFO/Straight-Line Methods Net Income Total Assets

= $25,000 =

$232,600 $321,050

$232,600 $26,050 + $300,000

−

$30,000

= 72.4%

LIFO/Double-Declining-Balance Methods = $25,000 =

$201,650 $290,100

$201,650 $25,100 + $300,000

−

$60,000

= 69.5%

The LIFO and double-declining-balance methods produce a lower return on assets. This combination of accounting methods produces a more conservative net income figure compared to the FIFO/straight-line methods because it charges higher cost of goods sold and depreciation costs against revenues in earlier years. Therefore, analysts would be more willing to accept a lower return on assets in the LIFO/ double-declining-balance case.

653 .

Chapter 13, P 7. Effect Transaction

Ratio

a. Sold merchandise on account. Current ratio b. Sold merchandise on account. Inventory turnover c. Collected on accounts receivable. Quick ratio d. Wrote off an uncollectible account. Receivable turnover e. Paid on accounts payable. Current ratio f. Declared cash dividend. Return on equity g. Incurred advertising expense. Profit margin h. Issued stock dividend. Debt to equity ratio i. Issued bonds payable. Asset turnover j. Accrued interest expense. Current ratio k. Paid previously declared cash dividend. Dividends yield l. Purchased treasury stock. Return on assets m. Recorded depreciation expense. Cash flow yield

Increase Decrease None x x* x x** x*** x x x x x x x x

* Assumes perpetual inventory system. ** Assumes an allowance for uncollectible accounts is used. *** Answer assumes a ratio before the transaction of >1. If the ratio were <1, the effect would be a decrease.

654 .

Chapter 13, P 8.

Ratio Name

2012

6. Favorable (F) or Unfavorable (U) Change

2011

1. Profitability and total asset management analysis $36,900

a. Profit margin

$800,400

$71,300

= 4.6%

$742,600

= 9.6%

$800,400 (

b. Asset turnover

$803,900

$685,200

$742,600 ) ÷

(

$685,200

$647,800

) ÷

2 Neutral

$800,400 $744,550

1.1 Times

$742,600 $666,500

$36,900 (

c. Return on assets

$803,900

$685,200

1.1 Times

$71,300 ) ÷

(

$685,200

$647,800

) ÷

2 U

$36,900 $744,550

= 5.0%

655 .

$71,300 $666,500

= 10.7%

Chapter 13, P 8. (Continued)

Ratio Name

2012

6. Favorable (F) or Unfavorable (U) Change

2011

2. Liquidity analysis $64,000

a. Cash flow yield

$36,900

b. Cash flows to sales

$64,000 $800,400

$99,000

1.7 Times

$71,300 $99,000

= 8.0%

$742,600

(

$803,900

= 13.3%

$64,000 c. Cash flows to assets

1.4 Times

$99,000

$685,200

) ÷ 2

(

$685,200

$647,800

) ÷ 2 U

$64,000 $744,550

$64,000 – = ($86,400)

d. Free cash flow

= 8.6% $31,400

= –

$119,000

656 .

$99,000 $666,500

$99,000 – = $26,000

= 14.9% $35,000

–

$38,000

Chapter 13, P 8. (Continued)

Ratio Name

2012

6. Favorable (F) or Unfavorable (U) Change

2011

3. Financial risk analysis $104,700 a. Debt to equity ratio

$50,000

$300,000

$200,000

$72,300

$149,200

$50,000

$300,000

$110,000 $152,900 U

$354,700 $449,200

0.8 Times

$232,300 $452,900

$36,900 (

b. Return on equity

$449,200

$452,900 ) ÷

0.5 Times

$71,300 2

(

$452,900

$376,600 ) ÷

2 U

$36,900 $451,050

$50,900 c. Interest coverage ratio

$71,300

= 8.2%

$25,000

$106,300

$25,000

$414,750

= 17.2% $20,000

$20,000 U

$75,900 $25,000

3.0 Times

657 .

$126,300 $20,000

6.3 Times

Chapter 13, P 8. (Continued)

Ratio Name

6. Favorable (F) or Unfavorable (U) Change

2012

2011

$454,100

$396,200

4. Operating asset management analysis

(

a. Inventory turnover

$122,600

$107,800

) ÷ 2

(

$107,800

$99,400

) ÷ 2 Neutral

b. Days' inventory on hand

$454,100

$115,200 365

Days

3.9

Times

3.9 Times

93.6

Days

$396,200

365

Days

3.8

Times

$800,400 (

c. Receivable turnover

$72,500

$103,600

3.8 Times

96.1

Days

$742,600

$42,700

) ÷ 2

(

$42,700

$52,700

) ÷ 2 U

d. Days' sales uncollected

$800,400 $57,600 365 Days 13.9 Times

13.9 Times

26.3 Days

$742,600 $47,700 365 Days 15.6 Times

15.6 Times

23.4 Days

Note: These analyses indicate the apparently favorable or unfavorable change in each ratio. Class discussion may focus on conditions that lead to different conclusions.

658 .

Chapter 13, P 8. (Continued)

Ratio Name

2012 $454,100 (

$104,700

6. Favorable (F) or Unfavorable (U) Change

2011 $14,800

$72,300

$396,200

) ÷ 2

(

$72,300

$8,400 $64,800

) ÷ 2

e. Payables turnover

U =

$468,900

365 Days f.

Days' payable

= 5.3 Times

$88,500

5.3 Times

$31,100

$104,700

5.9 Times

$122,600

$27,200

$50,000

= 5.9 Times

$68,550 365 Days

68.9 Days

$72,500

$404,600

$72,300

61.9 Days

$42,700 +

$107,800 $50,000

g. Current ratio

Neutral =

$226,200 $154,700

= 1.5 Times

$177,700 $122,300

= 1.5 Times

$31,100

$72,500

$27,200

$42,700

$104,700

$50,000

$72,300

$50,000

h. Quick ratio

Neutral =

$103,600 $154,700

= 0.7 Times

659 .

$69,900 $122,300

= 0.6 Times

Chapter 13, P 8. (Continued)

Ratio Name

2012

2011

6. Favorable (F) or Unfavorable (U) Change

5. Market strength analysis $80.00

a. Price/ earnings (P/E) ratio

$1.23

$31,400

65.0 Times

30,000 Shares

$120.00 $2.38

$35,000

$80.00

b. Dividends yield

50.4 Times

30,000 Shares

$120.00 F

$1.05 $80.00

= 1.3%

660 .

$1.17 $120.00

= 1.0%

Chapter 13, C 1. Based on Exhibit 13.1, Goodyear's business segments are North American Tire; Europe, Middle East, and Africa Tire; Latin American Tire; and Asia Pacific Tire. The relative size of each segment in terms of sales and income for 2009 is as follows (amounts in millions): Sales Segment

Income

Amount

Percentage

Amount

Percentage

$ 6,977

42.8%

($305)

-82.0%

Europe, Middle East, and Africa Tire

5,801

35.6%

$166

44.6%

Latin American Tire

1,814

11.1%

$301

80.9%

1,709 $16,301

10.5% 100.0%

$210 $372

56.5% 100.0%

North American Tire

Asia Pacific Tire Totals

The North American Tire segment is the largest segment in terms of sales (42.8 percent), but it had negative income in 2009. In terms of net income, Latin American Tire was most profitable in 2009 (80.9 percent of total net income). Finally, Latin American Tire is also the most profitable because it generated 80.9 percent of net income from only 11.1 percent of net sales. This presumption is confirmed by using return on assets, which is a good measure of profitability performance. The measures for all four segments are as follows: North American Tire

-6.3% [

($305)

÷ $4,836 ]

Europe, Middle East, and Africa Tire

3.2% (

$166

÷ $5,144 )

Latin American Tire

18.0% (

$301

÷ $1,672 )

Asia Pacific Tire

13.6% (

$210

÷ $1,548 )

Overall, the most profitable segment in terms of return on assets is Latin American Tire, followed by Asia Pacific Tire; Europe, Middle East, and Africa Tire; and North American Tire, which is the least profitable of all four segments.

661 .

Chapter 13, C 2. 1. Multistep income statement Dash Corporation Income Statements For the Years Ended December 31, 2012 and 2011 2012

2011

$2,000,000 1,100,000

$2,400,000 1,200,000

$ 900,000 450,000

$1,200,000 300,000

Income taxes expense*

$ 594,000 178,200

$ 900,000 270,000

Income from continuing operations

$ 415,800

$ 630,000

Net sales Cost of goods sold Gross margin Operating expenses Income from operations

$450,000 144,000

Gain on sale of investments Income from continuing operations before taxes

Discontinued operations Income from operations of discontinued segment (net of taxes, $96,000)

$224,000

Gain on disposal of discontinued segment (net of taxes, $84,000)

196,000

420,000 $ 835,800

$ 630,000

$1.04 1.05

$1.58 —

Extraordinary gain (net of taxes)

$2.09 1.49

$1.58 —

Net income

$3.57

$1.58

Net income Earnings per common share:** Income from continuing operations Discontinued operations (net of taxes) Income before extraordinary items

* $358,200 ** Rounded

–

$96,000

–

$84,000

= $178,200

662 .

Chapter 13, C 2. (Continued) 2.

User Insight: Restructuring plan assessed

Dash Corporation's operations have not improved, although the contrary might be inferred from the year's change in net income or earnings per share. It is apparent that in its restructuring, the company sold off profitable operations rather than improving the business. Income from continuing operations in 2012 is only $415,800 compared to $630,000 in 2011. The division that was sold was operating at a profit net of taxes ($224,000 in 2012) and was sold for a gain net of taxes ($196,000). In addition, the 2012 earnings were aided by the gain on sale of investments. In examining continuing operations, gross margin is a smaller percentage of sales in 2012 (45 percent) than in 2011 (50 percent), and operating expenses have actually increased from $300,000 to $450,000 despite the lower sales ($2,000,000 versus $2,400,000). In summary, it is correct to say that the restructuring plan was not a success.

663 .

Chapter 13, C 3. Summary of operations

2010

2009

2008

2007

2006

Sales

121.4%

115.8%

114.4%

104.1%

100.0%

Cost of products sold

120.7%

116.1%

112.3%

101.1%

100.0%

Interest expense

93.5%

107.4%

115.3%

105.4%

100.0%

Provision for income taxes

143.0%

149.8%

148.6%

132.7%

100.0%

Net income (before special items)

210.5%

213.3%

193.8%

178.8%

100.0%

Dividends paid: common

130.7%

128.7%

118.9%

113.0%

100.0%

Total assets

103.5%

99.2%

108.5%

103.0%

100.0%

Total debt

104.6%

116.5%

108.6%

101.3%

100.0%

Shareholders' equity

95.1%

62.4%

92.1%

89.9%

100.0%

Heinz's five-year trend reveals that although there is some variation, cost of products sold and interest expense have grown slower than sales (120.7 percent and 93.5 percent versus 121.4 percent). This trend had a positive impact on net income, which grew substantially to a level of 210.5 percent in 2010, when compared with 2006. The company's financial structure shows a shift from equity financing to debt financing over the five-year period. Total stockholders' equity has declined from 100.0 percent to 95.1 percent, and debt has risen from 100.0 percent to 104.6 percent. In summary, the company has grown its revenues and its bottom line over the fiveyear period. The company has also increased its dividends paid. Overall, return on assets will have increased in 2010 because net income increased more than total assets.

664 .

Chapter 13, C 4.

Receivable turnover

Roche

$50,009

SF 49,051

( $14,645 =

Days' sales uncollected

Pfizer +

$8,958 ) ÷ 2

4.2 Times

365 Days

4.2 Times

( SF 10,461 + 4.9 Times

= 86.9 Days

365 Days

( $12,403 =

Days' inventory on hand

$8,888 $8,392

365 Days 1.1 Times

( =

Days' payable

$4,370

$4,381 ) ÷ 2

( SF 5,648

1.1 Times

= 331.8 Days + +

$16,910 $3,061

365 Days 5.5 Times

365 Days 2.5 Times

$1,751 ) ÷ 2

( SF 2,300

5.5 Times =

66.4 Days

86.9 + 331.8 = 418.7 Days

Days of financing required

418.7 –

SF 14,433 SF 2,159

365 Days 6.7 Times 74.5

SF 5,830 ) ÷ 2

2.5 Times

= 146.0 Days +

-SF 182

SF 2,017 ) ÷ 2

6.7 Times

54.5 Days

146.0

220.5 Days

= 352.3 Days 220.5 –

54.5

166.0 Days

665 .

SF 5,739

SF 14,615

Operating cycle

66.4

SF 14,615

$8,022

74.5 Days

SF 14,615

$8,888 Payables turnover

4.9 Times

$8,888 Inventory turnover

SF 9,755 ) ÷ 2

Chapter 13, C 4. (Continued) The fact that these companies are in the pharmaceutical industry is more important than the fact that they come from different countries. The pharmaceutical industry has relatively long operating cycles. Roche has an operating cycle of 220.5 days versus Pfizer, which has one of 418.7 days. The primary reason is Pfizer has much longer days’ inventory on hand than does Roche. Also, the difference in days of financing required is very big. Roche provides 166.0 days versus 352.3 for Pfizer because of Roche's shorter days' payable. Note that the exchange rate of the SF to the U.S. dollar is irrelevant to this analysis because ratio analysis makes all currencies comparable.

666 .

Chapter 13, C 5. All computations are for the years ended December 31, 2009, and December 31, 2008. Profitability and total asset management ratios and analysis of CVS (in millions) 2009 Profit margin

$3,696 $98,729

2008 $3,212

= 3.7%

$87,472

= 3.7%

$98,729 Asset turnover

( =

Return on assets

$61,641 $98,729 $61,301

$3,696 $61,301

$60,960

= 1.6 Times

$87,472 )÷ 2

( =

$60,960 $87,472 $57,841

$3,212

= 6.0%

$57,841

$54,722

)÷ 2

= 1.5 Times

= 5.6%

CVS's profitability increased slightly from 2008 to 2009. Profit margin was the same both years at 3.7 percent, but this was offset by the increase in asset turnover; return on assets, as a result, increased from 5.6 percent to 6.0 percent.

667 .

Chapter 13, C 5. (Continued) Liquidity ratios and analysis of CVS (in millions) 2009 Cash flow yield

$4,035

Cash flows to sales

$4,035

$3,696

$98,729

2008 $3,947

1.1 Times

$3,212

$3,947

= 4.1%

$87,472

$4,035 Cash flows to assets

( =

Free cash flow

$61,641 $4,035 $61,301

$4,035 – + $23

1.2 Times

= 4.5% $3,947

$60,960 ) ÷ 2

(

$60,960 $3,947

= 6.6%

$439 – $2,548 = $1,071

$3,947 – + $19

$57,841

$54,722

)÷ 2

= 6.8% – $2,180 = $1,403

$383

CVS's liquidity decreased slightly from 2008 to 2009. Its cash flow yield decreased from 1.2 in 2008 to 1.1 in 2009. CVS's cash flow returns on sales and on assets are low and declined from 2008 to 2009. Free cash flow also decreased from 2008 to 2009. CVS will look to improve the trends and levels of cash flow returns.

668 .

Chapter 13, C 5. (Continued) Operating asset management ratios and analysis of CVS (in millions)

Inventory turnover

2008

$78,349

$69,182

( $10,343 $78,349 $9,748

Days' inventory on hand

2009 $9,153 ) ÷ 2

8.0 Times

365 Days 8.0 Times

= 45.6 Days

(

$9,153

$69,182 $8,581

Receivable turnover

( =

Days' sales uncollected

$5,457

8.1 Times

$98,729 $5,421

365 Days 18.2 Times

Payables turnover

( =

Days' payable

$3,560

$3,681

21.6 Times $17,537 $12,300

= 21.6 Times

$16,526

$5,457

$1,352

$12,300

= 19.2 Days

$13,490 +

) ÷ 2

= 19.0 Times

$3,697

19.0 Times

$1,145 $3,593

$70,327

365 Days

1.4 Times

= 20.7 Days +

$3,801

) ÷ 2

= 17.6 Times

$4,982

$69,182 (

$4,580

$87,472

17.6 Times

$1,190

= 16.9 Days

$5,384

365 Days

$3,801 ) ÷ 2

$79,539

$1,086

= 18.2 Times

365 Days

Current ratio

(

= 20.1 Days

$78,349

= 45.1 Days

$87,472

$5,384 ) ÷ 2

) ÷ 2

8.1 Times

365 Days

$98,729

$8,008

1.2 Times $5,384

$13,490

Quick ratio =

$6,548 $12,300

0.5 Times

$6,736 $13,490

0.5 Times

CVS's liquidity shows a few changes. The current ratio increased slightly. Because most sales are on credit card or cash, days' sales uncollected is approximately 20 days. The most important operating ratio, therefore, is receivable turnover, which remained fairly stable (17.6 and 18.2). The same is true of days' inventory on hand, at about 45 days. The payables turnover increased to 21.6 from 19.0, and the days' payable decreased from 19.2 to 16.9 days. 669 .

Chapter 13, C 5. (Continued) Financial risk ratios and analysis of CVS (in millions) 2009 $25,873

Debt to equity ratio

$35,768

2008 $26,386

0.7 Times

$34,574

$3,696 Return on equity

(

$35,768

$3,696 $35,171

= 10.5%

$5,913

Interest coverage ratio

+ $525

$3,212

$34,574 ) ÷ 2

$525

0.8 Times

12.3 Times

(

$34,574

$3,212 $32,948

= 9.7%

$5,537

+ $509

$31,322

$509

)÷ 2

11.9 Times

CVS's debt to equity ratio decreased slightly from 2008 to 2009. On the other hand, its return on equity increased from 9.7 percent in 2008 to 10.5 percent in 2009. Its interest coverage also increased slightly. These ratios are well under control and cause no concern at these levels.

670 .

Chapter 13, C 5. (Continued) Market strength ratios and analysis of CVS 2009 $31.01*

Price/earnings (P/E) ratio

$2.58

Dividends yield * 2009: 2008:

( (

$38.27 $44.29

$0.31 $31.01 + +

12.0 Times

= 1.0%

2008 $33.74* $2.23 $0.26 $33.74

15.1 Times

= 0.8%

$23.74 ) ÷ 2 $23.19 ) ÷ 2

Earning per share increased in 2009 as did the dividend yield. The average market price declined, resulting in a decrease in the price/earnings (P/E) ratio.

671 .

Chapter 13, C 6. CVS and Southwest compared across key financial performance measures CVS

Southwest

2009

2008

2009

2008

Profit margin

3.7%

1.0%

1.6%

Asset turnover Return on

1.6 Times

1.5 Times

0.7 Times

assets

6.0%

5.6%

0.7%

1.2%

1.1 Times $1,071 million

1.2 Times $1,403 million

0.7 Times

0.8 Times

Profitability and total asset management

Liquidity Cash flow yield Free cash flow

9.9 Times not meaningful $387 million ($2,457) million

Financial risk Debt to equity ratio

1.6 Times

1.8 Times

Note: The CVS calculations are shown in C 5. The Southwest calculations are shown on the next worksheet.

672 .

Chapter 13, C 6. (Continued) Profitability and total asset management ratios of Southwest (in millions) 2009 Profit margin

$99 $10,350

2008 $178

= 1.0%

$11,023

= 1.6%

$10,350 Asset turnover

( $14,269 =

Return on assets

$10,350 $14,169 $99

$14,169

$11,023

$14,068 ) ÷ 2

0.7 Times

( $14,068 =

$11,023 $15,420 $178

= 0.7%

$15,420

$16,772 ) ÷ 2

0.7 Times

= 1.2%

Liquidity ratios of Southwest (in millions) Cash flow yield

$985

Free cash flow

$985 $0 +

$99

= – =

9.9 Times

$13 $387

–

$585

($1,521) $178 ($1,521) $0 +

= not meaningful –

$13 – = ($2,457)

$923

Financial risk ratio of Southwest (in millions) Debt to equity ratio

$8,803 $5,466

1.6 Times

$9,115 $4,953

1.8 Times

The analysis of CVS and Southwest shows some of the differences and similarities of the retail industry versus the airline industry. For example, Southwest has a lower profit margin and asset turnover. The result is a lower return on assets for Southwest. Southwest has a much higher cash flow yield but much lower free cash flow in 2009. Southwest has improved its free cash flow since 2008. CVS has a lower debt to equity ratio and thus has less leverage than Southwest. CVS was more stable from 2008 to 2009.

673 .

Chapter 13, C 7. 1.

Common-size income statements, profit margin, and return on equity

Apple a Day*

Unforgettable Edibles*

Net sales

100.0%

Cost of goods sold

36.0%

40.0%

Gross margin

64.0%

60.0%

Operating expenses

45.0%

51.8%

Operating income

19.0%

8.3%

Gain on sale of real estate

0.0%

11.4%

Interest expense

-1.5%

-2.1%

17.5%

Net income (profit margin)

4.2% 13.4%

4.1% 13.4%

Return on equity

26.7%

24.7%

Income before income taxes Income taxes expense

*Additions and subtractions of percentages are inexact due to rounding. 2.

Results discussed

It is true that both firms have comparable profit margins. Both Apple a Day and Unforgettable Edibles earned 13.4 percent profit margins. However, the common-size income statement reveals that Apple a Day has a lower cost structure overall, as exhibited by a lower cost of goods sold percentage, a lower operating expenses percentage, and a lower interest expense percentage. Unforgettable Edibles has a slightly lower income tax percentage, but not enough to offset the higher cost and expense percentages. A one-time gain on the sale of real estate (11.4 percent of net sales) accounts for 65.1 percent of the 17.5 percent income before income taxes percentage reported. Without the gain, income before income taxes would be only 6.1 percent of sales. Return on equity is higher for Apple a Day, 26.7 percent versus 24.7 percent for Unforgettable Edibles. The higher return for Apple a Day is in part due to a smaller average stockholders' equity.

674 .

Chapter 13, C 7. (Continued) Unless the actual profit margin and return on equity are adjusted for one-time special items, the managers at Unforgettable Edibles might have earned a bonus through use of a one-time gain rather than by excellent management of the catering business. The timing of this gain could be questioned on ethical grounds if management timed the sale of real estate to ensure that it would meet its current year targets. A lender will be concerned about future cash flows for payment of interest and principal. Based on the available data, Apple a Day is a better risk from a lender's viewpoint for two reasons. First, its results reflect success at pricing and controlling costs, which should mean better cash flow from operations as long as its accounts receivable and inventory are well managed. Second, the management of Apple a Day did not have a special one-time item that boosted net income, so its net income is of higher quality.

675 .

CHAPTER 14—Solutions INVESTMENTS Chapter 14, SE 1. 2011 Dec. 31 Allowance to Adjust Short-Term Investments to Market Unrealized Gain on Short-Term Investments To record recognition of unrealized gain on trading portfolio $405,000 – $320,000 = $85,000 2012 Mar. 23 Cash Loss on Sale of Investments Short-Term Investments To record sale of 5,000 shares of FedEx at less than cost

85,000 85,000

95,000 5,000 100,000

Chapter 14, SE 2. 2011 Dec. 31 Allowance to Adjust Long-Term Investments to Market Unrealized Gain on Long-Term Unrealized Gain on Long-Term Investments To record increase in investment portfolio to market $640,000 – $570,000 = $70,000

676 .

70,000 70,000

Chapter 14, SE 3. 2012 Dec.

31 Unrealized Loss on Long-Term Investments Allowance to Adjust Long-Term Investments to Market To record decrease in investment portfolio to market $570,000 $490,000 – = $80,000 $80,000 + $70,000 = $150,000

150,000 150,000

Chapter 14, SE 4. 2011 Dec.

31 Investment in Bargain Company Income, Bargain Company Investment To record recognition of 30 percent of income reported by Bargain Company 30% × $60,000 = $18,000

18,000

31 Cash Investment in Bargain Company To report cash dividend received from Bargain Company 30% × $40,000 = $12,000

12,000

Chapter 14, SE 5. 1. 2. 3.

b c a

677 .

18,000

12,000

Chapter 14, SE 6. 2011 Dec.

31 Investment in Storm Company Income, Storm Company Investment To record recognition of 25 percent of income reported by Storm Company 25% $100,000 × = $25,000 31 Cash Investment in Storm Company To record cash dividend received from Storm Company 25% $72,000 × = $18,000

25,000 25,000

18,000 18,000

Chapter 14, SE 7. Goodwill Minority interest Common stock Retained earnings

— — 200,000 400,000

— 20,000 200,000 400,000

Chapter 14, SE 8. Goodwill Minority interest* Common stock Retained earnings * $100,000

–

$80,000

$20,000

Chapter 14, SE 9. Goodwill* Minority interest Common stock Retained earnings * $120,000

$ 20,000 — 200,000 400,000 –

$100,000

$20,000

678 .

Chapter 14, SE 10. P Company

S Company

Elimination Consolidated

Accounts receivable

$ 460,000

$ 300,000

($ 120,000)

Accounts payable

360,000

180,000

(

120,000)

420,000

Sales

2,400,000

1,780,000

(

540,000)

3,640,000

Cost of goods sold

1,420,000

1,080,000

(

540,000)

1,960,000

$ 640,000

Chapter 14, SE 11. May

31 Short-Term Investments Cash To record investment in 120-day U.S. Treasury bills

98,000

June 30 Short-Term Investments Interest Income To record accrual of interest on U.S. Treasury bills $2,000 × 30 / 120 = $500

500

Sept. 28 Cash Short-Term Investments Interest Income To record receipt of cash at maturity of U.S. Treasury bills and recognition of related interest income

679 .

98,000

500

100,000 98,500 1,500

Chapter 14, SE 12. Mar.

31 Short-Term Investments Cash To record investment in 90-day U.S. Treasury bills

Apr.

30 Short-Term Investments Interest Income To record accrual of interest on U.S. Treasury bills $333 $1,000 × 30 / 90 =

June

29 Cash Short-Term Investments Interest Income To record receipt of cash at maturity of U.S. Treasury bills and recognition of related interest income

680 .

129,000 129,000

333 333

130,000 129,333 667

Chapter 14, E 1. 1.

Long-term investments are reported in an investments section of the balance sheet. Short-term investments are reported in the current assets section of the balance sheet. The Allowance to Adjust Short-Term Investments to Market account appears on the balance sheet as a contra-asset account. Interest income, unrealized gains/losses, realized gains/losses earned/incurred on short-term investments appear on the income statement. Unrealized gains/ losses on long-term available-for-sale securities are reported as a special item in the stockholders’ equity section of the balance sheet and in a comprehensive income disclosure. The Allowance to Adjust Long-Term Investments Market account appears on the balance sheet as a contra-asset account.

The total market value of the portfolio of trading securities would have increased enough during the year to exceed the negative (credit) balance at the beginning of the year.

There are no cash flow effects in recording the share of income. However, any dividends are received in cash. Usually, the income is greater than the cash received.

Chapter 14, E 2. 1.

Both minority interest and goodwill would occur in a consolidation if the purchase was for less than 100 percent ownership (resulting in minority interest) and the price was more than book value (resulting in goodwill).

Financial statements of foreign subsidiaries need to be restated because they are in a currency other than the U.S. dollar, and the U.S. dollar must be used when the statements are consolidated with the U.S. parent company’s financial statements.

Held-to-maturity securities, which are always debt securities, are treated differently from any other investment because of the way management uses them. Management intends to hold them to their maturity date and refrain from selling them until that date.

681 .

Chapter 14, E 3. Jan.

6 Short-Term Investments Cash To record purchase of IBM shares as trading securities × $30 = $210,000 7,000

210,000

Feb. 15 Short-Term Investments Cash To record purchase of Quaker Oats shares as trading securities × $22 = $198,000 9,000

198,000

210,000

198,000

June 30 Allowance to Adjust Short-Term Investments to Market Unrealized Gain on Short-Term Investments To record recognition of unrealized gain on trading portfolio Security IBM Quaker Oats

( (

7,000 9,000

shares) shares)

Totals

Cost

Gain/ (Loss)

$210,000 198,000

$280,000 162,000

$70,000 ( 36,000)

$408,000

$442,000

$34,000

This entry is not affected by the adjusting entry on June 30.

682

34,000

Market Value

Aug. 20 Cash Loss on Sale of Investments Short-Term Investments To record sale of 9,000 shares of Quaker Oats at less than cost

34,000

144,000 54,000 198,000

Chapter 14, E 4. T accounts set up and transactions recorded in the accounts Unrealized Loss on Long-Term Investments

Allowance to Adjust Long-Term Investments to Market

Beg. Bal. Dec. 31

40,000 20,000

Beg. Bal. Dec. 31

40,000 20,000

End. Bal.

60,000

End. Bal.

60,000

Cost of portfolio of long-term investments Year-end market value of long-term investments

$485,000 425,000

Current balance of Unrealized Loss account

$ 60,000 40,000

Adjustment

$ 20,000

Unrealized loss

Chapter 14, E 5. The investment in Star Corporation should be accounted for using the costadjusted-to-market method because the investment represents less than 20 percent of the voting stock of Star. Thus, the investment in Star should be carried on the balance sheet at $1,000,000. The investment in Mit Corporation should be accounted for using the equity method because the investment (45 percent) represents a significant influence over the operations of Mit. The carrying value of the investment may be computed as follows: Cost Share of earnings Less share of dividends

( 45% × ( 45% ×

$8,180,000

Balance sheet value

683 .

$1,200,000 ) $800,000 )

$8,000,000 540,000 360,000

Chapter 14, E 6. T accounts set up and transactions recorded in the accounts Cash Dec.

320,000

Jan.

320,000 Bal.*

4,800,000 4,800,000

(4,480,000) Loss, Blue Corporation Investment

Dec.

Bal.

160,000 —

160,000 Investment in Blue Corporation

Jan.

4,800,000

Dec.

320,000

Dec.

160,000

4,800,000 Bal.

480,000

4,320,000

* The balance of Cash is negative because there are no data about the beginning balance and the largest entry has been posted to the credit side of the account. Chapter 14, E 7. 1.

c. Consolidation of parent and subsidiary financial statements Reason: More than 50 percent of voting stock

a. Cost-adjusted-to-market method Reason: Less than 20 percent of voting stock

a. Cost-adjusted-to-market method Reason: Nonvoting stock

c. Consolidation of parent and subsidiary financial statements Reason: More than 50 percent of voting stock

b. Equity method Reason: Between 20 percent and 50 percent of voting stock

c. Consolidation of parent and subsidiary financial statements Reason: More than 50 percent of voting stock

684 .

Chapter 14, E 8. Common Stock, Pool Manufacturing Company Retained Earnings, Pool Manufacturing Company Investment in Subsidiary Company To eliminate intercompany investment

400,000 200,000 600,000

Chapter 14, E 9. Dec.

31 Common Stock, East Corporation Retained Earnings, East Corporation Investment in Subsidiary Company Minority Interest To eliminate intercompany investment 80,000 shares × 80% × $11.20 = $716,800 Minority interest computed as follows: 20% × $896,000 = $179,200

685 .

800,000 96,000 716,800 179,200

Chapter 14, E 10. A and B Companies Work Sheet for Consolidated Balance Sheet September 1, 2011 Balance Sheet,

Balance Sheet,

Accounts

A Company

B Company

Other assets

1,103,000

544,500

480,000 —

— —

Total assets

1,583,000

544,500

1,677,500

Liabilities

435,500

94,500

530,000

Common stock

500,000 647,500

150,000 300,000

1,583,000

544,500

Investment in B Company Goodwill

Retained earnings

Consolidated Balance

Eliminations Debit

Credit

Sheet 1,647,500

* *

480,000

30,000

150,000 300,000

— 30,000

500,000 647,500

Total liabilities and stockholders’ equity * Elimination of intercompany investment

686 .

480,000

1,677,500

Chapter 14, E 11. Lion and Fish Companies Work Sheet for Consolidated Income Statement For the Year Ended December 31, 2011 Income Statement, Lion

Income Statement, Fish

Accounts

Company

Net sales

1,500,000 750,000

600,000 400,000

Gross margin

750,000

200,000

950,000

Less: Selling expenses

250,000

50,000

300,000

tive expenses

300,000

100,000

Total operating expenses

550,000

150,000

640,000

Income from operations

50,000

310,000

Other income

200,000 60,000

Net income

260,000

50,000

Cost of goods sold

Consolidated Income

Eliminations Debit (1)

Credit

280,000 (1)

280,000

Statement 1,820,000 870,000

General and administra-

(2)

(1)

Elimination of intercompany sales and purchases

(2)

Elimination of intercompany lease expense and income

687 .

(2)

60,000

340,000

60,000 340,000

340,000

310,000

Chapter 14, E 12. 2011 Nov.

Dec.

1 Short-Term Investments Cash To record investment in 120-day U.S. Treasury bills

776,000

31 Short-Term Investments Interest Income To record accrual of interest on U.S. Treasury bills

8,000

$24,000 2012 Apr.

180

688

8,000

$8,000

30 Cash Short-Term Investments Interest Income To record receipt of cash at maturity of U.S. Treasury bills and recognition of related interest income

776,000

800,000 784,000 16,000

Chapter 14, P 1. 1.

Investment entries prepared

Shore Service Corporation (a)

Long-Term Investments Cash Purchase of 200,000 shares of Shore Service Corporation; 6.7 percent ownership in Shore indicates cost-adjustedto-market method should be used

(b) Cash Dividend Income Receipt of $0.80 per-share dividend from Shore Service Corporation (c)

3,200,000 3,200,000

160,000 160,000

No entry required

Speed Drilling Company (a)

Investment in Speed Drilling Company Cash Purchase of 4,000,000 shares (20 percent) of Speed Drilling Company; seat on board of directors indicates significant influence and use of equity method

32,000,000

(b) Cash Investment in Speed Drilling Company Receipt of $0.40 per-share dividend from Speed Drilling Company

1,600,000

(c)

3,200,000

Investment in Speed Drilling Company Income, Speed Drilling Company Investment Recognition of 20 percent ($0.80 per share) of Speed Drilling Company's income under the equity method

32,000,000

1,600,000

3,200,000

689 .

Chapter 14, P 1. (Continued) Tom Oil Field Supplies Company (a) Long-Term Investments Cash Purchase of 2,000,000 shares (20 percent) of Tom Oil Field Supplies Company; cost-adjusted-to-market method to be used because failure to place representative on the board of directors indicates that significant influence does not exist

24,000,000

(b) Cash Dividend Income Receipt of $0.80 per-share dividend from Tom Oil Field Supplies Company

1,600,000

24,000,000

1,600,000

Adjusting entry prepared

Unrealized Loss on Long-Term Investments Allowance to Adjust Long-Term Investments to Market To record the adjustment to reduce investments to market Cost

Market

Tom

$ 3,200,000 24,000,000

$ 4,800,000 8,000,000

Totals

$27,200,000

$12,800,000

Shore

Market is lower than cost by $14,400,000.

690 .

14,400,000 14,400,000

Chapter 14, P 1. (Continued) 3. Sale of Tom shares recorded Cash Loss on Sale of Investments Long-Term Investments Sale of 2,000,000 shares in Tom Oil Field Supplies Company for $6 per share; original purchase price was $12 per share

12,000,000 12,000,000 24,000,000

4. Year-end adjustment recorded Allowance to Adjust Long-Term Investments to Market Unrealized Loss on Long-Term Investments Unrealized Gain on Long-Term Investments To record the year-end adjustment to Allowance to Adjust Long-Term Investments to Market because market now exceeds cost by $4,800,000 $14,400,000 + $4,800,000 = $19,200,000

19,200,000 14,400,000 4,800,000

691 .

Chapter 14, P 1. (Continued) 5.

User Insight: Principal factors identified

In determining how to account for Karas Gas' investments, the percentage ownership in the investee corporation and the level of Karas Gas' influence over the investee's operations were analyzed. When the percentage of ownership is low and/or Karas Gas cannot exercise significant influence, the investment would have been accounted for under the cost-adjusted-to-market method. When the percentage ownership is approximately 20 percent or more and significant influence exists, the equity method would have been used. Although Karas Gas owns 20 percent of Speed and 20 percent of Tom, the investments are accounted for differently because the influence of Karas Gas over the two companies differs. Whether the investment is classified as short term or long term depends on management's intent and the circumstances. If the intent is to hold the investment for less than one year, it is classified as a short-term investment. If the intent is to hold the investment for an indefinite time longer than one year, it is a longterm investment. This latter conclusion holds even if a change in circumstances requires the sale of an investment that has been held for less than one year. Also, an investment in which significant influence or control exists is usually classified as a long-term investment.

692 .

Chapter 14, P 2. 1.

T account prepared Investment in Oslo Company*

Beg. Bal.

600,000

1st quarter — Dividend

16,000

1st quarter — Income

32,000

2nd quarter — Dividend

16,000

2nd quarter — Income

24,000

3rd quarter — Dividend

16,000

3rd quarter — Income

64,000

4th quarter — Loss

16,000

4th quarter — Dividend

16,000

720,000 End. Bal.

80,000

640,000

*Each entry represents 40 percent of either earnings or dividends paid. 2.

User Insight: Income statement effects discussed

Basic Company records its share of Oslo's net income as an increase in the income account. Its share of a periodic loss has been recorded as an increase in the loss account. Both the income and loss accounts appear on the income statement. 3.

User Insight: Cash flow effects discussed

Since Basic Company owns 40 percent of Oslo Company, Basic would receive 40 percent of the dividends paid by Oslo or $64,000 (0.40 x $160,000). The dividends received would be shown in the cash flows from operating activities section of the statement of cash flows. Basic's share of earnings would have no cash flow effect but would need to be deducted from net income in the operating activities section to reconcile with cash flows from operating activities. 4.

User Insight: Percentage ownership effects discussed

If Basic Company owned only 10 percent of Oslo Company, Basic would use the cost-adjusted-to-market method of accounting. The dividends received would be shown as cash inflows. However, Basic would not record its share of Oslo's net income. If investments in Oslo are classified as long term, the unrealized gain or loss resulting from the adjustment is reported as a special item in the stockholders' equity section of the balance sheet and in a comprehensive income disclosure.

693 .

Chapter 14, P 3. 1. Worksheet for consolidated balance sheet prepared Sail and Ivan Companies Work Sheet for Consolidated Balance Sheet December 31, 2010 Balance Sheet, Sail

Balance Sheet, Ivan

Accounts

Company

Cash

200,000

60,000

260,000

Accounts receivable

275,000

600,000

875,000

Investment in Ivan Company

700,000

—

Property, plant, and equipment (net)

685,000 —

450,000 —

1,860,000

1,110,000

2,395,000

Accounts payable

475,000

535,000

1,010,000

Common stock, $20 par value

925,000 460,000

500,000 75,000

1,860,000

1,110,000

Goodwill Total assets

Retained earnings

Consolidated Balance

Eliminations Debit

Credit

(1) (1)

50,000

(1)

75,000

(1) (1)

700,000

Sheet

— 1,185,000 75,000

500,000 75,000

______

925,000 460,000

700,000

2,395,000

Total liabilities and stockholders' equity

(1) Elimination of intercompany investment; of the $125,000 excess of cost over book value, $50,000 is attributable to property, plant, and equipment and $75,000 to goodwill. 694 .

Chapter 14, P 3. (Continued) 2. User Insight: Goodwill accounts discussed The goodwill account would indicate that Sail Company paid more than fair value for Ivan Company. On the balance sheet, goodwill appears as an asset. You would expect the amount of this account to change from year to year as a result of the annual impairment review. Goodwill is impaired if the ability of the company to earn higher than the market rate of return on assets (ROA) is impaired. The following factors might cause the goodwill to become impaired: customer dissatisfaction, poor quality of management, manufacturing inefficiency, location disadvantages, or poor employee relations.

695 .

Chapter 14, P 4. 1. Worksheet for consolidated balance sheet prepared Gil and Cat Companies Work Sheet for Consolidated Balance Sheet June 30, 2010 Balance Sheet, Balance Sheet, Eliminations Gil Cat Company Company Debit Credit

Accounts Cash Accounts receivable Inventory Investment in Cat Company Property, plant, and equipment (net) Other assets

160,000 260,000 400,000 296,800

24,000 120,000 260,000 —

600,000 20,000

440,000 80,000

1,736,800

924,000

Accounts payable Long-term debt Common stock, $10 par value Retained earnings Minority interest Total liabilities and

320,000 400,000 800,000 216,800 —

200,000 300,000 400,000 24,000 —

stockholders' equity

1,736,800

924,000

Total assets

(3)

40,000

(1)

296,800

184,000 340,000 660,000 —

80,000

1,040,000 20,000

(2)

2,244,000 (3) (2) (1) (1)

40,000 80,000 400,000 24,000 _______ 544,000

(1)

127,200

480,000 620,000 800,000 216,800 127,200

544,000

2,244,000

(1)

Elimination of intercompany investment; minority interest equals 30 percent of Cat Company $400,000 $24,000 ) $127,200 ] . stockholders' equity [ 30% x ( + =

(2)

Elimination of intercompany long-term debt.

(3)

Elimination of intercompany receivables and payables. 696 .

Consolidated Balance Sheet

Chapter 14, P 4. (Continued) 2. User Insight: Minority Interest account discussed The minority interest account would indicate that Gil owned less than 100 percent of Cat. You would find that account on the balance sheet either between long-term liabilities and stockholders' equity or in the stockholders' equity section.

697 .

Chapter 14, P 5. 1.

T account prepared Investment in Kiev Company*

Beg. Bal.

300,000

1st quarter—Dividend

8,000

1st quarter—Income

16,000

2nd quarter—Dividend

8,000

2nd quarter—Income

12,000

3rd quarter—Dividend

8,000

3rd quarter—Income

32,000

4th quarter—Loss

8,000

4th quarter—Dividend

8,000

360,000 End. Bal.

40,000

320,000

*Each entry represents 40 percent of either earnings or dividends paid. 2.

User Insight: Income statement effects discussed

Bon Company records its share of Kiev’s net income as an increase in the income account. Its share of a periodic loss has been recorded as an increase in the loss account. Both the income and loss accounts appear on the income statement. 3.

User Insight: Cash flow effects discussed

Because Bon Company owns 40 percent of Kiev Company, Bon would receive 40 percent of the dividends paid by Kiev, or $32,000 (0.40 × $80,000). The dividends received would be shown in the cash flows from operating activities section of the statement of cash flows. Bon’s share of earnings would have no cash flow effect but would need to be deducted from net income in the operating activities section to reconcile with cash flows from operating activities. 4.

User Insight: Percentage ownership effects discussed

If Bon Company owned only 10 percent of Kiev Company, Bon would use the cost-adjusted-to-market method of accounting. The dividends received would be shown as cash inflows. However, Bon would not record its share of Kiev’s net income. If investments in Kiev were classified as long term, the unrealized gain or loss resulting from the adjustment would be reported as a special item in the stockholders’ equity section of the balance sheet and in a comprehensive income disclosure. 698 .

Chapter 14, P 6. 1. Worksheet for consolidated balance sheet prepared Cheese and Ham Companies Work Sheet for Consolidated Balance Sheet December 31, 2011 Balance Sheet, Cheese

Balance Sheet, Ham

Accounts

Company

Cash

400,000

120,000

520,000

Accounts receivable

550,000

1,200,000

1,750,000

Investment in Ham Company

1,400,000

—

Property, plant, and equipment (net) Goodwill

1,370,000 —

900,000 —

Total assets

3,720,000

2,220,000

4,790,000

950,000

1,070,000

2,020,000

1,850,000 920,000

1,000,000 150,000

3,720,000

2,220,000

Accounts payable Common stock, $20 par value Retained earnings

Consolidated Balance

Eliminations Debit

Credit

* *

100,000

150,000

* *

1,400,000

Sheet

— 2,370,000 150,000

1,000,000 150,000

1,850,000 920,000

Total liabilities and stockholders’ equity *

1,400,000

Elimination of intercompany investment; of the $250,000 excess of cost over book value, $100,000 is attributable to property, plant, and equipment and $150,000 to goodwill.

699 .

4,790,000

Chapter 14, P 6. (Continued) 2. User Insight: Goodwill accounts discussed The Goodwill account would indicate that Cheese Company paid more than fair value for Ham Company. On the balance sheet, goodwill appears as an asset. You would expect the amount of this account to change from year to year as a result of the annual impairment review. Goodwill is impaired if the ability of the company to earn higher than the market rate of return on assets (ROA) is impaired. The following factors might cause the goodwill to become impaired: customer dissatisfaction, poor quality of management, manufacturing inefficiency, location disadvantages, or poor employee relations.

700 .

Chapter 14, P 7. 1. Journal entries prepared 2011 Jan.

2 Long-Term Investments Cash

184,000 184,000

To record purchase of securities below. Zima, 10,000 shares at $4.00

$ 40,000

Kane, 15,000 shares at $6.00

90,000 54,000

Rodriguez, 6,000 shares at $9.00

$184,000

Total May

5 Long-Term Investments Cash

36,000 36,000

To record purchase of 6,000 shares of Drennan stock at $6.00 July

16 Cash Loss on Sale of Investments

36,000 4,000

Long-Term Investments

40,000

To record sale of 10,000 shares of Zima at $3.60 Sept. 30 Long-Term Investments Cash

32,000 32,000

To record purchase of 5,000 shares of Kane at $6.40 Dec.

31 Unrealized Loss on Long-Term Investments Allowance to Adjust Long-Term Investments

10,000

to Market

10,000

To record reduction of long-term investment portfolio to market $212,000

–

$202,000

$10,000

Company

Market

Total

Cost

Kane

20,000

$6.50

$130,000

$122,000

Rodriguez

6,000

8.00

Drennan

6,000

4.00

48,000 24,000

54,000 36,000

$202,000

$212,000

Totals

701 .

Chapter 14, P 7. (Continued) 2012 Feb.

July

Aug.

1 Cash Dividend Income To record receipt of a cash dividend from Kane of $0.20 per share

4,000

15 Cash Loss on Sale of Investments Long-Term Investments To record sale of 6,000 shares of Rodriguez for $8 per share

48,000 6,000

1 Cash Dividend Income To record receipt of a cash dividend from Kane of $0.20 per share

4,000

Sept. 10 Long-Term Investments Cash To record purchase of 3,000 shares of Parmet for $14 per share Dec.

4,000

54,000

4,000

42,000 42,000

31 Allowance to Adjust Long-Term Investments to Market

9,000

Unrealized Loss on Long-Term Investments

9,000

To record the adjustment of investment portfolio to market Company

Market

Total

Cost

Kane

20,000

$ 6.50

$130,000

$122,000

Drennan

6,000

5.00

Parmet

3,000

13.00

30,000 39,000

36,000 42,000

$199,000

$200,000

Totals

Note: Adjustment equals previous balance of $10,000 from December 31, 2010, entry minus new balance of $1,000 ($200,000 – $199,000), or $9,000.

702 .

Chapter 14, P 7. (Continued) 2.

User Insight: Effect of investment increases discussed

The current method used is cost-adjusted-to-market because all the investments are under 20 percent ownership. If the Kane investment were increased to 25 percent in 2012, the equity method would then be appropriate. If the Parmet investment were increased to 60 percent, the consolidation method would then be appropriate because it is a controlling interest.

703 .

Chapter 14, P 8. 1.

Journal entries prepared

2011 Jan.

Apr.

May

June

16 Short-Term Investments Cash To record investment in 120-day U.S. Treasury bills

146,000

15 Short-Term Investments Cash To record investment in the following trading securities: 10,000 shares of King Tools $400,000 150,000 5,000 shares of Mellon Gas $550,000 Total investment

550,000

16 Cash Short-Term Investments Interest Income To record receipt of maturity value of U.S. Treasury bills

150,000

2 Cash Dividend Income To record receipt of cash dividends as follows: King Tools $20,000 7,500 Mellon Gas

27,500

Total dividends

550,000

146,000 4,000

27,500

$27,500

30 Unrealized Loss on Short-Term Investments Allowance to Adjust Short-Term Investments to Market To record unrealized loss on trading portfolio:

55,000 55,000

Cost

Market Value

Gain/ (Loss)

King Tools (10,000 shares) Mellon Gas (5,000 shares)

$400,000 150,000

$320,000 175,000

($80,000) 25,000

Totals

$550,000

$495,000

($55,000)

Security

704 .

146,000

Chapter 14, P 8. (Continued) 2011 Nov. 14 Cash Short-Term Investments Gain on Sale of Investments To record sale of 10,000 shares of King Tools for $42 per share; cost was $40 per share 2012 Feb. 15 Short-Term Investments Cash To record investment in 9,000 shares of MKD Communications Apr. 1 Short-Term Investments Cash To record investment in 120-day U.S. Treasury bills June 1 Cash Dividend Income To record receipt of cash dividends from Mellon Gas 30 Short-Term Investments Interest Income To record accrual of interest on U.S. Treasury bills $4,500 × 90 / 120 = $3,375 30 Allowance to Adjust Short-Term Investments to Market Unrealized Gain on Short-Term Investments To record unrealized gain on trading portfolio:

400,000 20,000

450,000 450,000

195,500 195,500

11,000 11,000

3,375 3,375

160,000 160,000

Cost

Market Value

Gain/ (Loss)

Mellon Gas (5,000 shares) MKD Communications (9,000 shares)

$150,000 450,000

$165,000 540,000

$ 15,000 90,000

Totals

$600,000

$705,000

$105,000

Security

Credit balance of Allowance to Adjust Short-Term Investments from 2011 Excess of market value over cost in 2012

$ 55,000 105,000 $160,000

Total adjustment

705 .

420,000

Chapter 14, P 8. (Continued) 2.

Balance sheet presentation shown

Short-term investments (at cost)* Plus allowance to adjust short-term investments to market

$798,875 105,000

Short-term investments (at market)

$903,875

or $903,875

Short-term investments (at market, cost* is $798,875)

* Note that short-term investments (at cost) includes the cost of U.S. Treasury bills adjusted for the effects of interest, as follows: Security

Cost

U.S. Treasury bills ($195,500 + $3,375)

$198,875

Mellon Gas (5,000 shares) MKD Communications (9,000 shares)

150,000 450,000

Total

$798,875

User Insight: The statement explained

Held-to-maturity securities are debt securities that management intends to hold to their maturity date and whose cash value is not needed until that date. Trading securities are stock or debt securities bought and held principally for the purpose of being sold in the near term to generate profits on short-term changes in prices. Therefore, held-to-maturity and trading securities represent different types of assets generating different kinds of income. Thus, they require different accounting treatment.

706 .

Chapter 14, C 1. 1. and 2. Items and their value on financial statements identified Statement

Section

Value

Short-term investments

Balance sheet

Current assets

Fair value

Long-term investments

Balance sheet

Investments

Fair value

Investment income

Income statement

Other income

Purchase of investments

Statement of cash flows

Investing activities

Sales of investments

Statement of cash flows

Investing activities

Change in unrealized gains (losses) on long-term investments, net

Statement of stockholders’ equity

Comprehensive income

3. Impairments and unrealized losses discussed Impairments are declines in the fair value of an investment or other asset that is judged to be more than temporary, and they are recorded as losses on the income statement. Unrealized losses are declines in fair value of available-for-sale investments that are judged to be temporary. Unrealized losses are deducted from stockholders’ equity and included in comprehensive income. Chapter 14, C 2. 1.

Goodwill is the amount paid for a subsidiary that exceeds the fair value of the subsidiary’s assets less its liabilities. Minority interest is the amount recorded on a consolidated balance sheet that represents the holdings of owners of less than 50 percent of a subsidiary’s voting stock.

Goodwill is subject to an annual impairment test as to whether there is a decline in fair value that is less than temporary. When such a decline is observed, the goodwill amount on the balance sheet is reduced and a loss is recorded.

707 .

Chapter 14, C 3. CVS has an asset called goodwill. Goodwill arises when a company purchases a controlling interest in another company at a price that exceeds the fair value of the net tangible and intangible assets. In this case, the amount in both 2009 and 2008 exceeds $25 billion, or approximately 40 percent of total assets. Thus, CVS must have paid substantially more than the fair value to make its acquisitions. When a company pays more than the fair value of net tangible and intangible assets, the excess is considered goodwill, a long-term intangible asset. Chapter 14, C 4. Southwest Air has very substantial unrealized gains and losses in its other comprehensive income on the statement of stockholders’ equity. The unrealized gain was $636,000,000 on derivative instruments in 2007; there were an unrealized loss of $2,166,000,000 in 2008 and an unrealized gain of $366,000,000 in 2009. These amounts reflect fluctuations in the fair value of these availablefor-sale investments that have not been sold but are still owned at the end of the year.

708 .

Chapter 14, C 5. 1.

Insider trading is the practice of buying or selling shares of a publicly held company based on information that has not yet been made available to the public. Insiders include the officers and employees of a public company. Insiders can also include any individual, even a person unconnected with a company, who receives a "hot tip." Insider trading is unethical and illegal in the United States.

Insider trading in the United States is unethical and illegal because of a tradition of full disclosure of information about public companies. No persons should benefit at the expense of other persons because they are in possession of information that is not available to the public. Only after information about a public company is released to the stockholders and the general public can insiders buy and sell the company’s stock. Germany, in an effort to attract more investment in its country, has adopted new insider trading laws to protect investors.

This question is not answered in the text but is included to motivate students to think about why practices may develop in another country differently from the way they do in the United States. For example, the principal reason for different views of insider trading existing previously is that fundamentally Germany has had a type of financial market different from that in the United States. Whereas the United States has a long tradition of wide public ownership of stocks in an environment in which public availability of information is important, in Germany and some other countries, companies have traditionally been owned by a limited number of individuals, banks, and financial institutions. There has been little public ownership of stocks in these countries, and as a result, there was not the perceived need for public disclosure of information. This perception is changing in Europe since trading in euro-dominated securities began in January 1999.

This question is meant to elicit a number of responses. More students agree with the approach taken in the United States because of the reason stated in 2 above. As public ownership of stock becomes more common around the world, it is likely that the local laws will gravitate toward more disclosure and less tolerance for insider trading.

709 .

Chapter 14, C 6. 1. Investment transactions recorded Jan.

10 Short-Term Investments Cash To record investment of idle cash in short-term marketable securities

Feb.

10 Cash Dividend Income To record receipt of dividends on stock investments Ford: 5,000 shares × $0.10 = $ 500 McDonald’s: 5,000 IBM: 4,350

shares ×

$0.14

700

shares ×

$0.20

870

May

June

2,070 2,070

10 Cash Interest Income Short-Term Investments To record maturity of three-month Treasury bills at face value including interest income

100,000

10 Cash Dividend Income To record receipt of dividends on stock investments; same amount as above

2,070

1 Cash Short-Term Investments Gain on Sale of Investments To record sale of 1,000 shares of McDonald’s at $28 = $28,000 1,000 shares × $28 = ( 25,000) 1,000 shares × $25

28,000

$ 3,000

Gain

710 .

577,300

$2,070

Total Apr.

577,300

2,200 97,800

2,070

25,000 3,000

Chapter 14, C 6. (Continued) June

Aug.

30 Unrealized Loss on Short-Term Investments Allowance to Adjust Short-Term Investments to Market To adjust for decline in market value of stock investments Cost

Market

Ford (5,000 shares)

$ 50,000

$ 55,000

$ 5,000

McDonald’s (4,000 shares) IBM (4,350 shares)

100,000 304,500

92,000 282,750

( 8,000) ( 21,750)

Total

$454,500

$429,750

($24,750)

10 Cash Dividend Income To record receipt of dividends on stock investments Ford: 5,000 shares × $0.10 = $ 500 McDonald’s: 4,000 shares × $0.14 = 560 IBM: 870 4,350 shares × $0.20 =

1,930 1,930

$1,930

1 Cash Short-Term Investments Gain on Sale of Investments To record sale of short-term investments:

481,000 454,500 26,500

Cost

Selling Price

Gain/ (Loss)

Ford (5,000 shares)

$ 50,000

$ 45,000

($ 5,000)

McDonald’s (4,000 shares) IBM (4,350 shares)

100,000 304,500

88,000 348,000

( 12,000) 43,500

Total

$454,500

$481,000

$26,500

711 .

24,750

Gain/ (Loss)

Total Nov.

24,750

Chapter 14, C 6. (Continued) 2. Balance sheet presentation on June 30 shown Short-term investments (at market, cost is $454,500)

$429,750

3. Allowance account discussed The balance of Allowance to Adjust Short-Term Investments to Market is not affected by the sale of securities on November 1. It remains the same as it was at the end of the preceding fiscal year—that is, a $24,750 credit balance. It will stay at this balance until next June 30, when it will be adjusted as necessary depending on the relationship of cost to market value of short-term investments at that time. 4. Strategy assessed The strategy used by Malam Christmas Tree Company is acceptable, but there is risk involved in buying common stocks. These companies do not pay as high a dividend as could be earned from government Treasury bills, which carry no risk. The company needs to assess its objectives before investing the idle cash. Does it want to preserve cash while earning a moderate return, or does it want to assume significantly higher risk on the chance of earning a higher return?

712 .

APPENDIX A—Solutions ACCOUNTING FOR UNINCORPORATED BUSINESSES

Appendix A, SE 1. Jan.

1 Cash Office Equipment Bob, Capital Kim, Capital To record formation of partnership

12,000 8,000 12,000 8,000

Appendix A, SE 2. Computation of capital ratios: Bob Kim

$12,000 8,000

12 ÷

= 60%

8 ÷

= 40%

$20,000 Division of income: Bob

$5,000

0.60

= $3,000

Kim

$5,000

0.40

= $2,000

Appendix A, SE 3. Income of Partner Bob

Kim

Total income for distribution

Income Distributed $5,000

Distribution of interest Bob

(

$12,000

0.10

)

Kim

(

$ 8,000

0.10

)

$1,200 $ 800

Remaining income after interest

( 2,000) $3,000

Equal distribution of remaining income Bob

1,500

Kim

1,500

( 3,000) —

$2,300

$5,000

Remaining income $2,700

Income of partners

713 .

Appendix A, SE 4. Income of Partner Bob

Kim

Total income for distribution

Income Distributed $5,000

Distribution of interest Bob

(

$12,000

0.10

)

Kim

(

$ 8,000

0.10

)

$1,200 $ 800

( 2,000)

Remaining income after interest Distribution of salary Bob

$3,000 ( 6,000)

6,000

Negative balance after interest and salary

($3,000)

Equal distribution of negative balance ( 1,500)

Bob

( 1,500)

Kim

—

Remaining income $5,700

Income of partners

($ 700)

$5,000

Appendix A, SE 5. The Capital account balances would remain the same at $15,000 for Bob and $10,000 for Sonia because Sonia is buying Kim's interest directly from Kim and not from the partnership. Dec.

31 Kim, Capital Sonia, Capital To transfer Kim's Capital account balance to Sonia

714 .

10,000 10,000

Appendix A, SE 6. Partners’ equity in the original partnership Cash investment by Sonia

$25,000 11,000

Partners’ equity in the new partnership

$36,000

Sonia’s equity

$36,000

$ 6,000

Bonus to original partners Investment by Sonia

$11,000 6,000

Less equity assigned to Sonia

$ 5,000

Distribution of bonus to original partners Bob

(

$5,000

2 )

$ 2,500

Kim

(

$5,000

2 )

2,500

$ 5,000

New Capital account balances: Bob

$15,000

$2,500

$17,500

Kim

$10,000

$2,500

$12,500

Sonia

$ 6,000

Dec.

31 Cash Bob, Capital Kim, Capital Sonia, Capital Investment by Sonia for one-sixth interest in partnership, bonus distributed to Bob and Kim

715 .

11,000 2,500 2,500 6,000

Appendix A, SE 7. Partners’ equity in the original partnership Cash investment by Sonia

$25,000 5,000

Partners’ equity in the new partnership

$30,000

Sonia’s equity

$30,000

$ 7,500

Bonus to new partner Equity assigned to Sonia

$7,500

Less investment by Sonia

5,000

$ 2,500

Distribution of bonus from original partners Bob

(

$2,500

× 1

2 )

$1,250

Kim

(

$2,500

× 1

2 )

1,250

$ 2,500

New Capital account balances: Bob

$15,000

–

$1,250

$13,750

Kim

$10,000

–

$1,250

$ 8,750

Sonia

$ 7,500

Dec.

31 Cash Bob, Capital Kim, Capital Sonia, Capital Investment by Sonia for one-fourth interest in partnership, bonus from Bob and Kim

716 .

5,000 1,250 1,250 7,500

Appendix A, P 1. 1.

Entry prepared

Cash Building Equipment Ed Rivers, Capital Bob Bascomb, Capital Initial investments of Ed Rivers and Bob Bascomb 2.

Share of income for each partner determined

Income shared equally

240,000 220,000 140,000 240,000 360,000

2011

2012

Rivers (

$84,000

× 0.50 )

(

$40,000

× 0.50 )

$42,000 $20,000

Bascomb (

$84,000

× 0.50 )

(

$40,000

× 0.50 )

42,000 20,000 $84,000

Totals

$40,000

Because the partners failed to agree on an income-sharing arrangement, income must be shared equally. This answer is identical to a .

Income shared on the basis of the partners' original investments 2011

2012

Rivers (

$84,000

240 / 600

)

(

$40,000

240 / 600

)

$33,600 $16,000

Bascomb (

$84,000

360 / 600

)

(

$40,000

360 / 600

)

24,000 $84,000

Totals

717 .

50,400 $40,000

Appendix A, P 1. (Continued) d.

Interest on investments; remainder shared equally Income of Partner 2011 computation:

Rivers

Bascomb

Total Income for Distribution

Income Distributed $84,000

Distribution of Interest Rivers (

$240,000

× 0.10 )

$24,000

Bascomb (

$360,000 × 0.10 ) Remaining Income after Interest

$36,000

( 60,000) $24,000

Equal Distribution of Remaining Income Rivers (

$24,000

× 0.50 )

Bascomb (

$24,000

× 0.50 )

12,000 12,000

( 24,000) —

Remaining Income $36,000

Income of Partners

2012 computation:

$48,000

$84,000

Income of Partner

Income

Rivers

Bascomb

Total Income for Distribution

Distributed $40,000

Distribution of Interest Rivers (

$240,000

× 0.10 )

$24,000

Bascomb (

$360,000 × 0.10 ) Negative Balance after Interest

$36,000

( 60,000) ($20,000)

Equal Distribution of Negative Balance Rivers (

$20,000

× 0.50 )

Bascomb (

$20,000

× 0.50 )

( 10,000) ( 10,000)

—

Remaining Income $14,000

Income of Partners

718 .

20,000

$26,000

$40,000

Appendix A, P 1. (Continued) e.

Salaries allowed; remainder shared equally Income of Partner 2011 computation:

Rivers

Bascomb

Total Income for Distribution

Income Distributed $84,000

Distribution of Salaries Rivers

$40,000

Bascomb

$28,000

Remaining Income after Salaries

( 68,000) $16,000

Equal Distribution of Remaining Income Rivers (

$16,000

× 0.50 )

Bascomb (

$16,000

× 0.50 )

8,000 8,000

( 16,000) —

Remaining Income $48,000

Income of Partners

2012 computation:

$36,000

$84,000

Income of Partner

Income

Rivers

Bascomb

Total Income for Distribution

Distributed $40,000

Distribution of Salaries Rivers

$40,000

Bascomb

$28,000

Negative Balance after Salaries

( 68,000) ($28,000)

Equal Distribution of Negative Balance Rivers (

$28,000

× 0.50 )

Bascomb (

$28,000

× 0.50 )

( 14,000) ( 14,000)

—

Remaining Income $26,000

Income of Partners

719 .

28,000

$14,000

$40,000

Appendix A, P 1. (Continued) f.

Interest and salaries allowed; remainder shared equally Income of Partner

2011 computation:

Rivers

Bascomb

Total Income for Distribution

Income Distributed $84,000

Distribution of Salaries Rivers

$40,000

Bascomb

$28,000

Remaining Income after Salaries

( 68,000) $16,000

Distribution of Interest Rivers (

$240,000

× 0.09 )

21,600

Bascomb (

$360,000 × 0.09 ) Negative Balance after Salaries and

32,400

Interest

( 54,000) ($38,000)

Equal Distribution of Negative Balance Rivers (

$38,000

× 0.50 )

Bascomb (

$38,000

× 0.50 )

( 19,000) ( 19,000)

38,000 —

Remaining Income $42,600

Income of Partners

2012 computation:

$41,400

$84,000

Income of Partner

Income

Rivers

Bascomb

Total Income for Distribution

Distributed $40,000

Distribution of Salaries Rivers

$40,000

Bascomb

$28,000

Negative Balance after Salaries

( 68,000) ($28,000)

Distribution of Interest Rivers (

$240,000

× 0.09 )

21,600

Bascomb (

$360,000 × 0.09 ) Negative Balance after Salaries

32,400

and Interest

( 54,000) ($82,000)

Equal Distribution of Negative Balance Rivers (

$82,000

× 0.50 )

Bascomb (

$82,000

× 0.50 )

( 41,000) ( 41,000)

—

Remaining Income $20,600

Income of Partners 720 .

82,000

$19,400

$40,000

Appendix A, P 2. a.

July 31 Margaret, Capital Vonice, Capital Sale of 20 percent of Margaret's capital interest in the partnership to Vonice $45,000 × 0.20 = $9,000

9,000

July 31 Cash Vonice, Capital Admission of Vonice to the partnership

20,000

July 31 Cash Vonice, Capital Margaret, Capital Tracy, Capital Lou, Capital Sale of a 20 percent interest in the partnership to Vonice, bonus distributed to the original partners partners

30,000

9,000

20,000

24,000 3,000 1,000 2,000

Computation: Original partners' capital Vonice's investment

$ 90,000 30,000

Capital of new partnership

$120,000

Vonice's investment

$ 30,000

Vonice's interest ( $120,000

24,000

)

0.20

Bonus to the original partners *Distribution of bonus to original partners: Margaret ( $6,000

× 45

90 )

$3,000

Tracy ( $6,000

× 15

90 )

Lou ( $6,000

× 30

90 )

1,000 2,000 $6,000

Total bonus

721 .

6,000 *

Appendix A, P 2. (Continued) Partners' capital ratios: Partner

Capital Balance

Margaret

$45,000

Tracy

15,000 30,000

Lou

Ratios

$90,000 d.

July

31 Cash Margaret, Capital Tracy, Capital Lou, Capital Vonice, Capital Sale of a 40 percent interest in the partnership to Vonice, bonus charged to the original partners

30,000 9,000 3,000 6,000 48,000

Computation: Original partners' capital Vonice's investment

$ 90,000 30,000

Capital of new partnership

$120,000

Vonice's interest ( $120,000

0.40

)

Vonice's investment

$ 48,000 30,000

Bonus to Vonice

$ 18,000

*Distribution of bonus from original partners: Margaret (

$18,000

× 45 / 90 )

$ 9,000

Tracy (

$18,000

× 15 / 90 )

Lou (

$18,000

× 30 / 90 )

3,000 6,000

Total bonus

$18,000

Partners' capital ratios: See answer to c .

722 .

Appendix A, P 2. (Continued) e.

July

31 Margaret, Capital Tracy, Capital Lou, Capital Cash Withdrawal of Margaret from the partnership*

45,000 2,500 5,000 52,500

* Distribution of excess cash over Margaret's capital balance between the remaining partners: Tracy (

$7,500

× 15 / 45 )

Lou (

$7,500

× 30 / 45 ) Total

July

$7,500

31 Margaret, Capital Vonice, Capital Sale of Margaret's partnership interest to Vonice

723 .

$2,500 5,000

45,000 45,000

INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS): AN OVERVIEW—Solutions Discussion Questions 1. Convergence is a process through which the IASB works with the U.S. Financial Accounting Standards Board (FASB) and other national bodies to achieve identical or nearly identical standards worldwide. Adoption would mean that the Securities and Exchange Commission (SEC) mandates the use of IFRS by public companies in the United States. For adoption to take place, the SEC must act. 2. Currently, IFRS are now acceptable under the AICPA Code of Professional Conduct for use by non-public companies in the United States. In addition, the SEC allows foreign companies that list on U.S. stock exchanges to report using their IFRS-based statements. 3. The main reasons put forth against the adoption of IFRS are that the IASB is concerned principally with public companies and depends on large accounting firms, IFRS are subjective (rely too much on judgment) and will not promote comparability, and the IASB is subject to pressure from the European Commission. 4. The main reason to support use of IFRS is that they would promote comparability around the world. IFRS are also cost-effective, especially for global U.S. companies. Further, they would create value by lowering financial reporting and transparency risks. 5. The proposal is for all financial statements to follow roughly the current organization of the statement of cash flows. All statements will be divided into five categories as follows: 

Business: Includes line items related to operating and investing activities



Financing: Includes line items related to financing activities



Income taxes



Discontinued operations



Equity

The resulting statements, especially the statement of comprehensive income and the statement of financial position, will differ substantially from current U.S. GAAP and IFRS financial statements. 6. Both U.S. GAAP and IFRS recognize accrual accounting as the key concept underlying income measurement. However, the FASB and IASB implement this concept very differently. There are important exceptions under both systems, but generally: 

U.S. GAAP emphasizes the matching rule and measurement of items on the income statement.



IFRS emphasize measurement of assets and liabilities on the balance sheet at fair value.

7. Under U.S. GAAP, assets can reflect a variety of values based on both entry and exit prices: fair value, purchase cost, amortized cost, replacement cost, and depreciated cost. In contrast, IFRS uses fair value as a single concept based on exit value. Specifically, fair value is the amount an asset may be exchanged for, or a liability settled, between knowledgeable parties in an arm’s-length transaction. Fair value is not always easy to determine and may have to be estimated because a ready market for the asset may not exist. 8. Fair values are compatible with the conceptual framework for the following reasons: 

They are relevant because they reflect conditions relating to economic resources and obligations under which financial statement users will make decisions.



They can be faithful representations of assets and liabilities because they reflect risk and probability-weighted assessments of expected future cash flows.



They are timely because they reflect changes in economic conditions.



They are comparable because fair value depends only on the characteristics of the asset or liability being measured, not on what the characteristics are of the entity holding the asset or liability or when it was acquired.



They enhance consistency, a dimension of comparability, because they reflect the same type of information every period. 2

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