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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

ACCOUNTING AND THE FINANCIAL STATEMENTS

DISCUSSION QUESTIONS 1.

Accounting is an information system that identifies, measures, records, and communicates financial information about a company's business activities to permit informed decisions by users of the information. Accounting is often referred to as the language of business because it communicates relevant and reliable information about economic activities of a company that helps people make better decisions.

Accounting information is demanded (or needed) by decision-makers both inside and outside the business to provide information about business activities and finances so that informed decisions can be made. Six groups that create the demand for accounting information and their uses of accounting information are described next: (1)

(2) (3) (4)

(5) (6)

Managers use accounting information to help decide which actions to take, predict the consequences of their actions, and evaluate the effectiveness of their past decisions. They also use accounting information to control the operations of the company. Investors (owners) need accounting information about a business to evaluate the future prospects of a business and to decide where to invest their money. Creditors (lenders) need accounting information to decide whether or not to lend money (extend credit) to a business. Governments need accounting information about businesses to determine taxes owed by businesses, to implement a variety of regulatory objectives, and to make national economic policy decisions. Labor unions use accounting information when negotiating wage increases for its members. Financial analysts use accounting information when offering buy or sell recommendations to clients.

An accounting entity is a business that has an identity separate from that of its owners and managers and for which accounting records are kept. There are three main forms that accounting entities take: a sole proprietorship, a partnership, and a corporation.

A sole proprietorship is a business entity owned by one person. A partnership is a business entity owned jointly by two or more individuals. The owner of a sole proprietorship and the partners in a partnership are responsible for the debts of the business. A corporation is a separate legal entity formed by one or more persons called stockholder(s). A corporation is legally separate from the affairs of its owners, which limits the stockholders’ legal responsibility for the debt of the business to the amount that the stockholders invested in the business. Corporate shareholders

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

generally pay more taxes than owners of sole proprietorships or partnerships. Although the combined number of sole proprietorships and partnerships largely outnumbers the number of corporations, the majority of business in the United States is conducted by corporations. 5.

The three main types of business activities are financing activities, investing activities, and operating activities. Financing activities involve obtaining the funds necessary to begin and operate a business. These funds come from either issuing stock or borrowing money. Investing activities involve buying and selling assets that enable a corporation to operate. Operating activities are the normal business activities that a company engages in as it conducts its business. These activities involve selling products or services, purchasing inventory, collecting amounts due from customers, and paying suppliers.

Assets are the economic resources (or future economic benefits) obtained or controlled by a business. Liabilities are the creditors’ claims on the resources of a business. Stockholders’ equity is the ownership claim on the resources of a business. Stockholders’ equity is considered a residual interest in the assets of a business that remain after deducting the business’s liabilities.

Revenues are the increases in assets that result from the sale of products or services. Expenses are the costs of assets used, or the liabilities created, in the operation of the business. If revenues are greater than expenses, a business has earned net income. If expenses are greater than revenues, a business has incurred a net loss.

The four primary financial statements are as follows: (1)

(2) (3)

(4)

Balance sheet: A presentation of information about a company’s economic resources (assets) and the claims against those resources by creditors and owners (liabilities and stockholders’ equity) at a specific point in time. Income statement: A report on how well a company has performed over a period of time. Retained earnings statement: A report on how much of the company’s income was retained in the business and how much was distributed to owners over a period of time. Statement of cash flows: A report on the changes in a company’s cash during a period of time. The statement of cash flows provides information about the company’s sources (inflows) and uses (outflows) of cash.

There are many questions that can be answered based on each of the financial statements: (1)

Balance sheet: a. What is the total amount of assets (economic resources) of a corporation? What is the total amount of liabilities (claims against the resources) for a corporation? b. How much equity do the owners of the corporation have in its assets? c. Is the corporation able to pay its debts as they become due?

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

(2)

(3)

(4)

Income statement: a. How much revenue was earned last month? Last quarter? Last year? b. What was the total amount of expenses incurred to earn that revenue? c. How much better-off is the corporation at the end of the year than it was at the beginning of the year? d. Was the corporation profitable, and what are the prospects for the corporation’s future profitability? e. What are the prospects for the future growth of the corporation? Retained earnings statement: a. How much income was distributed in dividends by the corporation? b. What amount of equity in the business has been generated internally? Statement of cash flows: a. How much cash was taken in or paid out as a result of operations? b. How much cash was invested in new equipment? c. How much cash was used to pay off business debt?

10. Point-in-time measurement means as of a particular date. The balance sheet is a point-in-time measurement. The period-of-time description applies to what has happened over a time interval. The income statement is a period-of-time measurement that explains the business activities between balance sheet dates. The statement of cash flows and the statement of retained earnings are also period-oftime measurements. 11. The fundamental accounting equation is: Assets = Liabilities + Stockholders’ Equity The equation is significant because it means that the balance sheet must always balance. This implies that what a company owns (its resources) must always be equal to the claims of its creditors (liabilities) and investors (stockholders’ equity). 12. Each financial statement includes a heading that is comprised of (a) the name of the company, (b) the title of the financial statement, and (c) the time period covered— either a point-in-time measurement (an exact date) or a period-of-time description (e.g., a year ended in a specific date). 13. Current assets are cash and other assets that are reasonably expected to be converted to cash within 1 year or the operating cycle, whichever is longer. Current liabilities are obligations that will be satisfied within 1 year or the operating cycle, whichever is longer. Since current assets are presented separately from other assets, statement users can see if the firm is likely to have enough resources available to meet its current liabilities as they become due. If current assets were presented among other assets, such a determination would be difficult. Current liabilities are separated from long-term liabilities because current liabilities will require asset outflows (or replacement with another liability) much

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

sooner than will long-term liabilities. If all liabilities were presented together, financial statement users would have difficulty determining the assets (economic resources) required in the near future to satisfy the current liabilities. 14. Current assets are generally listed on the balance sheet in order of liquidity or nearness to cash, whereas current liabilities are usually listed in the order in which they will be paid. 15. The two main components of equity are contributed capital and retained earnings. Contributed capital is increased by investments of new capital in a company by its owners (the issue of common stock to stockholders). Retained earnings is the accumulated net income of a company that has not been distributed to owners. Retained earnings is increased by net income and decreased by net losses and dividends. 16. Net Income = Total Revenues − Total Expenses 17. The single-step income statement format takes into account only two categories: total revenues and total expenses. Total expenses are subtracted from total revenues in a single step to arrive at net income. The multiple-step income statement organizes revenues and expenses into multiple categories. The resulting subtotals (gross margin [gross profit], income from operations, and net income) highlight important relationships between revenues and expenses that financial statement users find useful. 18. A retained earnings statement summarizes and explains the changes in retained earnings during an accounting period. Retained earnings is the income earned by the company but not paid to the owners in the form of dividends. The retained earnings statement starts with the balance in retained earnings at the beginning of the period. To this balance, add net income (or subtract the net loss) obtained from the income statement. Next, subtract any dividends the company declared during the period. The total is the retained earnings at the end of the period that is reported on the balance sheet. 19. The statement of cash flows classifies cash flows into three categories: (1) cash flows from operating activities, (2) cash flows from investing activities, and (3) cash flows from financing activities. Cash flows from operating activities are the cash flows related to the normal operations of the business in earning income, and these include cash sales and collections of accounts receivable minus cash paid for goods, services, wages, salaries, and interest. Cash flows from investing activities are cash flows related to the acquisition or sale of investments and long-term assets, including cash received from the sales of property, plant, and equipment; investments; and other long-lived assets minus the cash spent to purchase long-term assets. The cash flows from investing activities by a healthy, growing business will often reflect an excess of expenditures over receipts. Cash flows from financing activities are the

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

cash flows related to obtaining the capital of the company, including the cash contributed by owners and borrowed from creditors minus amounts paid as dividends and repayments of liabilities. 20. The retained earnings statement describes the changes in retained earnings, a balance sheet account, that occurs between two balance sheet dates. One of the major sources of change in retained earnings is the net income (or net loss) for the year, which is determined on the income statement. The other major source of change in retained earnings is dividends, which are not considered a part of income. 21. Examples of unethical behavior will differ from one student to another. One example is an accountant who gives in to personal pressure to prepare financial statements that overstate the income of the company by bending or violating generally accepted accounting principles. Overstated income may lead decision-makers to make the wrong choices. Decision-makers inside and outside the business must be able to rely on the financial information they receive to make proper decisions. Therefore, ethical behavior by accountants is necessary. Acting ethically is not always easy. However, because of the important role of accounting in society, accountants are expected to maintain the highest level of ethical behavior.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

MULTIPLE-CHOICE QUESTIONS 1-1.

1-2.

1-3.

1-4.

1-5.

1-6.

1-7.

($7,500 + $3,900 + $3,100)

1-8.

($6,000 + $11,500)

1-9.

1-10. b

($12,900 − $6,300)

($182,300 − $108,800 − $48,600 − $12,000)

1-11. c 1-12. c

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

BRIEF EXERCISES BE 1-13 a. b. c. d. e.

Government Manager Creditor Investor Financial Analyst

BE 1-14 a. b. c. d. e. f. g.

Corporation Sole proprietorship, Partnership Partnership Corporation Corporation Sole proprietorship Corporation

BE 1-15 a. b. c. d. e. f. g.

Financing Operating Investing Financing Operating Operating Financing

BE 1-16 Note: Be sure to treat situations b. through d. independently. 1.

Assets = Liabilities $425,000 = $260,000 X = $165,000 Assets = Liabilities $498,000* = $292,000** X = $206,000 * $425,000 + $73,000 = $498,000 ** $260,000 + $32,000 = $292,000 Assets = Liabilities $373,000* = X X = $173,000

+ Equity + X + Equity + X

+ Equity + $200,000**

* $425,000 − $52,000 = $373,000 ** $165,000 (from part 1) + $35,000 = $200,000

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

BE 1-16 (Continued) 4.

Assets = Liabilities X = $345,000* X = $437,000

+ Equity + $92,000**

* $260,000 + $85,000 = $345,000 ** $165,000 (from part 1) − $73,000 = $92,000

BE 1-17 Scenario 1:

Assets = Liabilities X = $42,000 (a) = $98,000

Scenario 2:

$115,000 = X (b) = $38,000

Scenario 3:

$54,000 = $18,500 (c) = $35,500

+ Equity + $56,000 + $77,000 + X

BE 1-18 1. b 2. c 3. a 4. d 5. a 6. f 7. d 8. a 9. a 10. e 11. g 12. a

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

BE 1-19 Cavernous Homes Inc. Balance Sheet December 31 Assets Cash. ........................................................................................... Accounts receivable ..................................................................... Supplies ....................................................................................... Total assets..................................................................................

$3,200 4,500 8,100 $15,800

Liabilities and Stockholders’ Equity Liabilities: Notes payable ........................................................................ Total liabilities ................................................................. Stockholders’ equity: Common stock ........................................................................ Retained earnings .................................................................. Total stockholders’ equity ................................................ Total liabilities and stockholders’ equity .......................................

$5,000 $5,000 $7,000 3,800 10,800 $15,800

BE 1-20 Rutherford Company Income Statement For the year ending December 31 Revenues and gains: Sales revenue ........................................................................ Interest income...................................................................... Total revenues ................................................................ Expenses and losses: Cost of goods sold .................................................................. Salaries expense .............................................................. Insurance expense ................................................................. Loss on disposal of property, plant, and equipment ................ Income taxes expense ............................................................ Total expenses and losses ............................................... Net income .................................................................................

$65,000 3,900 $68,900 $28,800 22,500 4,300 1,200 2,400

(59,200) $9,700

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

BE 1-21 Rutherford Company Income Statement For the year ending December 31 Sales revenue ........................................................................ Cost of goods sold .................................................................. Gross margin ......................................................................... Operating expenses Salaries expense .................................................................... Insurance expense ................................................................. Total operating expenses ................................................. Income from Operations ........................................................ Other income and expenses: Interest income...................................................................... Loss on disposal of property, plant, and equipment ................ Total other income and expenses ..................................... Income before income taxes ........................................................ Income taxes expense .................................................................. Net income ..................................................................................

$65,000 (28,800) $36,200 $22,500 4,300 (26,800) $9,400 $ 3,900 (1,200) 2,700 $ 12,100 (2,400) $ 9,700

BE 1-22 a. b. c. d. e. f.

Increases retained earnings (I) Decreases retained earnings (D) Increases retained earnings (I) No effect on retained earnings (NE) Decreases retained earnings (D) Decreases retained earnings (D)

BE 1-23 Beginning retained earnings ......................................................... + Net income ($82,000 − $55,000) ............................................. − Dividends .............................................................................. = Ending retained earnings ........................................................

$35,000 27,000 (8,000) $54,000

BE 1-24 a. b. c. d. e.

Operating activities (O) Financing activities (F) Financing activities (F) Operating activities (O) Investing activities (I)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

BE 1-25 (a) $55,000 ($30,000 + $25,000 = a) (b) $64,000 (b + $30,000 = $94,000) (c) $20,000 ($50,000 + c = $70,000)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

EXERCISES E 1-26 1. 2. 3. 4. 5. 6.

Bank (B) Government (G) Business managers (M) Investor (I) Labor union (U) Financial analyst (FA)

E 1-27 1.

Sole proprietorship: 1, 2, 4, 5 Partnership: 2, 3, 4, 5, 7 Corporation: 2, 3, 4, 5, 6, 8 There are many advantages and disadvantages to each particular type of business entity as listed below. a. Sole Proprietorship • Advantages (i) The business is easily formed. (ii) Control over the operations of the business is maintained by the owner. (iii) Sole proprietorships pay less taxes relative to corporations. • Disadvantages (i) The owner is personally liable for the debt of the business. (ii) The life of the business is limited to the owner’s life. b. Partnership • Advantages (i) Have increased access to the financial resources and individual skills of each of the partners. (ii) Partnerships pay less taxes relative to corporations. • Disadvantages (i) Control over the operations of the business is shared among the partners. (ii) The partners are personally liable for the debt of the business. c. Corporation • Advantages (i) Can more easily raise large amounts of money. (ii) Ownership of the business can be easily transferred by selling stock. (iii) The owners’ liability is limited to the amount invested in the business. • Disadvantages (i) The formation and organization of the business are more complex. (ii) Corporations generally pay higher taxes.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-28 a. b. c. d. e. f. g.

Investing (I) Financing (F) Operating (O) Investing (I) Operating (O) Financing (F) Financing (F)

E 1-29 a. b. c. d. e. f. g. h. i. j.

Financing (F) Investing (I) Investing (I) Operating (O) Operating (O) Financing (F) Operating (O) Operating (O) Investing (I) Financing (F)

E 1-30 1. 2. 3. 4. 5. 6. 7.

c e b g d f a

E 1-31 1. 2. 3.

Assets $116,200 212,600 (c) 70,800***

Liabilities (a) $60,800* 145,900 22,500

Equity $55,400 (b) 66,700** 48,300

* $116,200 − $55,400 = $60,800 ** $212,600 − $145,900 = $66,700 *** $22,500 + $48,300 = $70,800

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-32 1. Higgins Company Balance Sheet Specific point in time Assets Current assets: Cash Accounts receivable Inventory Prepaid insurance Total current assets Property, plant, and equipment: Building Equipment Less: Accumulated depreciation Total property, plant, and equipment Intangible assets: Trademarks Total assets Liabilities and Stockholders’ Equity Liabilities: Current liabilities: Accounts payable Income taxes payable Wages payable Total current liabilities Long-term liabilities: Notes payable Bonds payable Total long-term liabilities Total liabilities Stockholders’ equity: Common stock Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity 2.

To assess liquidity, it would be helpful to have information on the Higgins Company’s current assets (cash, accounts receivable, inventory, and prepaid insurance) and current liabilities (accounts payable, income taxes payable, and wages payable). With this information, a user could compute a company’s working capital (current assets − current liabilities) and current ratio (current assets ÷ current liabilities). These two measures are helpful in assessing a company’s ability to pay its debts as they become due.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-33 1.

Since the operating cycle is 6 months, Dunn would use 1 year as the breakpoint between current and noncurrent items. a. There are 17 months of prepaid rent ($8,500 / $500). Dunn should include $6,000 (12 months  $500 per month) as a current asset and $2,500 (the (remaining 5 months  $500 per month) as a long-term asset. b. The $9,700 is a current liability. c. Since all items are expected to be sold within 12 months, the entire $46,230 is a current asset. d. The $700 portion of marketable securities is a current asset. The remaining $1,200 is a longterm investment. e. The $1,050 of cash is a current asset. f. The $60,000 note due in 5 years is a long-term liability. The $3,750 interest related to the current year is a current liability. The remaining interest of $750 will not be recognized until the following year and, therefore, is not on the current year balance sheet. g. The entire $2,850 is a current asset. h. The store equipment and its accumulated depreciation are not current assets. Instead, they are classified as property, plant, and equipment. Dunn Sporting Goods Partial Balance Sheet December 31, 2020

Current assets: Cash ........................................................................................ Short-term investment in marketable securities ....................... Accounts receivable ................................................................. Inventory ................................................................................. Prepaid rent............................................................................. Total current assets............................................................

$ 1,050 700 2,850 46,230 6,000

Current liabilities: Accounts payable ..................................................................... Interest payable on equipment loan (see f above) .................... Total current liabilities .......................................................

$ 9,700 3,750

$56,830

$13,450

Current Assets − Current Liabilities $56,830 − $13,450 $43,380 Current Assets / Current Liabilities $56,830 / $13,450 4.23

Working Capital = = = Current Ratio = = =

These ratios give users insights into a company’s liquidity—that is, a company’s ability to pay obligations as they become due. These ratios show that Dunn Sporting Goods has adequate current assets to cover all of the current liabilities that will become due in the near future. Comparing these ratios to other companies in the same industry and examining the trend in these measures over time will yield additional insights.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-34 1. Hanson Construction Partial Balance Sheet December 31 Current assets: Cash ........................................................................................ Accounts receivable ................................................................. Notes receivable ...................................................................... Supplies ................................................................................... Total current assets............................................................

$1,380 7,000 1,500 6,200

Current liabilities: Accounts payable ..................................................................... Notes payable .......................................................................... Total current liabilities .......................................................

$2,100 6,800

$16,080

$ 8,900

The accounts receivable of $5,000 due in 18 months will be classified as a long-term asset. The construction equipment and related accumulated depreciation are classified as property, plant, and equipment (a noncurrent asset). 2. Hanson Construction’s liquidity may be evaluated by examining its current ratio and working capital. Its current ratio is 1.81 ($16,080 / $8,900) and its working capital is $7,180 ($16,080 − $8,900). Because current assets well exceed the current liabilities, Hanson appears to be able to pay its debts that become due within the next year.

E 1-35 The balance sheet at December 31 will show equipment at its historical cost of $425,000 reduced by accumulated depreciation (a contra-asset) of $40,000. Therefore, the net book value (or carrying value) of the equipment is $385,000. (Note: The concepts of book value and carrying value will be covered in more detail in later chapters.) The equipment and accumulated depreciation will be reported under the caption “Property, plant, and equipment” in the asset section of the balance sheet. The income statement will show depreciation expense of $40,000. In a multiple-step income statement, depreciation expense will be reported as an operating expense.

E 1-36 Mulcahy Manufacturing Inc. Partial Balance Sheet December 31 Stockholders’ equity: Common stock ......................................................................... Retained earnings .................................................................... Total stockholders’ equity ..................................................

$150,000 37,500 $187,500

Note: Transactions among stockholders do not change stockholders’ equity balances.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-37 1. College Spirit Balance Sheet December 31 Assets Current assets: Cash ....................................................................................... Accounts receivable ................................................................ Inventory ................................................................................ Prepaid rent............................................................................ Total current assets...........................................................

$ 13,300 6,700 481,400 54,000 $555,400

Long-term investments: Investment ............................................................................ Property, plant, and equipment: Furniture ................................................................................ Less: Accumulated depreciation .............................................. Furniture, net ................................................................... Total assets...................................................................................

110,900 $ 88,000 (23,700) 64,300 $730,600

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable .................................................................... Notes payable ......................................................................... Income taxes payable ............................................................. Total current liabilities ......................................................

$104,700 50,000 11,400 $166,100

Long-term liabilities: Bonds payable ....................................................................... Total liabilities .................................................................. Stockholders’ equity: Common stock ........................................................................ Retained earnings ................................................................... Total stockholders’ equity ................................................. Total liabilities and stockholders’ equity ........................................

180,000 $346,100 $300,000 84,500 384,500 $730,600

College Spirit has working capital of $389,300 ($555,400 − $166,100) and a current ratio of 3.34 ($555,400 / $166,100).

The working capital and current ratios show that College Spirit has adequate current assets to cover all of the current liabilities that will become due in the near future. Therefore, College Spirit’s liquidity should not be a major concern. Comparing these items to those of other companies in the same industry and examining the trends in these measures over time will yield additional insights.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-38 1. Jerrison Company Balance Sheet December 31 Assets Current assets: Cash ................................................................................ Investments (short-term) ................................................. Accounts receivable ......................................................... Prepaid insurance ............................................................ Inventory ......................................................................... Total current assets....................................................

$ 11,400 21,000 95,500 5,700 187,900 $321,500

Long-term investments: Investment ...................................................................... Property, plant, and equipment: Land ................................................................................ Building ........................................................................... Less: Accumulated depreciation ....................................... Building, net .............................................................. Trucks .............................................................................. Less: Accumulated depreciation ....................................... Trucks, net ................................................................. Equipment (data processing) ............................................ Less: Accumulated depreciation ....................................... Equipment, net ................................................................ Total property, plant, and equipment ......................... Total assets............................................................................

32,700 $ 41,000 $ 419,900 (216,800) 203,100 $ 106,100 (31,200) 74,900 $ 309,000 (172,400) 136,600

455,600 $809,800

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-38 (Continued) Liabilities and Stockholders’ Equity Current liabilities: Accounts payable ..................................................................... Notes payable .......................................................................... Salaries payable ....................................................................... Interest payable ....................................................................... Income taxes payable .............................................................. Total current liabilities .......................................................

$ 65,100 150,000 14,400 12,600 21,600 $263,700

Long-term liabilities: Bonds payable ........................................................................ Total liabilities ................................................................... Stockholders’ equity: Common stock……………………………………………… .......................... Retained earnings*………………………………………… ........................ Total stockholders’ equity .................................................. Total liabilities and stockholders’ equity .........................................

200,000 $463,700 $150,000 196,100 346,100 $809,800

*Note: Retained earnings is computed using the concepts implied by the fundamental accounting equation. Because assets must equal liabilities plus stockholders’ equity, retained earnings is computed by determining the amount that causes both sides of the accounting equation to remain equal. This amount is computed as follows:

First, compute stockholders’ equity: Total Assets $809,800 X

= = =

Total Liabilities + Total Stockholders’ Equity $463,700 + X $346,100

Next, compute retained earnings: Total Stockholders’ Equity $346,100 Y

= = =

Common Stock + Retained Earnings $150,000 + Y $196,100

Jerrison has working capital of $57,800 ($321,500 − $263,700) and a current ratio of 1.22 ($321,500 / $263,700).

While Jerrison appears to be liquid, inventory is its largest current asset at $187,900. If a large portion of inventory cannot be sold, Jerrison will most likely not generate sufficient cash flow to pay its obligations as they become due.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-39 a. Current assets: (a) + $19,200 + $85,700 + $10,400 = $142,200 (a) = $26,900 b. Long-term liabilities: $14,500 + (b) = $50,300 (b) = $35,800 c. Total liabilities and stockholders’ equity: (e) = Total assets (e) = $142,200 d. Total stockholders’ equity: $142,200 (e) = $50,300 + (d) (d) = $91,900 e. Contributed capital: (c) + $56,900 = $91,900 (d) (c) = $35,000 f.

Total assets: (g) = Total liabilities and stockholders’ equity (g) = $149,200

g. Long-term investments: $25,000 + (f) + $92,800 + $9,200 = $149,200 (g) (f) = $22,200 h. Total liabilities: $12,300 + $34,900 = (h) (h) = $47,200 i.

Contributed capital: (i) + $67,000 = $102,000 (j) (i) = $35,000

Total stockholders’ equity: $47,200 (h) + (j) = $149,200 (j) = $102,000

E 1-40 1.

Butler Company Income Statement For a period of time Revenues: Sales revenue Expenses: Cost of goods sold Advertising expense Salaries expense Utilities expense Depreciation expense Interest expense Income taxes expense Net income

2. Information contained on the income statement can be used to predict a company’s ability to generate future income. Specifically, by examining a company’s net profit margin (Net Income / Sales Revenue), a financial statement user can gain insights into management’s ability to control expenses, a critical factor to achieve future profitability.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-41 1.

ERS Inc. Income Statement For the year ending December 31

Revenues: Service revenue ............................................................ Expenses: Wages expense ............................................................ Salaries expense .......................................................... Supplies expense .......................................................... Rent expense ................................................................ Utilities expense ........................................................... Advertising expense ...................................................... Depreciation expense ................................................... Insurance expense ........................................................ Interest expense ........................................................... Income taxes expense ................................................... Total expenses ......................................................... Net income ...................................................................

$933,800 $448,300 195,600 66,400 58,400 26,100 24,200 16,250 11,900 10,100 15,150 (872,400) $ 61,400

Net profit margin is 6.58% ($61,400 net income / $933,800 service revenue). This indicates that $0.0658 of each sales dollar is profit. If ERS were to increase revenues by $100,000, an additional $6,580 of profit would be recognized. If ERS wanted to achieve larger profits, it should focus on controlling its expenses.

A declining profit margin implies that ERS is having difficulty maintaining control over its expenses. While further investigation is warranted to determine the cause of the growing expenses (e.g., is it due to increasing costs that are within management control or are the cost increases due to economic factors beyond ERS’s short-term control), the declining profit margin signals that ERS may have difficulty generating future profits that are comparable with its past performance.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-42 Bergin Pastry Shop Income Statement For the year ending December 31 Net sales .................................................................................... Cost of goods sold* .................................................................... Gross margin ............................................................................. Operating expenses** ................................................................ Income from operations .............................................................

$85,300 (50,600) $34,700 (25,500) $ 9,200

Other expenses and losses: Interest expense .................................................................. Income before taxes .................................................................. Income taxes expense*** .......................................................... Net income ................................................................................

(1,800) $ 7,400 (1,110) $ 6,290

* Cost of goods sold is computed as net sales ($85,300) minus gross margin ($34,700). ** Operating expenses are computed as gross margin ($34,700) minus income from operations ($9,200). *** 15%  $7,400 = $1,110

E 1-43 1.

Wright Auto Supply Income Statement For the year ending December 31

Revenues: Sales revenue ...................................................................... Expenses: Cost of goods sold .............................................................. Wages expense .................................................................. Salaries expense ................................................................. Depreciation expense ......................................................... Rent expense ..................................................................... Interest expense ................................................................ Income taxes expense ........................................................ Total expenses ............................................................. Net income ..............................................................................

$ 585,600 $292,000 96,750 33,800 31,250 21,000 2,400 32,520

(509,720) $ 75,880

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-43 (Continued) 2.

Wright Auto Supply Income Statement For the year ending December 31

Sales revenue ............................................................................ Cost of goods sold ...................................................................... Gross margin ............................................................................. Operating expenses: Wages expense ................................................................... Salaries expense ................................................................. Depreciation expense ......................................................... Rent expense ...................................................................... Total operating expenses .............................................. Income from operations ...................................................... Other expenses and losses: Interest expense ........................................................... Income before taxes ........................................................... Income taxes expense ......................................................... Net income ......................................................................... 3.

$ 585,600 (292,000) $ 293,600 $96,750 33,800 31,250 21,000 (182,800) $ 110,800 (2,400) $ 108,400 (32,520) $ 75,880

Both a single-step income statement and a multiple-step income statement report the same amount for net income. However, a single-step income statement only contains two categories: total revenues and total expenses. These two categories are subtracted to arrive at net income. A multiple-step income statement provides three important classifications that financial statement users find useful: gross margin, income from operations, and net income. The only difference between the two formats is how the revenues and expenses are classified.

E 1-44 1.

Beginning retained earnings ............................................. + Net income ($837,400 − $792,100) ................................. − Dividends ...................................................................... = Ending retained earnings................................................

Sherwood is paying 85% ($38,650 / $45,300) of its income to its shareholders in the form of dividends. This large dividend payout will result in investors receiving relatively more of the company’s earnings in the form of cash during the year rather than in share appreciation. Financial statement users should examine the dividend payout ratio in relation to the firm’s current ratio and working capital to ensure that Sherwood is not paying too much in dividends so that it will be able to repay its debts when they become due.

$ 18,240 45,300 (38,650) $ 24,890

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-45 1.

Cash flow from operating activities: Cash received from customers ........................................................ $ 139,800 Cash paid for advertising ................................................................ (34,200) Cash paid to employees for salaries ................................................ (46,400) Cash paid for supplies .................................................................... (28,700) Net cash provided by operating activities .......................................

$ 30,500

Cash flow from investing activities: Cash paid for purchase of land and building .................................... $(128,700) Cash paid to purchase machine ...................................................... (32,000) Net cash used by investing activities ...............................................

(160,700)

Cash flow from financing activities: Cash received from owners ............................................................ $ 201,500 Cash paid for dividends to stockholders .......................................... (37,500) Net cash provided by financing activities ........................................

164,000

Walters has positive cash flow, especially from operations, showing the company is in a good financial position to pay its debts as they become due. The negative cash flow (cash outflow) in investing is a sign of a growing company that is investing in revenue-producing assets. In addition, from the large amount of cash received from financing activities, it appears that Walters is able to raise large amounts of capital to finance its operations.

E 1-46 Cash at the end of the year: Cash flow from operating activities ....................................................... Cash outflow for investing activities ...................................................... Cash flow from financing activities ........................................................ Change in cash ...................................................................................... Add: Cash as on January 1 ..................................................................... Cash at December 31 ............................................................................

$ 892,250 (990,300) 108,400 $ 10,350 20,400 $ 30,750

Retained earnings at the end of the year: Retained earnings as on January 1 ......................................................... Add: Net income ($650,100 − $578,600) ................................................ Less: Dividends declared ....................................................................... Retained earnings as on December 31 ...................................................

$ 105,600 71,500 (30,000) $ 147,100

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-47 From the information given in the problem and the fundamental accounting equation: Assets January 1 $82,400 December 31 $88,500

= = =

Liabilities $9,200 $11,300

+ + +

Equity ($50,000 + Retained Earnings) ($50,000 + Retained Earnings)

Solve for retained earnings as on January 1 and December 31: Retained Earnings

= = =

Assets − Liabilities − Common Stock $82,400 − $9,200 − $50,000 $23,200

December 31 Retained Earnings

= = =

Assets − Liabilities − Common Stock $88,500 − $11,300 − $50,000 $27,200

January 1

Using the computed amounts for retained earnings, dividends declared can be determ using the relationships found in the retained earnings statement. Beginning retained earnings ........................................................... + Net income ................................................................................. − Dividends declared ...................................................................... = Ending retained earnings .............................................................

$23,200 19,500 ? $27,200

Dividends = $15,500

E 1-48 From the information given in the problem and the fundamental accounting equation: January 1 December 31

Assets = $152,200 = $171,800 =

Liabilities $56,600 $63,750

+ + +

Equity ($60,000 + Retained Earnings) ($60,000 + Retained Earnings)

For each year, solve for retained earnings: January 1

Retained Earnings

= = =

Assets − Liabilities − Common Stock $152,200 − $56,600 − $60,000 $35,600

December 31

Retained Earnings

= = =

Assets − Liabilities − Common Stock $171,800 − $63,750 − $60,000 $48,050

Using the computed amounts for retained earnings, net income can be determined using the relationships found in the retained earnings statement. Beginning retained earnings ........................................................... + Net income ................................................................................. − Dividends declared...................................................................... = Ending retained earnings .............................................................

$ 35,600 ? (20,000) $ 48,050

Net income = $32,450

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

E 1-49 a. b. c. d. e. f. g. h.

Unethical (U) Ethical (E) Unethical (U) Ethical (E) Ethical (E) Unethical, and probably illegal (U) Ethical (E) Unethical (U)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

PROBLEM SET A P 1-50A The fundamental accounting equation requires that there be an equality between assets and liabilities plus stockholders’ equity. Therefore, the amount of liabilities that Huffer must have at the end of the year can be inferred from the fundamental accounting equation if both assets and stockholders’ equity are known. The amount of Huffer’s assets at December 31 is $285,500. Huffer’s stockholders’ equity at the end of the year is the amount of stockholders’ equity at the beginning of the year plus (minus) net income (loss) minus dividends declared plus the sale of common stock.

Equity, January 1 Net income Dividends declared Common stock issued Equity, December 31

Common Stock $50,000

+ +

15,000 $65,000

Retained Earnings $ 88,200 51,750 (10,000)

= =

Stockholders’ Equity $138,200

$194,950

$129,950

The amount of liabilities that Huffer must have at the end of the year is determined by using the balance sheet equation and solving for the missing amount. Assets As of December 31 $285,500 Liabilities = $285,500 − $194,950 = $90,550

= =

Liabilities ?

+ +

Equity $194,950

P 1-51A It is necessary to answer these questions out of order because of the way the relationships among the accounts work. (a)

(b)

(c)

Assets

Liabilities

Assets Assets

= =

$126,900 $231,000

Assets

Liabilities

$145,200 Stockholders’ Equity

= =

$92,600 $52,600

Stockholders’ Equity (all at the beginning of the year) Stockholders’ Equity

Net Income

−

Dividends

Ending

+ =

$77,500 $26,000

−

Dividends

Stockholders’ Equity $104,100

− − =

Expenses Expenses $477,300

= =

Net Income $77,500

Beginning Stockholders’ Equity $52,600 Dividends

(d)

Revenues $554,800 Expenses

Stockholders’ Equity (all at the end of the year) $104,100

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-52A Powers Wrecking Service Income Statement For the year ending December 31 Revenues: Service revenue ..................................................................... Sales revenue ......................................................................... Interest income....................................................................... Total revenues .................................................................. Expenses: Wages expense ....................................................................... Rent expense .......................................................................... Supplies expense .................................................................... Depreciation expense ............................................................. Miscellaneous expense ........................................................... Income taxes expense ............................................................. Total expenses .................................................................. Net income ....................................................................................

$425,000 137,000 1,575 $563,575 $243,200 84,000 48,575 24,150 17,300 43,900 (461,125) $102,450

P 1-53A Cooper Merchandising Income Statement For the year ending December 31 Net sales ...................................................................................... Cost of goods sold ........................................................................ Gross margin ................................................................................ Operating expenses: Wages expenses ........................................................................... Rent expense ................................................................................ Supplies expense .......................................................................... Depreciation expense .................................................................. Miscellaneous expense ................................................................ Total operating expenses ................................................. Income from operations ...............................................................

$625,000 (248,000) $377,000 $ 103,600 65,000 23,575 12,150 8,300

Other income and expenses: Interest income ...................................................................... Income before taxes ..................................................................... Income taxes expense ................................................................... Net income ...................................................................................

(212,625) $164,375 1,250 $165,625 (32,500) $133,125

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-54A Floyd:

Revenues $125 Assets $905

− − = =

Expenses $92 Liabilities $412

= = + +

Net Income $33 (a) Stockholders’ Equity $493 (b)

Slater:

Revenues $715 Assets $1,988

− − = =

Expenses $531 (c) Liabilities $1,165 (d)

= = + +

Net Income $184 Stockholders’ Equity $823

Wooderson:

Revenues $72 (e) Assets $197 (f)

− − = =

Expenses $54 Liabilities $117

= = + +

Net Income $18 Stockholders’ Equity $80

O’Bannion:

Revenues $2,475 Assets $8,140

− − = =

Expenses $3,075 (g) Liabilities $2,280

= = + +

Net Income (Loss) $(600) Stockholders’ Equity $5,860 (h)

P 1-55A Rogers Enterprises Income Statement For the year ending December 31 Revenues: Service revenue ....................................................................... Expenses: Salaries expense ...................................................................... Rent expense ........................................................................... Supplies expense ..................................................................... Interest expense ...................................................................... Income taxes expense .............................................................. Net income ..............................................................................

$463,500 $235,200 135,000 34,400 16,000 12,800

(433,400) $ 30,100

Rogers Enterprises Balance Sheet December 31 Assets Current assets: Cash ........................................................................................ Accounts receivable ................................................................. Supplies ................................................................................... Prepaid rent............................................................................. Total current assets............................................................ Property, plant, and equipment ..................................................... Total assets....................................................................................

$13,240 72,920 42,000 31,500

$159,660 90,000 $249,660

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-55A (Continued) Liabilities and Stockholders’ Equity Current liabilities: Salaries payable ..................................................................... $ 14,800 Income taxes payable ............................................................ 4,150 Total current liabilities .......................................................

$ 18,950

Long-term liabilities: Notes payable (due in 10 years) .............................................. Total liabilities ...................................................................

25,000 $ 43,950

Stockholders’ equity: Common stock (10,000 shares) ............................................... Retained earnings* ................................................................ Total stockholders’ equity ................................................. Total liabilities and stockholders’ equity ........................................

$ 70,000 135,710 205,710 $249,660

*Retained earnings is computed as the amount needed to make the fundamental accounting equation balance.

P 1-56A Moore Inc. Income Statement For the year ending December 31 Sales revenue .............................................................................. Cost of goods sold ........................................................................ Gross margin ............................................................................... Operating expenses: Salaries expense .................................................................... Rent expense ......................................................................... Supplies expense ................................................................... Total operating expenses ................................................ Income from operations ............................................................... Other income and expenses: Interest income ..................................................................... Interest expense .................................................................... Total other income and expenses ..................................... Income before income taxes ........................................................ Income taxes expense ........................................................... Net income ..................................................................................

$ 863,500 (395,000) $468,500 $ 235,200 135,000 34,400 ($ 404,600) $ 63,900 2,000 (16,000)

(14,000) 49,900 (8,600) $ 41,300

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-56A (Continued) Moore Inc. Balance Sheet December 31 Assets Current assets: Cash ................................................................................ Accounts receivable ......................................................... Supplies........................................................................... Prepaid rent .................................................................... Total current assets..................................................... Property, plant, and equipment .............................................. Total assets.............................................................................

$ 16,290 68,910 44,100 31,500 $160,800 90,000 $250,800

Liabilities and Stockholders’ Equity Current liabilities: Salaries payable ................................................................ Income taxes payable ....................................................... Total current liabilities ................................................. Long-term liabilities: Notes payable (due in 10 years) ........................................ Total liabilities ............................................................. Stockholders’ equity: Common stock (10,000 shares) .......................................... Retained earnings* ........................................................... Total stockholders’ equity ............................................ Total liabilities and stockholders’ equity ...................................

$ 14,800 4,150 $ 18,950 25,000 $ 43,950 $ 70,000 136,850 206,850 $250,800

* Retained earnings is computed as the amount needed to make the fundamental accounting equation balance.

P 1-57A Dittman Expositions Retained Earnings Statement For the years ending December 31, Year 1, and December 31, Year 2 Retained earnings, beginning of year* ...................................... Add: Net income** .................................................................. Less: Dividends declared .......................................................... Retained earnings, end of year ................................................. *

Year 1 $20,900 25,400 (10,250) $36,050

Year 2 $36,050 33,000 (12,920) $56,130

The ending retained earnings balance for Year 1 becomes the beginning retained earnings balance for Year 2

** Net income computed as follows: ................................................. Revenue ................................................................................. Less: Expenses ........................................................................ Net income ............................................................................

Year 1 $407,500 (382,100) $ 25,400

Year 2 $451,600 (418,600) $ 33,000

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-58A (a) $30,700 − Dividends (a) = $27,200 Dividends (a) = $3,500 (b) Retained Earnings, Beginning (Year 2) = Retained Earnings, Ending (Year 1) = $27,200 (c) Retained Earnings, Beginning (b) + Net Income = (c) $27,200 + $10,100 = $37,300 You must solve for (e) prior to solving for (d): (e) Retained Earnings, Ending (Year 2) = Retained Earnings, Beginning (Year 3) = $33,600 (d) Retained Earnings, Ending (e) = (c) − Dividends (d) $33,600 = $37,300 − Dividends (d) Dividends (d) = $3,700 You must solve for (g) prior to solving for (f): (g) Retained Earnings, Ending = (g) − Dividends $41,200 = (g) − $3,900 (g) = $45,100 (f)

Retained Earnings, Beginning + Net Income (f) = (g) $33,600 + Net Income (f) = $45,100 Net Income (f) = $11,500

P 1-59A 1.

Ashton Appliances Income Statement For the year ending December 31

Revenues: Sales revenue ....................................................................... Expenses: Cost of goods sold................................................................. Salaries expense ................................................................... Rent expense ........................................................................ Insurance expense ................................................................ Interest expense ................................................................... Depreciation expense (furniture) .......................................... Depreciation expense (building) ............................................ Income taxes expense ........................................................... Total expenses .................................................................. Net income ...................................................................................

$948,670 $511,350 228,710 80,800 36,610 15,500 12,000 11,050 16,650

(912,670) $ 36,000

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-59A (Continued) Ashton Appliances Retained Earnings Statement For the year ending December 31 Beginning retained earnings, January 1 ........................................... Add: Net income* .......................................................................... Ending retained earnings, December 31 ..........................................

$ 54,000 36,000 $ 90,000

* From the income statement

Ashton Appliances Balance Sheet December 31 Assets Current assets: Cash ...................................................................... Accounts receivable ............................................... Inventory............................................................... Total current assets........................................... Property, plant, and equipment: Building ................................................................. Less: Accumulated depreciation ............................. Building, net ..................................................... Furniture ............................................................... Less: Accumulated depreciation ............................. Furniture, net ................................................. Total property, plant, and equipment ............. Other assets.................................................................. Total assets...................................................................

$ 41,450 69,900 59,850 $171,200 $ 300,000 (104,800) $195,200 $ 130,000 (27,600) 102,400 297,600 92,800 $ 561,600

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable................................................... Income taxes payable ............................................ Salaries payable ..................................................... Total current liabilities ...................................... Long-term liabilities: Bonds payable ....................................................... Total liabilities ................................................. Stockholders’ equity: Common stock ....................................................... Retained earnings* ................................................ Total stockholders’ equity ................................. Total liabilities and stockholders’ equity ........................

$ 16,800 12,000 7,190 $ 35,990 192,000 $227,990 $ 243,610 90,000 333,610 $ 561,600

* From the retained earnings statement

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-59A (Continued) 3.

Both a single-step income statement and a multiple-step income statement report the same amount for net income. However, a single-step income statement contains only two categories: total revenues and total expenses. These two categories are subtracted to arrive at net income. A multiple-step income statement provides three important classifications that financial statement users find useful: gross margin, income from operations, and net income. The only difference between the two formats is how the revenues and expenses are classified. Ashton Appliances Income Statement For the year ending December 31

Sales revenue ................................................................................ Cost of goods sold .......................................................................... Gross margin ................................................................................. Operating expenses: Salaries expense ..................................................................... Rent expense .......................................................................... Insurance expense .................................................................. Depreciation expense (furniture) ............................................ Depreciation expense (building) .............................................. Total operating expenses ................................................... Income from operations .................................................................

$948,670 ($511,350) $437,320 228,710 80,800 36,610 12,000 11,050

Other income and expenses: Interest expense ..................................................................... Income before income taxes .......................................................... Income taxes expense ............................................................. Net income ....................................................................................

(369,170) $ 68,150 (15,500) $52,650 (16,650) $ 36,000

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-60A Berko Company: (a) $62,100 ($50,000 + $12,100) (b) $17,100 ($12,100 + $7,000 − $2,000) (c) $67,100 ($17,100 + $50,000) (d) $25,400 ($92,500 − $67,100) Manning Company: (e) $9,300 ($44,300 − $35,000) (f) $7,500 ($9,300 − $1,800) (g) $42,500 ($35,000 + $7,500) (h) $57,300 ($42,500 + $14,800) Lucas Company: (i) $40,000 ($66,400 − $26,400) Must solve for (k) before (j): (k) $29,500 ($84,500 − $55,000) (j) $2,900 ($26,400 + $6,000 − $29,500) (l) $14,700 ($99,200 − $84,500) Corey Company: (m) $7,100 ($27,600 − $21,900 + $1,400) (n) $42,600 ($15,000 + $27,600) (o) $53,300 ($10,700 + $42,600)

P 1-61A First, use the fundamental accounting equation to determine stockholders’ equity: Assets = Liabilities + Stockholders’ Equity Beginning $385,500 = $152,800 + $232,700 * End $420,250 = $156,600 + $263,650 ** * $385,500 − $152,800 = $232,700 ** $420,250 − $156,600 = $263,650

Next, use these fundamental relationships to solve for each situation: Stockholders’ Equity Change in Stockholders’ Equity Change in Retained Earnings Therefore,

= = =

Common Stock + Change in Common Stock + Net Income − Dividends

Change in Stockholders’ Equity

Change in Common Stock + Net Income − Dividends

($263,650 − $232,700) = $0 + Net Income − $0 Net Income = $30,950

($263,650 − $232,700) = $40,000 + Net Income − $0 Net Loss = ($9,050)

($263,650 − $232,700) = $0 + Net Income − $15,000 Net Income = $45,950

($263,650 − $232,700) = $35,000 + Net Income − $20,000 Net Income = $15,950

Retained Earnings Change in Retained Earnings

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

PROBLEM SET B P 1-50B The fundamental accounting equation requires that there be an equality between assets and liabilities plus stockholders’ equity. Therefore, the amount of liabilities that KJ Corporation must have at the end of the year can be inferred from the fundamental accounting equation if both assets and stockholders’ equity are known. The amount of KJ’s assets at December 31 is $710,100. KJ’s stockholders’ equity at the end of the year is the amount of stockholders’ equity at the beginning of the year plus (minus) net income (loss) minus dividends plus the sale of common stock. Common Stock $100,000

Retained Stockholders’ + Earnings = Equity Equity, Jan. 1 + $134,900 = $234,900 Net income 205,500 Dividends (70,000) Common stock issued 75,000 ________ = ________ Equity, Dec. 31 $175,000 + $270,400 = $445,400 The amount of liabilities that KJ must have at the end of the year is determined by using the balance sheet equation and solving for the missing amount. Assets = Liabilities + Equity At Dec. 31 $710,100 = ? + $445,400 Liabilities = $710,100 − $445,400 = $264,700

P 1-51B It is necessary to answer these questions out of order because of the way the relationships between the accounts work. (a)

Assets

= Liabilities + Stockholders’ Equity (all at the beginning of the year) = $368,200 + $272,900 = $641,100 Note: Item (d) is found prior to finding items (b) and (c). = Revenues − = $929,440 − = $94,120 Note: Item (c) is found prior to finding item (b).

Expenses $835,320

Net Income

−

Dividends

$94,120

−

$35,500

Ending Stockholders’ Equity

$331,520

Assets $758,150 Liabilities

+ +

Stockholders’ Equity (all at end of year) $331,520

(d)

Net Income

(c)

Beginning + Stockholders’ Equity $272,900 +

(b)

= = =

Liabilities Liabilities $426,630

Ending Stockholders’ Equity Ending Stockholders’ Equity

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-52B Parker Renovation Inc. Income Statement For the year ending December 31 Revenues: Service revenue ..................................................................... Interest income ..................................................................... Total revenues .................................................................. Expenses: Wages expense ...................................................................... Depreciation expense ............................................................ Utilities expense .................................................................... Insurance expense ................................................................. Miscellaneous expense .......................................................... Income taxes expense ............................................................ Total expenses .................................................................. Net income ...................................................................................

$763,400 5,475 $768,875 $ 222,900 135,000 109,300 65,850 31,000 61,400 (625,450) $143,425

P 1-53B Lakas Company Income Statement For the year ending December 31 Net sales ....................................................................................... Cost of goods sold .......................................................................... Gross margin ................................................................................. Operating expenses: Wages expenses ..................................................................... Rent expense .......................................................................... Supplies expense .................................................................... Depreciation expense ............................................................. Miscellaneous expense ........................................................... Total operating expenses Income from operations ................................................................ Other income and expenses: Interest income ..................................................................... Interest expense .................................................................... Total other income and expenses ...................................... Income before taxes ..................................................................... Income taxes expense ................................................................... Net income ...................................................................................

$ 425,000 (178,400) $246,600 $ 66,100 35,910 13,122 11,590 8,800 (135,522) $111,078 620 (850)

(230) $ 110,848 (23,200) $ 87,648

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-54B Crick:

Net Income $81 (a) Assets $709

= = = =

Revenues $925 Liabilities $332

− − + +

Expenses $844 Stockholders’ Equity $377 (b)

Pascal:

Net Income $289 Assets $1,810

= = = =

Revenues $533 Liabilities $860 (d)

− − + +

Expenses $244 (c) Stockholders’ Equity $950

Eiffel:

Net Income $126 Assets $552 (f)

= = = =

Revenues $503 (e) Liabilities $454

− − + +

Expenses $377 Stockholders’ Equity $98

Hilbert:

Net Income (Loss) ($340) Assets $3,150

= = = =

Revenues $1,125 Liabilities $2,267

− − + +

Expenses $1,465 (g) Stockholders’ Equity $883 (h)

P 1-55B Ross Airport Auto Service Income Statement For the year ending December 31 Revenues: Service revenue (parking)....................................................... Service revenue (repair) ......................................................... Interest income ..................................................................... Total revenues .................................................................. Expenses: Wages expense ...................................................................... Rent expense ......................................................................... Supplies expense ................................................................... Interest expense .................................................................... Depreciation expense ............................................................ Income taxes expense ............................................................ Total expenses .................................................................. Net income ...................................................................................

$232,600 198,500 4,100 $435,200 $246,100 103,500 36,900 21,300 12,450 2,700

(422,950) $ 12,250

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-55B (Continued) Ross Airport Auto Service Balance Sheet December 31 Assets Current assets: Cash ...................................................................................... Accounts receivable ............................................................... Inventory............................................................................... Prepaid rent .......................................................................... Total current assets...........................................................

$ 7,700 39,200 6,100 27,300 $ 80,300

Long-term investments: Investments ......................................................................

35,000

Property, plant, and equipment: Equipment .............................................................................. $ 270,800 Less: Accumulated depreciation .............................................. (42,300) Total assets....................................................................................

228,500 $ 343,800

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable................................................................... Wages payable ...................................................................... Income taxes payable ............................................................ Interest payable..................................................................... Total current liabilities ......................................................

$ 17,200 12,500 1,100 4,800 $ 35,600

Long-term liabilities: Notes payable ....................................................................... Total liabilities ................................................................. Stockholders’ equity: Common stock ....................................................................... Retained earnings .................................................................. Total stockholders’ equity ................................................. Total liabilities and stockholders’ equity ........................................

160,000 $ 195,600 $ 100,000 48,200 148,200 $ 343,800

Note: Dividends do not appear on the income statement or the balance sheet. Instead, dividends are reported on the retained earnings statement.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-56B Cheng Company Income Statement For the year ending December 31 Sales revenue .......................................................................... Cost of goods sold .................................................................... Gross margin ........................................................................... Operating expenses: Salaries expense ............................................................... Rent expense .................................................................... Supplies expense .............................................................. Research and development expense ................................. Insurance expense ............................................................ Total operating expenses ............................................ Income from operations ........................................................... Other income and expenses: Gain on disposal of property, plant, and equipment .......... Interest expense ...............................................................

$ 525,100 (279,800) $ 245,300 $ 115,900 65,000 14,400 12,700 5,000 ($ 213,000) $ 32,300 5,000 (8,450)

Income taxes expense .................................................. Net income ..............................................................................

(3,450) 28,850 (6,000) $ 22,850

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Cheng Company Balance Sheet December 31 Assets Current assets: Cash ................................................................................ Accounts receivable ......................................................... Supplies........................................................................... Prepaid rent .................................................................... Total current assets..................................................... Property, plant, and equipment .............................................. Patent .................................................................................... Total assets.............................................................................

$ 14,275 58,930 24,600 8,500 $106, 305 105,000 12,380 $ 223,685

Liabilities and Stockholders’ Equity Current liabilities: Salaries payable ............................................................... Income taxes payable ...................................................... Total current liabilities ................................................ Long-term liabilities: Notes payable (due in 10 years)................................... Total liabilities ............................................................ Stockholders’ equity: Common stock (10,000 shares) .......................................... Retained earnings* ........................................................... Total stockholders’ equity ............................................ Total liabilities and stockholders’ equity ...................................

$11,400 2,850 $ 14,250 15,000 $ 29,250 $ 105,000 89,435 194,435 $ 223,685

* Retained earnings is computed as the amount needed to make the fundamental accounting equation balance.

P 1-57B Magical Experiences Vacation Company Retained Earnings Statement For the years ending December 31, Year 1, and December 31, Year 2 Retained earnings, beginning of year* ...................................... Add: Net income** .................................................................. Less: Dividends ........................................................................ Retained earnings, end of year .................................................

Year 1 $ 55,300 33,400 (14,000) $ 74,700

Year 2 $ 74,700 74,600 (16,000) $ 133,300

* The ending retained earnings balance for Year 1 becomes the beginning retained earnings balance for Year2. ** Net income is computed as follows: Year 1 Year 2 Revenue ................................................................................. $221,900 $325,400 Less: Expenses ........................................................................ (188,500) (250,800) Net income ............................................................................ $ 33,400 $74,600

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-58B (a) $26,900 − $11,100 = $15,800 (b) Retained Earnings, Ending (Year 1) = Retained Earnings, Beginning (Year 2) = $ 19,500 You must solve for (e) prior to solving for (c) or (d): (e) Retained Earnings, Ending (Year 2)

= Retained Earnings, Beginning (Year 3) = $ 26,700

You must solve for (d) prior to solving for (c): (d) = Retained Earnings, Ending, Year 2 (e) + Dividends = $ 26,700 + $5,200 = $ 31,900 (c) Net Income = (d) − Retained Earnings, Beginning (Year 2) = $ 31,900 (d) − $19,500 = $ 12,400 (f)

= Retained Earnings, Beginning (Year 3) + Net Income = $ 26,700 + $9,500 = $ 36,200

(g) Dividends = (f) − Retained Earnings, Ending (Year 3) = $ 36,200 (f) − $34,100 = $ 2,100

P 1-59B McDonald Boat Company Income Statement For the year ending December 31 Revenues: Sales revenue ................................................................... Expenses: Cost of goods sold ............................................................. Wages expense ................................................................. Depreciation expense (equipment).................................... Utilities expense ............................................................... Interest expense ............................................................... Supplies expense .............................................................. Depreciation expense (building) ........................................ Rent expense .................................................................... Income taxes expense ....................................................... Total expenses........................................................... Net income ...................................................................................

$ 1,932,300 $ 987,200 348,700 142,300 131,300 99,400 89,100 21,500 14,600 21,700

(1,855,800) 76,500

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-59B (Continued) McDonald Boat Company Retained Earnings Statement For the year ending December 31 Retained earnings, January 1 ........................................ Add: Net income .......................................................... Less: Dividends ............................................................ Retained earnings, December 31 ..................................

$ 128,600 76,500 (25,300) $ 179,800

McDonald Marina Balance Sheet December 31 Assets Current assets: Cash .................................................................. Accounts receivable ........................................... Supplies............................................................. Total current assets....................................... Property, plant, and equipment: Land .................................................................. Building ............................................................. Less: Accumulated depreciation ......................... Equipment ......................................................... Less: Accumulated depreciation ......................... Total property, plant, and equipment ............ Total assets...............................................................

$ 22,300 268,700 9,800 $ 300,800 $ 875,000 $ 197,300 (64,500) $ 2,490,000 (950,400) 2,547,400

132,800 1,539,600 $ 2,848,200

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable............................................................... Wages payable .................................................................. Interest payable................................................................. Rent payable ..................................................................... Total current liabilities ..................................................

$ 26,400 21,600 18,000 2,400 $ 68,400

Long-term liabilities: Bonds payable ................................................................... Total liabilities ................................................................... Stockholders’ equity: Common stock ................................................................... Retained earnings .............................................................. Total stockholders’ equity ............................................. Total liabilities and stockholders’ equity ....................................

2,000,000 $ 2,068,400 $ 600,000 179,800

779,800 $ 2,848,200

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-59B (Continued) 3.

McDonald Boat Company Income Statement For the year ending December 31

Sales revenue ................................................................................ Cost of goods sold .......................................................................... Gross margin ................................................................................. Operating Expenses: Wages expense ....................................................................... Depreciation expense (equipment) ......................................... Utilities expense ..................................................................... Interest expense ..................................................................... Supplies expense .................................................................... Depreciation expense (building) .............................................. Rent expense .......................................................................... Total operating expenses .................................................. Income from operations ................................................................. Income taxes expense .................................................................... Net income ....................................................................................

$1,932,300 ($ 987,200) $ 945,100 348,700 142,300 131,300 99,400 89,100 21,500 14,600 (846,900) $ 98,200 ($ 21,700) $ 76,500

P 1-60B Stackhouse Company: (a) $5,000 ($21,700 − $18,800 + $2,100) (b) $66,700 ($45,000 + $21,700) (c) $81,100 ($14,400 + $66,700) Compton Company: (d) $54,300 ($39,000 + $15,300) (e) $21,600 ($15,300 + $7,100 − $800) (f) $60,600 ($21,600 + $39,000) (g) $27,600 ($88,200 − $60,600) Bellefleur Company: Must solve for (i) first. (i) $15,300 ($95,300 − $80,000) (h) $1,300 ($6,900 + $9,700 − $15,300) (j) $18,100 ($113,400 − $95,300)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

P 1-60B (Continued) Merlotte Company: (k) $13,900 ($38,900 − $25,000) (l) $9,400 ($13,900 − $4,500 − $0) (m) $34,400 ($25,000 + $9,400) (n) $50,100 ($15,700 + $34,400)

P 1-61B First, use the fundamental accounting equation to determine stockholders’ equity: Beginning End

Assets $256,500 $358,200

= = =

Liabilities $92,650 $121,900

+ + +

Stockholders’ Equity $163,850 * $236,300 **

* $256,500 − $92,650 = $163,850 ** $358,200 − $121,900 = $236,300

Next, use these fundamental relationships to solve for each situation: Stockholders’ Equity = Common Stock Change in Stockholders’ Equity = Change in Common Stock Change in Retained Earnings = Net Income − Dividends

+ +

Retained Earnings Change in Retained Earnings

Net Income − Dividends

Therefore, Change in Stockholders’ Equity

= Change in Common Stock

($236,300 − $163,850) = $0 + Net Income − $0 Net Income = $72,450

($236,300 − $163,850) = $15,000 + Net Income − $0 Net Income = $57,450

($236,300 − $163,850) = $0 + Net Income − $10,000 Net Income = $82,450

($236,300 − $163,850) = $20,000 + Net Income − $12,000 Net Income = $64,450

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

CASES Case 1-62 Answers to this question may vary; however, many students will focus on income. If Jim had kept track of his revenues (e.g., his earnings from the summer job, the small scholarship, and the fixed amount from his parents) and his expenses (e.g., tuition, books, apartment, and entertainment) during earlier semesters, he might have been able to budget for the spring term. Many of his expenses will be the same or very similar from term to term. Jim could use the information from the fall term to predict what his revenues and expenses would be for the spring term. He would then have a better idea of how much he could spend on entertainment without “maxing out” his credit card. In addition, Jim could keep track of his assets and liabilities. He could track which assets were current (e.g., cash in his bank account) and which liabilities would become due in the near term (e.g., spring tuition, living expenses). He could then know prior to the spring term which bills would become due and if he had enough liquid assets to pay these bills. Keeping better track of his revenues, expenses, income, assets, and liabilities may have allowed Jim to avoid overspending his resources.

Case 1-63 1.

The following examples are illustrative, and students' answers may vary: a.

Nonbusiness entities (including governments and educational institutions): The Accounting Review (university and college educators), American Accounting Association Issues in Accounting Education (university and college educators), American Accounting Association Journal of Government Financial Management (governmental accountants), Association of Government Accountants (AGA)

Business entities: Strategic Finance (management accountants and finance professionals), Institute of Management Accountants Financial Executive (controllers, treasurers, and senior financial executives), Financial Executives Institute Internal Auditor (internal auditors), Institute of Internal Auditors

Public practice: Journal of Accountancy (certified public accountants), American Institute of Certified Public Accountants The CPA Journal (certified public accountants), New York State Society of CPAs

Activities and events in one segment of the accounting profession affect activities and events in other segments of the profession. Education affects preparedness for public practice. New business activities require new auditing procedures. Accounting research affects the practice of accounting, and accounting practice influences the form of accounting research. Information about developments outside one’s own segment of accounting can help one better understand and, perhaps, shape developments inside one’s own segment.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Case 1-64 Student responses to this assignment will vary widely, but it is a good basis for classroom discussion. Some students may have interests in various accounting careers, while others may have interests in other business careers or perhaps graduate professional degrees. Of those with plans for graduate education, some may intend to work for several years before returning for additional education, while others may plan to go directly into graduate school. Some may plan to start their careers in one field and then move into another after several years. Some may have plans to start their own business. The steps necessary to implement these plans can be an interesting basis for discussion.

Case 1-65 1.

Current assets (1/31/2023) Current liabilities (1/31/2023) Current assets (1/31/2022) Current liabilities (1/31/2022)

= = = =

$5,210 + $28,100 + $7,152 = $40,462 $19,655 $4,125 + $32,891 + $7,853 = $44,869 $35,483

Agency Rent-A-Car reported a current ratio of 2.06 ($40,462 / $19,655) in 2023 and a current ratio of 1.26 ($44,869 / $35,483) in 2022. Its working capital is $20,807 ($40,462 − $19,655) in 2023 and $9,386 ($44,869 − $35,483) in 2022. These ratios show that the company has adequate current assets to cover the current liabilities in both years. In addition, its liquidity is improving between 2022 and 2023. 2.

Net Income = Stockholders’ Equity (1/31/2023) − Stockholders’ Equity (1/31/2022) + Dividends* $172,529 − $135,819 + $21,000 = $57,710

* Beg. Stockholders’ Equity $135,819 + Net Income − Dividends $21,000 = End. Stockholders’ Equity $172,529

Case 1-66 1.

Trends: (a) Revenues decreased dramatically from 2021 to 2022. (b) Operating income (loss) has fluctuated dramatically in the 5-year period but shows some improvement (less of a loss) in 2023. (c) Net income (loss) was down dramatically from 2022 and seems to be slowly recovering in 2023 with a much smaller loss.

In 2019 and 2020, Wright Brothers Aviation Company had adequate assets to cover the current liabilities, but the ratio changed dramatically in 2021, 2022, and 2023, causing current liabilities to be much larger than current assets. It seems as though Wright Brothers used its assets to pay down its long-term debt in 2021.

Yes, the company has shown a considerable decrease throughout the 5-year period in net income and also shows that it may have difficulty in paying current liabilities with the small amount of current assets it has.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Case 1-67 Ethical behavior by accountants is important to society because capital markets and businesses cannot operate efficiently or effectively without reliable financial information. Financial information determines the way in which resources are deployed and distributed. Thus, individuals who stand to benefit from changes in resource deployment or distribution have an incentive to misrepresent financial information or to pressure accountants to do so. Such individuals may even create financial incentives for accountants to bias or misrepresent the facts. Unethical behavior by an accountant, once revealed, usually brings loss of employment and frequently loss of professional credentials (e.g., professional license) as well. In addition, individuals may face criminal or civil prosecution.

Case 1-68 There are many ethical implications involved with the discussion between Lola and Frank. It is not ethical to change items in the financial statements simply to appear better to the public. This can be very misleading to both creditors and investors and could potentially cause harm to these parties who based their expectations of future performance on the past numbers that have been changed. If the company doesn’t perform as well as expected, these creditors and investors will likely blame the accounting numbers that have been misrepresented. If management intends to pay off accounts within a year, they need to be classified as current liabilities. Also, investments that have been purchased with the intent to hold them for a long period of time should be considered long-term investments. Management should not reclassify these unless their intent changes and they plan to sell the investments within the next year. In addition, the company should follow generally accepted accounting principles and record its assets at historical cost. Management cannot pick and choose which assets to present at their market value. Management should not use the excuse of “judgment” to alter numbers in order to make the company appear better on paper.

Case 1-69 1.

Apple’s fiscal year ended on September 28, 2019. This year-end is different from previous years for the simple reason that Apple has a floating year-end. Apple’s year-end always falls on the last Saturday of the month of September, so the actual date changes from year to year.

Apple presents 2 years of balance sheet information and 3 years of income statement information.

Balance sheet information: a. For 2019, Apple reported total assets of $338,516,000,000, total liabilities of $248,028,000,000, and total stockholders’ equity of $90,488,000,000. b. The dollar amounts for all three categories have changed in the past year. For 2018, Apple reported total assets of $365,725,000,000, total liabilities of $258,578,000,000, and total stockholders’ equity of $107,147,000,000. This represented a decrease in total assets of $27,209,000,000 ($338,516,000,000 − $365,725,000,000), a decrease in total liabilities of $10,550,000,000 ($248,028,000,000 − $258,578,000,000), and a decrease in total stockholders’ equity of $16,659,000,000 ($90,488,000,000 − $107,147,000,000). c. For 2019, Apple reported current assets of $162,819,000,000 and current liabilities of $105,718,000,000. For 2018, Apple reported current assets of $131,339,000,000 and current liabilities of $115,929,000,000.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Case 1-69 (Continued) d.

Apple reported working capital of $57,101,000,000 ($162,819,000,000 − $105,718,000,000) for 2019 and working capital of $15,410,000,000 ($131,339,000,000 − $115,929,000,000) for 2018. Apple’s current ratio was 1.54 ($162,819,000,000 / $105,718,000,000) for 2019 and 1.13 ($131,339,000,000 / $115,929,000,000) for 2018. Apple’s current assets are greater than its current liabilities for both years, which indicates that Apple should be able to pay the liabilities that become due within the next year. Apple’s working capital and current ratio have increased during 2019 when compared to 2018. Thus, Apple appears to have sufficient liquidity.

Income statement information: a. For 2019, Apple reported revenues (net sales) of $260,174,000,000 and expenses of $204,918,000,000 ($161,782,000,000 + $34,462,000,000 + $10,481,000,000 − $1,807,000,000). Note: The $18,070,000,000 is a combination of other income and expenses and was subtracted from expenses. Apple’s net income was $55,256,000,000. b. Sales decreased by $11,964,000 from 2018 to 2019 but increased by $29,313,000 from 2017 to 2018, as shown in the comparative income statements. As noted in the management discussion and analysis, the decrease in sales in 2019 is due primarily to decreased iPhone sales. This decrease in sales has caused a corresponding decrease in cost of sales (an expense).

Statement of cash flows information: a. For 2019, Apple reported a net cash inflow from operating activities of $69,391,000,000, a net cash inflow from investing activities of $45,896,000,000, and a net cash outflow from financing activities of $90,976,000,000). b. In 2019, Apple paid $10,495,000,000 for the acquisition of property, plant, and equipment.

Management’s discussion and analysis information: a. Apple’s management considers several accounting policies critical, including following generally accepted accounting principles, revenue recognition, allowance for doubtful accounts, inventory valuation, warranty costs, valuation of marketable securities, income taxes, and contingencies policy. This information was found in the management’s discussion and analysis section of the annual report. More detail on significant accounting policies can also be found in the notes to the financial statements (Note 1). b. The company believes that future gross margins will be under downward pressure due to global product pricing pressures, increased competition, compressed product life cycles, potential increases in cost of components, and a shift to lower gross margin products. Its analysis can be found in the management’s discussion and analysis section (Item 7 of the 10-K).

The financial statements are audited by Ernst & Young.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Case 1-70 1.

Kroger is one of the largest retailers in the world based on sales. Its revenues are predominately earned, and cash is generated as consumer products are sold to customers in its stores, fuel centers, and via our online platforms. It manufactures and processes some of the food available in its supermarkets. Sprouts Farmers Market operates as a healthy grocery store that has made healthy living accessible to shoppers for nearly two decades by offering affordable, fresh, natural and organic products. They do offer various private label food products.

The fiscal year-end for Kroger is on the Saturday nearest to January 31. Its most current fiscal year-end is February 1, 2020. Sprouts' fiscal year ends on the Sunday closest to December 31. Its most current fiscal year-end is December 29, 2019. The fiscal year-ends are expected to be similar because the two companies are in the same industry and follow the same major trends in sales.

Balance sheet information: a.

Kroger (as on February 1, 2020): Assets = $45,256,000,000 Liabilities = $36,663,000,000 ($14,243,000,000 + $22,420,000,000 ) Stockholders’ equity = $8,573,000,000 Sprouts (as on December 29, 2010): Assets = $2,722,983,000 Liabilities = $2,141,031,000 ($416,812,000 + $1,724,219,000) Stockholders’ equity = $581,952,000

Kroger (as on February 1, 2020): Current assets = $10,890,000,000 Current liabilities = $14,243,000,000 Sprouts (as on December 29, 2010): Current assets = $387,839,000 Current liabilities = $416,812,000

Kroger’s current assets are approximately 76% of its current liabilities. Kroger reported working capital of -$3,353,000,000 ($10,890,000,000 − $14,243,000,000) and a current ratio of 0.76 ($10,890,000,000/$14,243,000,000). The liquidity picture of Sprouts is similar. Sprouts reports working capital of -$28,973,000 ($387,839,000 − $416,812,000) and a current ratio of 0.93 ($387,839,000 / $416,812,000). Both companies may have to seek additional financing to pay off the liabilities coming due in the next year.

Kroger has almost 17 times the total assets of Sprouts. Thus, Kroger is a much larger company.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Case 1-70 (Continued) 4.

Income statement information: a.

Kroger (for the fiscal year ending February 1, 2020): Revenues ...................................................................... Expenses ....................................................................... Net income ...................................................................

$ 122,286,000,000 120,627,000,000 $ 1,659,000,000

Sprouts (for the fiscal year ending December 29, 2010): Revenues ...................................................................... Expenses ....................................................................... Net income ...................................................................

$ 5,634,835,000 5,485,206,000 $149,629,000

* $120,035,000,000 + $270,000,000 + $469,000,000 +-$147,000,000 ** $5,634,835,000 *** $3,740,017,000 + $1,677,458,000 + $21,192,000 +$46,539,000

For Sprouts, revenues show an increasing trend through the 3 years presented. Cost of sales and other expenses have correspondingly increased, resulting in relatively stable income. Kroger shows relatively stable revenues, costs, and income. This stability is reflected in the earnings per share information, which has remained relatively stable also.

Obtained from the statements of cash flows for each of the companies: Kroger: In addition to operating activities, its major source of cash includes borrowings related to long-term debt and sales of businesses. Major uses of cash include capital expenditures (purchases of property, plant, and equipment) and repayment of borrowings. Sprouts: Its major sources of cash arise from its operations as well as proceeds from revolving credit facilities (long-term borrowings). Major uses of cash include capital expenditures, repayment of borrowings, and repurchases of common stock.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Annual Report Problem 1. a. $19,810 million b. $18,375 million c. $110,225 million d. $72,653 million e. $21,729 million 2.

a. $20,810 million b. $20,375 million c. $115,736 million d. $76,286 million e. $22,815 million

3. a. The Home Depot, Inc. b. HD c. Atlanta, GA d. 1.02 e. $39,541 million f. $16,635 million

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Case 1-72 1.

The first concern for Front Row Entertainment is to obtain financing for the business. Normally, a concert promoter must pay a significant amount of up-front cash to secure the venue and advertise the tour. Therefore, it is critical that Front Row Entertainment raise a large amount of cash if the business is to succeed. This cash may be raised by issuing debt (e.g., notes payable, bonds payable), shares of stock (e.g., common stock), or a combination of both. Next, Front Row Entertainment must purchase the assets necessary to operate. Because a concert promoter provides a service, the initial investment in property, plant, and equipment is likely to be relatively small and involve typical office equipment (e.g., desks, telephones, computers). These assets are normally combined and reported as equipment on the balance sheet. The business can now begin to operate. Revenues (e.g., sales revenue, service revenue) will be generated as Front Row Entertainment fulfills its contractual duties (e.g., sells tickets). One of the major expenses for a concert promoter would be the fees paid to the musical artist upon completion of the event (reported as cost of sales). In addition, Front Row Entertainment will likely incur large expenses initially as it books the venue and advertises the concert. Typical expenses may include rent expense (for office space of the business as well as a rental fee on the venue), utilities expense, salaries expense (for Cam and Anna’s salaries), advertising expense, and insurance expense. Some of these expenses may be prepaid (resulting in accounts such as prepaid advertising or prepaid rent), while payment for others may be delayed (resulting in accounts such as accounts payable, salaries payable, and rent payable).

Cam and Anna can choose to organize Front Row Entertainment as either a partnership or a corporation. Relative to the corporate form of organization, partnerships are easier to organize. In addition, the control of the partnership would be shared by Cam and Anna, and the business would have access to the financial resources and skills of each partner. Finally, a partnership would also pay less taxes than a corporation. This is because the corporate tax rate is higher than the individual tax rate and the corporation’s income is taxed twice: once at the corporate level and again at the stockholder level as earnings are distributed. However, the corporate form also has advantages. First, it can raise larger amounts of resources through the issuance of stock. Second, the corporate form limits the liability of its stockholders to the amount they have invested in the business. If the business were to fail, shareholders would only lose their investment. On the other hand, creditors could attempt to recover their losses from the personal assets of the partners. Finally, corporations have an unlimited life, with ownership easily transferred by the sale of stock. However, partnerships are dissolved when any partner leaves the partnership. Cam and Anna need to carefully weigh the advantages and disadvantages of each form of business organization and select the form that best fits their needs.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 1: Accounting and the Financial Statements

Case 1-72 (Continued) 3.

Cam and Anna will need to prepare four basic financial statements: a balance sheet, an income statement, a retained earnings statement, and a statement of cash flows. A balance sheet reports the resources (assets) owned by a company and the claims against those resources (liabilities and stockholders’ equity) at a specific point in time. By providing information about the structure of assets, liabilities, and stockholders’ equity, a balance sheet provides users insights into whether a company can pay its obligations as they become due (liquidity). An income statement reports how well a company has performed its operations (revenues, expenses, and income) over a period of time. By providing information about a company’s current profitability, users are better able to judge a company’s ability to generate future income and growth potential. Such information impacts the decision of whether to make a loan to the company or invest in the company. A retained earnings statement reports how much of a company’s income was retained in the business and how much was distributed to owners over a period of time. Insights into a company’s dividend policy assist investors in determining a company’s ability to pursue future growth opportunities. Finally, a statement of cash flows reports the sources and uses of a company’s cash over a period of time. This information allows investors and creditors to judge the ability of a company to generate cash in the future, as well as to assess the creditworthiness of a company and its ability to pay future dividends.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

THE ACCOUNTING INFORMATION SYSTEM

DISCUSSION QUESTIONS 1.

The conceptual framework of accounting is the collection of general concepts that logically flow from the objective of financial reporting—to provide information that is useful in making business and economic decisions. The conceptual framework supports the development of generally accepted accounting principles (GAAP) and provides a consistent body of thought for financial reporting. An understanding of the conceptual framework will provide a logical structure to financial accounting that will help in understanding complex accounting standards.

The conceptual framework identifies two fundamental qualitative characteristics: relevance and faithful representation. Relevant information is capable of making a difference in a decision by helping users predict future events or providing feedback about prior expectations. Relevant information is also material. Faithfully represented information portrays the economic event it intends to portray. Faithfully represented information should be complete (includes all necessary information for the user to understand the economic event), neutral (unbiased), and free of errors (as accurate as possible). In addition to the fundamental qualitative characteristics, the FASB has identified four enhancing characteristics: comparability, verifiability, timeliness, and understandability. Comparable information allows external users to identify similarities and differences between two or more items. Comparability includes consistency, which can be achieved by a company applying the same accounting principles for the same items over time. Verifiable information describes a situation in which independent parties can reach a consensus on the measurement of the activity. Information is timely if it is available to users before it loses its ability to influence decisions. Finally, if users having reasonable knowledge of accounting and business can, with reasonable study effort, comprehend the meaning of the information, it is considered understandable.

Trade-offs are often necessary between the qualitative characteristics. For example, the most relevant information may not be able to be faithfully represented. Similarly, a change in accounting principle may temporarily reduce comparability but improve the relevance of the information. The goal should be to provide the most relevant information that can be faithfully represented.

Comparability refers to the ability to compare information across different companies or with similar information about the same company for another time period. Consistency refers to the use of the same accounting principles for the same items, either from one time period to another time period with in a company or in a single period across companies.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

The cost constraint limits the ability of a company to provide useful information. The cost constraint refers to the idea that some information that is useful would be too expensive for the company to provide based on the benefit that is achieved from providing it.

The four underlying accounting assumptions are the economic entity assumption, going concern assumption, time period assumption, and monetary unit assumption. The economic entity assumption requires that a company be accounted for separately from its owners. The continuity assumption assumes that a company will continue to operate long enough to carry out its existing commitments. The time-period assumption allows the life of a company to be divided into artificial time periods so that net income can be measured for a specific period of time. The monetary unit assumption requires that a company account for and report its financial results in monetary terms.

There are four principles used to measure and record business transactions. First, the historical cost principle requires transactions to be recorded at their cost: the exchange price at the time the activity occurs. Second, the revenue recognition principle determines when revenue is recorded and reported by a company. Under this principle, revenue is recognized in the period a company satisfies its performance obligation or promise within a contract. Generally, this occurs when services are performed or goods are delivered to customers. Third, the expense recognition principle requires that an expense be recorded and reported in the same period as the revenue it helped generate. This may or may not be in the same period that cash is paid. Fourth, the conservatism principle states that accountants should take care to avoid overstating assets or income.

Many events occur that affect the financial position and the operations of a business but only those that qualify for recognition as transactions are recorded in the accounting records. To qualify as a transaction, the effect of the underlying events must impact a financial statement element (asset, liability, stockholders’ equity, revenue, or expense) and, thus, the company’s financial statements. In addition, the event must be able to be faithfully represented.

Faithful representation refers to information faithfully representing the economic event that it is intending to portray. Faithfully presented information should be complete, neutral, and error free. If information is not faithfully represented, it may mislead decision-makers. These decision-makers would find it extremely difficult, if not impossible, to use information that is incomplete or subject to significant error and/or bias.

10. Transaction analysis usually begins with gathering the source documents that describe business activities. Accountants must then analyze these documents to determine which transactions should be recognized in the accounting system. If the transaction is to be recorded in the accounting system, the transaction must then be analyzed to determine the effects it will have on the fundamental accounting equation. This

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

analysis involves three steps: (1) write down the accounting equation, (2) identify the financial statement elements that are affected by the transaction, and (3) determine whether the element increased or decreased. 11. Yes, it is possible for a transaction to affect only one side of the accounting equation. While the accounting equation must always remain in balance (meaning that there must always be a dual effect on the accounting equation), these effects can be on the same side of the accounting equation. An example of this is when a customer pays cash for an accounts receivable. Both cash and accounts receivable are asset accounts (on the left side of the equation). One asset, accounts receivable, is decreasing, while another asset, cash, is increasing by the same amount. This results in the accounting equation remaining in balance, even though only one side of the equation was affected. 12. When a firm earns revenue, its net income is increased. When a firm incurs an expense, its net income is decreased. At the end of the accounting period, net income is added to retained earnings, a stockholders’ equity account. Therefore, an increase in revenue increases stockholders’ equity, and a decrease in revenue decreases stockholders’ equity. Likewise, an increase in expense decreases stockholders’ equity, and a decrease in expense increases stockholders’ equity. 13. A T-account is a two-column record that consists of a title and two sides divided by a vertical line. A T-account gets its name because it resembles the capital letter “T.” The left side is referred to as the debit side, and the right side is referred to as the credit side. 14. No, debit does not mean increase, and credit does not mean decrease. The words debit and credit simply refer to the left and right side of an account. Neither debit nor credit has direct positive or negative connotations. Only when the terms debit and credit are associated with a particular account can a debit or a credit be identified as an increase or a decrease. For example, a debit increases an asset account but decreases a liability account. 15. To debit an account means to add an amount to the left side of that account. A debit balance is a balance on the left side of an account. To credit an account means to add an amount to the right side of that account. A credit balance is a balance on the right side of an account. Debits and credits do not represent increases or decreases. 16. The normal balance of each of the accounts is as follows: (a) (b) (c) (d) (e) (f) (g) (h)

cash—debit sales—credit notes payable—credit inventory—debit retained earnings—credit salary expense—debit equipment—debit unearned revenue—credit

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

17. In each journal entry, the sum of the debits must equal the sum of the credits. If transactions are recorded with debits equal to credits, then the equality of the accounting equation will be maintained. 18. “Double-entry” is an appropriate description of an accounting system, because each transaction will affect at least two accounts and each transaction must have debit and credit entries that must be equal. 19. Accounting transactions are typically recorded initially in a journal on an event-byevent basis. The recording of events in a journal allows the entire effect of a transaction to be contained in one place. The individual effects of a transaction are then posted to the general ledger. Potentially, a firm could put these transactions directly into the general ledger. However, if the transaction were recorded directly into the general ledger, there would be no evidence of the complete transaction in one place, which would make the use of the information very cumbersome. 20. Trial balances help detect errors resulting from inequality of debits and credits. A trial balance usually will not help in the detection of omitted entries or errors of analysis, journalizing, or posting when those errors cause incorrect account balances with equal debits and credits. 21. The initial steps of the accounting cycle involve (1) analyzing transactions, (2) journalizing transactions, (3) posting to the general ledger, and (4) preparing a trial balance. In the first step, data are collected about business activities and analyzed to determine which activities meet the criteria for recognition in the accounting records. If the data meet the recognition criteria, the effect on the fundamental accounting equation is determined. In the second step, the effects of the transaction on the fundamental accounting equation are recorded in the accounting system using debits and credits. In the third step, journal entries are posted to the general ledger, which is organized on an account-by-account basis. Finally, a trial balance is prepared from account balances in the ledger.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

MULTIPLE-CHOICE QUESTIONS 2-1.

2-2.

2-3.

2-4.

2-5.

2-6.

2-7.

2-8.

2-9.

2-10. a 2-11. c 2-12. a 2-13. d 2-14. a 2-15. b

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

BRIEF EXERCISES BE 2-16 a. b. c. d. e. f. g.

Relevance; faithful representation Comparability Consistency Understandability Faithful representation Verifiable Timeliness

BE 2-17 a. b. c. d.

Cost versus benefit Relevance Comparability Materiality

BE 2-18 a. b. c. d.

Monetary unit assumption Economic entity assumption Going concern assumption Time period assumption

BE 2-19 a. b. c. d. e. f.

Revenue recognition principle Conservatism principle Historical cost principle Expense recognition principle Revenue recognition principle Expense recognition principle

BE 2-20 a. b. c. d.

Yes, the event qualifies for recognition. Yes, the event qualifies for recognition. Yes, the event qualifies for recognition. No, the event does not qualify for recognition because no financial statement element will be affected until at least one party to the contract performs its responsibility (the service is performed or money is actually exchanged).

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

BE 2-21

a. b. c. d.

Assets + +/− + −

Liabilities NE NE + NE

Stockholders’ Equity + NE NE −

BE 2-22

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

Assets 50,000 25,000 (25,000) (500) 10,000 3,000 (3,000) (2,500) (−800) 2,100

Liabilities 50,000

Stockholders’ Equity Contributed Capital + Retained Earnings

(500) 10,000

(2,500) (−800) 2,100

BE 2-23

a. b. c. d. e. f. g. h. i. j.

Account Accounts Payable Accounts Receivable Retained Earnings Service Revenue Equipment Common Stock Salary Expense Repair Expense Cash Notes Payable

Normal Balance Credit Debit Credit Credit Debit Credit Debit Debit Debit Credit

Debit Decrease Increase Decrease Decrease Increase Decrease Increase Increase Increase Decrease

Credit Increase Decrease Increase Increase Decrease Increase Decrease Decrease Decrease Increase

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

BE 2-24 Date Jan.

Journal Account and Explanation 1 Cash Notes Payable

Debit 50,000

Credit 50,000

4 Equipment Cash

25,000

6 Rent Expense Cash

500

25,000

500

15 Accounts Receivable Service Revenue

10,000

25 Cash Accounts Receivable

3,000

10,000

3,000

28 Land Cash Notes Payable

200,000

30 Salaries Expense Cash

2,500

10,000 190,000

2,500

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

BE 2-25 Beg. Bal. Jan. 1

Cash 12,000 50,000

End. Bal.

25,000 500 3,000 10,000 2,500 27,000

Beg. Bal. Jan. 4

Equipment 5,000 25,000

End. Bal.

30,000

Jan. 25

Service Revenue 19,500 10,000 29,500

Beg. Bal. Jan. 4 Jan. 6 Jan. 28 Jan. 30

Jan. 15

Accounts Receivable 6,300 10,000 3,000

End. Bal.

13,300 Notes Payable 0 50,000 190,000 240,000

Beg. Bal. Jan. 15 End. Bal.

Beg. Bal. Jan. 30 End. Bal.

1,000 500

End. Bal.

1,500

Beg. Bal. Jan. 1 Jan. 28 End. Bal.

Salary Expense 5,000 2,500 7,500

Rent Expense

Beg. Bal. Jan. 6

Jan. 25

Land Beg. Bal Jan. 28 End. Bal.

0 200,000 200,000

BE 2-26 Borges Inc. Trial Balance December 31 Account Cash .................................................................................................... Accounts Receivable ............................................................................ Equipment ........................................................................................... Accounts Payable ................................................................................. Common Stock..................................................................................... Dividends ............................................................................................ Service Revenue................................................................................... Rent Expense ....................................................................................... Salaries Expense .................................................................................. Advertising Expense .............................................................................

Debit $ 12,850 5,700 12,725

Credit

$ 2,825 15,000 1,500 23,150 2,400 4,300 1,500 $40,975

$ 40,975

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

EXERCISES E 2-27 1. a. b. c. d. 2.

Timeliness Verifiability Understandability Relevance

e. f. g. h.

Relevance Faithful representation Comparability Faithful representation

The conceptual framework flows logically from the fundamental objective of financial reporting—to provide information that is useful for making investment and credit decisions—and its purpose is to support the development of a consistent set of accounting standards and provide a consistent body of thought for financial reporting. The conceptual framework provides a logical structure to financial accounting and helps to explain “why” accountants adopt certain practices.

E 2-28 1. 2. 3. 4.

e. a. d. f.

Historical cost Economic entity Monetary unit Revenue recognition

5. 6. 7. 8.

b. c. h. g.

Going-concern Time-period Conservatism Expense recognition

E 2-29 1. and 2. a. b.

c. d. e.

Yes, the event qualifies for recognition. No, the agreement does not qualify for recognition because no financial statement element will be affected until at least one party to the contract performs its responsibility (the service is performed or money is actually exchanged). Yes, the event qualifies for recognition. Yes, the event qualifies for recognition. No, this transaction does not qualify for recognition in the financial statements of the company because it does not affect the overall common stock of the company. This transaction is between two entities (the individual investors) that are separate from the company. Yes, the event qualifies for recognition.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-30 1. and 2. a. Qualify. b. Does not qualify. The accounting equation has not been affected by ordering the product. When the cash register is delivered or paid for, one of the parties to the contract will have performed, and the transaction will qualify for recording. c. Qualify. d. Does not qualify. It has to do with the owner’s personal transactions, not the company’s transactions. e. Does not qualify. The extension does not affect the accounting equation. Once one of the parties performs according to the contract (the store is occupied in March or rent is paid), the transaction will be recorded. f. Qualify. g. Qualify.

E 2-31 1.

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

Increase assets (cash) $2,900 and increase stockholders’ equity (revenue) $2,900. Increase assets (accounts receivable) $1,650 and increase stockholders’ equity (revenue) $1,650. Increase assets (land) $100,000 and decrease assets (cash) $100,000. Increase assets (supplies) $800 and increase liabilities (accounts payable) $800. Decrease assets (cash) $1,200 and decrease stockholders’ equity (dividend) $1,200. Decrease assets (cash) $725 and decrease liabilities (accounts payable) $725. Decrease assets (cash) $1,500 and decrease stockholders’ equity (expense) $1,500. Increase assets (cash) $860 and decrease assets (accounts receivable) $860. Increase assets (cash) $200,000 and increase stockholders’ equity (common stock) $200,000.

For transaction d, supplies were recorded as an asset at their historical cost—the exchange price of the transaction. Later, as the supplies are used, the expense recognition principle will guide the amount of supplies that will be expensed. This application of the principle will be discussed more fully in Chapter 3.

E 2-32

a. b. c. d. e. f. g. h. i. j. k.

Assets 300,000 (80,000) 80,000 2,120 (2,120) (1,200) 4,480 (2,200) (850) (1,640) 1,910 (400)

Liabilities

Stockholders’ Equity Contributed Capital + Retained Earnings 300,000

2,120 (2,120) (1,200) 4,480 (2,200) (850) (1,640)

1,910 (400)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-33 1.

a. b. c. d. e. f. 2.

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

Assets 875,000 (875,000) 125,000 86,000 10,400 (10,400) (36,250) (5,000)

Liabilities

Stockholders’ Equity Contributed Retained Capital + Earnings

125,000 86,000

(36,250) (5,000)

Investing Financing Investing Operating Operating Financing

E 2-34 a. b. c. d.

This transaction is a result of purchasing land for cash. This transaction is a result of paying cash for an expense (e.g., rent expense) or a result of paying cash for dividends. This transaction is a result of issuing common stock in exchange for cash. This transaction is a result of borrowing cash.

E 2-35

a. b. c. d. e. f. g. h. i. j. k.

Assets 100,000 60,000 (42,000) 42,000 (9,000) 9,000 7,100 19,250 (10,200) (13,500) 13,500 1,680 (1,100) (1,680)

Liabilities

Stockholders’ Equity Contributed Retained Capital + Earnings 100,000

60,000

7,100 19,250 (10,200)

1,680 (1,100) (1,680)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-36

Assets 15,000 1,500 50,000 (8,500) 2,400 (500)

a. b. c. d. e.

Liabilities 15,000

Stockholders’ Equity Contributed Retained Capital + Earnings 1,500

41,500 2,400 (500)

E 2-37 a. b. c. d.

This transaction is the result of purchasing equipment for cash. This transaction is the result of performing services (generating revenue) in exchange for cash. This transaction is the result of purchasing supplies on account (on credit). This transaction is the result of the use of supplies.

E 2-38 Account Accounts Payable Accounts Receivable Accumulated Depreciation (Equipment) Advertising Expense Cash Common Stock Cost of Goods Sold Depreciation Expense (Equipment) Equipment Interest Expense Inventory Notes Payable Retained Earnings Sales Revenue Utilities Expense

Debit

Credit X

X X X X X X X X X X X X X X

Financial Statement Balance Sheet Balance Sheet Balance Sheet Income Statement Balance Sheet Balance Sheet Income Statement Income Statement Balance Sheet Income Statement Balance Sheet Balance Sheet Balance Sheet, Retained Earnings Statement Income Statement Income Statement

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-39

Assets Increase (Debit) Increase (Debit) Decrease (Credit) Increase (Debit) Decrease (Credit) Increase (Debit) Increase (Debit) Increase (Debit) Decrease (Debit) Increase / Decrease (Debit) / (Credit) Decrease (Credit)

a. b. c. d. e. f. g. h. i. j.

Liabilities Increase (Credit) Increase (Credit)

Stockholders’ Equity Contributed Retained Capital + Earnings

Decrease (Debit) Increase (Credit)

Increase (Credit)

Decrease (Debit) Increase (Credit) Increase (Credit) Increase (Credit)

Decrease (Debit)

E 2-40 Transaction a. b. c. d.

e. f. g.

Account Land Cash Equipment Notes Payable Supplies Accounts Payable Notes Payable Interest Expense Cash Accounts Payable Cash Accounts Receivable Service Revenue Cash Service Revenue

Increase/ Decrease Increase Decrease Increase Increase Increase Increase Decrease Increase Decrease Decrease Decrease Increase Increase Increase Increase

Debit / Credit Debit Credit Debit Credit Debit Credit Debit Debit Credit Debit Credit Debit Credit Debit Credit

Amount $65,000 $65,000 $26,400 $26,400 $1,200 $1,200 $20,000 $700 $20,700 $3,550 $3,550 $61,300 $61,300 $12,800 $12,800

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-40 (Continued) Transaction h. i. j.

Account Cash Accounts Receivable Wages Expense Cash Cash Common Stock

Increase/ Decrease Increase Decrease Increase Decrease Increase Increase

Debit / Credit Debit Credit Debit Credit Debit Credit

Amount $26,910 $26,910 $12,760 $12,760 $45,000 $45,000

E 2-41 Journal Account and Explanation

Date Mar.

Cash Service Revenue

Debit 51,000

51,500

Inventory Accounts Payable

1,800

Wages Expense Cash

9,200

Rent Expense Cash

1,000

Trucks Cash Notes Payable

40,800

Cash Accounts Receivable

1,050

1,800

9,200

1,000

1,000 39,800

1,050

Accounts Payable Cash

950

Cash Notes Payable

10,000

Utilities Expense Cash

185

Advertising Expense Cash

Credit

950

10,000

185 1,550

1,550

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-42 1.

Journal Account and Explanation

Date Nov.

Dec.

Cash Service Revenue

Debit 2,200

Credit 2,200

Supplies Accounts Payable

3,865

Wages Expense Cash

6,220

Accounts Payable Cash

3,865

Utilities Expense Cash

1,950

Repairs & Maintenance Expense Accounts Payable

1,630

Accounts Payable Cash

1,630

3,865

6,220

3,865

1,950

1,630

The recording of the November 10 transaction was based on the expense recognition principle. Remington’s workers helped to produce revenue in November. Therefore, the wages expense that was part of Remington’s normal operations needs to be recorded in the same period as the revenue.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-43 Date Jan.

Journal Account and Explanation 14

Feb.

Mar.

May

June

Cash Common Stock

Debit 80,000

80,000

Cash Notes Payable

45,000

Land Buildings Cash Notes Payable

30,000 60,000

Buildings Cash

4,000

Buildings Accounts Payable

11,000

Accounts Payable Cash

11,000

Supplies Cash

Credit

45,000

34,000 56,000

4,000

11,000

11,000 650

650

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-44 1.

Journal Account and Explanation

Date Jan.

Feb.

Apr.

May

June

Cash Common Stock

Debit 10,000

Credit 10,000

Supplies Accounts Payable

720

Accounts Payable Cash

720

Accounts Receivable Service Revenue

12,500

Cash Accounts Receivable

12,500

Accounts Receivable Service Revenue

9,500

Wages Expense Cash

6,700

12,500

9,500

6,700

2. Jan. 15 May 12 End. Bal.

Cash 10,000 720 12,500 6,700 15,080

Jan. 24 End. Bal.

Supplies 720 720

Feb. 20 June 24

Apr. 25 June 5 End. Bal.

Feb. 20

Common Stock 10,000 10,000

Jan. 15 End. Bal.

Service Revenue 12,500 9,500 22,000

Apr. 25 June 5 End. Bal.

June 24 End. Bal.

Accounts Receivable 12,500 12,500 9,500 9,500 Accounts Payable 720 720 0

May 12

Jan. 24 End. Bal.

Wages Expense 6,700 6,700

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E 2-44 (Continued) 3.

Rosenthal Decorating Inc. Trial Balance June 30

Debit $15,080 9,500 720

6,700 $32,000

Credit

$10,000 22,000 _______ $32,000

E 2-45 Badger Auto Parts Trial Balance December 31 Account Cash .................................................................................................... Accounts Receivable ............................................................................ Prepaid Rent ........................................................................................ Inventory ............................................................................................. Accumulated Depreciation (Furniture) .................................................. Accounts Payable ................................................................................. Interest Payable ................................................................................... Income Taxes Payable .......................................................................... Notes Payable (Long-term) ................................................................... Common Stock..................................................................................... Retained Earnings, Jan. 1 ...................................................................... Sales Revenue ...................................................................................... Cost of Goods Sold ............................................................................... Advertising Expense ............................................................................. Utilities Expense .................................................................................. Depreciation Expense (Furniture) ......................................................... Interest Expense .................................................................................. Income Taxes Expense .........................................................................

Debit $ 3,200 40,800 15,250 60,500

Credit

$ 47,300 8,500 1,800 3,600 50,000 100,000 15,900 264,700 184,300 29,200 9,700 10,400 6,650 3,800 $491,800

_________ $ 491,800

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

E2-46 Mason Company Trial Balance December 31 Account Cash .................................................................................................... Accounts Receivable ............................................................................ Supplies ............................................................................................... Prepaid Insurance ................................................................................ Accounts Payable ................................................................................. Salaries Payable ................................................................................... Unearned Service Revenue................................................................... Notes Payable ...................................................................................... Common Stock..................................................................................... Dividends ............................................................................................ Retained Earnings ................................................................................ Service Revenue................................................................................... Insurance Expense ............................................................................... Salaries Expense .................................................................................. Supplies Expense .................................................................................

Debit $20,000 10,300 1,200 1,900

Credit

$ 3,000 1,900 2,100 3,100 10,000 2,000 8,000 19,200 1,500 9,500 900 $47,300

_______ $47,300

E 2-47 a. b. c. d. e.

The trial balance WILL balance but there is still an error. The transaction was recorded at an incorrect dollar amount. Supplies will be overstated by $36 and cash will be understated by $36. The trial balance will not balance; sales will be overstated by $54. The trial balance will balance; both accounts will be overstated. The trial balance will balance; accounts payable will be overstated by $5,270 and cash will be overstated by $5,270. The trial balance WILL NOT balance; accounts receivable will be understated by $7,600.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

PROBLEM SET A P 2-48A 1.

a. This transaction does not qualify for recognition because receiving a new price list does not affect the accounting equation. Boatsman must enter into a sales contract with one if its customers and there must be performance under the contract (e.g., merchandise is delivered or a service is performed by Boatsman or the customer makes a cash payment) before the transaction is recorded. b. This transaction does not qualify for recognition because the offer does not affect the accounting equation. When there is performance under the contract (property or money is exchanged), the transaction will be recorded. c. This transaction does qualify for recognition because the receipt of cash by Boatsman and the delivery of the deed constitute performance. Assets (cash and land) have been affected by this transaction. d. This transaction does not qualify for recognition, because the total of common stock of Boatsman has not changed as a result of this transaction. This transaction does not involve Boatsman but two other entities: two stockholders. e. This transaction does qualify for recognition, because Boatsman has incurred an expense (maintenance) that will lower stockholders’ equity. The actual performance of the service by the dealer leads to recognition by Boatsman, regardless of whether Boatsman has paid the dealer for the maintenance. Item d illustrates the economic entity assumption—the transactions of a company are accounted for separately from its owners.

P 2-49A 1.

a. b. c. d. e. f. g. h. i. j. k. l.

Cash + 8,000 15,000 (850)

Assets Accounts Receivable + Supplies 15,900 4,100

= =

2,250 8,000 (1,080) (2,150) 4,700 (3,180) 1,920 (500) 1,290 (1,000) 31,410 +

Liabilities + Equity Accounts Notes Common Retained Payable + Payable + Stock + Earnings 2,500 4,000 12,000 9,500 15,000 (850)** 2,250 8,000 (1,080) (2,150)** 4,700* (3,180)** 1,920*

500 (1,290) 16,530

3,670

12,000 +

27,000 +

(1,000) 8,940

*Revenues = $4,700 + $1,920 = $6,620 **Expenses = $850 + $2,150 + $3,180 = $6,180

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-49A (Continued) 2.

Madero Accounting Services Trial Balance August 31

Debit $31,410 16,530 3,670

Credit

$ 3,670 12,000 27,000 9,500 1,000 6,620 6,180 $58,790

_______ $58,790

P 2-50A 1.

July 2: July 4: July 5: July 7: July 9: July 11: July 14:

Common stock was issued for $1,000 cash. Bought $250 of supplies on account. Paid $150 on a previous account payable. Performed services for cash of $2,500. Bought land for $700 cash. Received cash of $150 for payment of an account receivable. Paid a $750 expense with cash. Chen Construction Company Trial Balance July 31

Debit $2,250 1,250 1,000 3,700

_____ $8,200

Credit

$1,200 5,000 2,000 $8,200

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-51A Account Accounts Payable. Accounts Receivable. Accumulated Depreciation. Cash. Common Stock. Depreciation Expense. Equipment. Income Taxes Expense. Interest Expense. Land. Notes Payable. Prepaid Rent. Retained Earnings. Salaries Expense. Service Revenue. Supplies.

Type of Account Liability Asset Contra Asset Asset Equity Expense Asset Expense Expense Asset Liability Asset Equity Expense Revenue Asset

Normal Balance Credit Debit Credit Debit Credit Debit Debit Debit Debit Debit Credit Debit Credit Debit Credit Debit

Increase Credit Debit Credit Debit Credit Debit Debit Debit Debit Debit Credit Debit Credit Debit Credit Debit

Decrease Debit Credit Debit Credit Debit Credit Credit Credit Credit Credit Debit Credit Debit Credit Debit Credit

Debit 38,900

Credit

P 2-52A Journal Account and Explanation

Date Sept.

5 8 10 11 12 18 22 23 28 30

Trucks Cash Inventory Accounts Payable Supplies Accounts Payable Cash Service Revenue Accounts Receivable Service Revenue Wages Expense Cash Cash Accounts Receivable Cash Notes Payable Cash Common Stock Dividends Cash

38,900 4,200 4,200 1,250 1,250 13,600 13,600 2,400 2,400 4,750 4,750 2,400 2,400 20,000 20,000 35,000 35,000 3,250

3,250

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-53A 1.

Journal Account and Explanation

Date June

Cash Common Stock

Debit 25,000

25,000

Supplies Accounts Payable

1,675

Trucks Cash Notes Payable

13,700

Wages Expense Cash

4,230

Accounts Receivable Service Revenue

10,340

Cash Accounts Receivable

6,100

Cash Service Revenue

Credit

1,675

1,500 12,200

4,230

10,340

6,100 520

520

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-53A (Continued) 2. June 1 26 29 End. Bal.

Cash 25,000 1,500 6,100 4,230 520 25,890

June 3 End. Bal.

Supplies 1,675 1,675

June 14 End. Bal.

June 8 14

Accounts Payable 1,675 1,675

June 3 End. Bal.

Common Stock 25,000

June 1

25,000

End. Bal.

June 22

Accounts Receivable 10,340 6,100

End. Bal.

4,240

June 8 End. Bal.

Trucks 13,700 13,700

June 26

Notes Payable 12,000 12,200

June 8 End. Bal.

Service Revenue 10,340 520 10,860

June 22 29 End. Bal.

Wages Expense 4,230 4,230

P 2-54A 1.

Asset

Liabilities

Equity

22,000

(13,500)

(5,320)

(58,800)

128,200

146,850

18,650 f.

(59,110)

(3,500)

109,400 (109,400)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-54A (Continued) Date a.

f.*

Journal Account and Explanation Cash Common Stock

Debit 22,000

22,000

Rent Expense Cash

13,500

Utilities Expense Cash

5,320

Wages Expense Cash

58,800

Cash Accounts Receivable Service Revenue

18,650 128,200

Supplies Expense Cash

59,110

Dividends Cash

3,500

Cash Accounts Receivable

Credit

13,500

5,320

58,800

146,850

59,110

3,500 109,400 109,400

* An alternative answer would involve making the following two entries: Supplies ............................................................................................................. Cash ........................................................................................................... Supplies Expense ............................................................................................... Supplies .....................................................................................................

59,110 59,110 59,110

59,110

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-54A (Continued) 3. (a) (e) (h)

End. Bal.

Cash 22,000 13,500 18,650 5,320 109,400 58,800 59,110 3,500 9,820 Common Stock 22,000 22,000 Service Revenue 146,850 146,850

Utilities Expense 5,320 5,320

(f) End. Bal.

Supplies Expense 59,110 59,110

(b) (c) (d) (f) (g)

(a) End. Bal.

(e) End. Bal.

(e)

Accounts Receivable 128,200 109,400

End. Bal.

18,800

(g) End. Bal.

Dividends 3,500 3,500

(b) End. Bal.

Rent Expense 13,500 13,500

(d) End. Bal.

Wages Expense 58,800 58,800

(h)

4. Karleen’s Catering Service Trial Balance December 31 Account Cash .................................................................................................... Accounts Receivable ............................................................................ Common Stock…………………………………………………………………………............ Dividends ............................................................................................ Service Revenue................................................................................... Rent Expense ....................................................................................... Utilities Expense .................................................................................. Wages Expense .................................................................................... Supplies Expense .................................................................................

Credit $ 9,820 18,800

Debit

$ 22,000 3,500 146,850 13,500 5,320 58,800 59,110 $ 168,850

________ $ 168,850

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-55A 1. and 3. Beg. Bal. (b) (c)

End. Bal.

(d)

Cash 16,300 58,000 384,000 5,000 983,000 56,000 702,000 22,200 19,700 520,400

(d) (e) (f) (g) (h) (i)

Beg. Bal. (a)

Accounts Receivable 384,000 384,000 994,000 983,000

End. Bal.

11,000

(b) (c)

Accounts Payable 11,900 11,900

Beg. Bal. End. Bal.

(h)

Interest Payable 11,200 11,200 0

Beg. Bal. End. Bal.

Rent Payable 10,000 10,000 0

Beg. Bal. End. Bal.

(e)

Insurance Payable 1,000 1,000 0

Beg. Bal. End. Bal.

Common Stock 165,000 165,000

Beg. Bal. End. Bal.

Service Revenue 994,000 994,000

(a) End. Bal.

Notes Payable 100,000 100,000 Retained Earnings 101,200 101,200

(d) End. Bal.

Rent Expense 48,000 48,000

(e) End. Bal.

Insurance Expense 4,000 4,000

(f) End. Bal.

Utilities Expense 56,000 56,000

(g) End. Bal.

Salaries Expense 702,000 702,000

(h) End. Bal.

Interest Expense 11,000 11,000

(i) End. Bal.

Income Taxes Expense 19,700 19,700

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-55A (Continued) 2. Date a.

Journal Account and Explanation Accounts Receivable Service Revenue

Debit 994,000

Credit 994,000

Cash Accounts Receivable

384,000

Cash Accounts Receivable

983,000

Rent Payable Rent Expense Cash Insurance Payable Insurance Expense Cash

10,000 48,000

Utilities Expense Cash

56,000

Salaries Expense Cash

702,000

Interest Payable Interest Expense Cash

11,200 11,200

Income Taxes Expense Cash

19,700

384,000

983,000

58,000 1,000 4,000 5,000

56,000

702,000

22,200

19,700

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-55A (Continued) 4.

Western Sound Studios Trial Balance December 31

Account Cash .................................................................................................... Accounts Receivable ............................................................................ Accounts Payable ................................................................................. Notes Payable ...................................................................................... Common Stock..................................................................................... Retained Earnings ................................................................................ Service Revenue................................................................................... Rent Expense ...................................................................................... Insurance Expense ............................................................................... Utilities Expense .................................................................................. Salaries Expense .................................................................................. Interest Expense .................................................................................. Income Taxes Expense .........................................................................

Debit $520,400 11,000

Credit

$11,900 100,000 165,000 101,200 994,000 48,000 4,000 56,000 702,000 11,000 19,700 $1,372,100

_________ $1,372,100

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

PROBLEM SET B P 2-48B 1. a.

This transaction does not qualify for recognition because simply signing a contract does not affect the accounting equation. When there is performance under the contract (e.g., products or cash are exchanged), the transaction will be recorded.

This transaction does not qualify for recognition because selling stock to another person does not affect the total amount of common stock outstanding for the company. This transaction does not involve Malcolm Motors but two other entities—two stockholders.

This transaction does qualify for recognition because the transaction affects two accounting elements—cash and the amount of stock outstanding have been increased.

This event does qualify for recognition. While there is no external event affecting the accounting equation (e.g., no cash is being paid for the building), Malcolm must still recognize depreciation as it occupies the building. The concept of depreciation was introduced in Chapter 1 and will be discussed more completely in Chapters 3 and 7.

This event does not qualify for recognition because Malcom Motors does not pay to use the land. Unlike other physical assets, land is not depreciated so there is no periodic cost to recognize. Therefore, the accounting equation has not been affected.

This transaction does qualify to be recorded because two accounting elements have been affected—Malcom Motors has incurred an expense, which lowered its stockholders’ equity, and has paid cash, which lowered its assets.

This transaction does qualify for recognition because two accounting elements have been affected—Malcom Motors has incurred an expense, which lowered its stockholders’ equity, and has incurred a liability that will be paid in the future.

2. Item b illustrates the economic entity assumption—the transactions of a company are accounted for separately from its owners.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-49B 1.

a. b. c. d. e. f. g. h. i. j.

Cash + 3,000 12,000 3,850 925

Assets Accounts Receivable + Supplies 6,600 4,800

= =

Liabilities + Equity Accounts Notes Common Retained Payable + Payable + Stock + Earnings 500 1,000 10,000 2,900 12,000 3,850

(925) 1,140

1,140 (875)

(875) 2,980 (1,350) (800) (1,340) (500) 14,910 +

8,655 +

5,940

765

1,000 +

22,000

2,980* (1,350)** (800)** (1,340)** (500) + 5,740

* Revenues = $3,850 + $2,980 = $6,830 ** Expenses = $1,350 + $800 + $1,340 = $3,490

Emerson Consulting Inc. Trial Balance January 31 Account Cash .................................................................................................... Accounts Receivable ............................................................................ Supplies ............................................................................................... Accounts Payable ................................................................................. Notes Payable ...................................................................................... Common Stock..................................................................................... Retained Earnings ................................................................................ Dividends ............................................................................................ Revenue .............................................................................................. Expenses .............................................................................................

Debit $14,910 8,655 5,940

Credit

765 1,000 22,000 2,900

500 3,490 $33,495

6,830 _______ $33,495

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-50B 1.

April 3: April 8: April 9: April 11: April 15: April 18: April 24:

Received cash from a bank loan of $2,000. Purchased equipment with cash for $700. Paid an accounts payable with cash for $325. Used supplies of $140 (an expense). Purchased $150 of supplies with cash. Performed services in exchange for cash of $1,500. Received $375 in payment of an account receivable from a customer.

Brilliant Minds Inc. Trial Balance April 30

Debit $3,200 325 910 1,900

______ $6,335

Credit

$300 2,000 2,000 2,035 $6,335

P 2-51B Account Accounts Payable Accounts Receivable Bonds Payable Building Cash Common Stock Copyright Cost of Goods Sold Depreciation Expense Income Taxes Expense Income Taxes Payable Insurance Expense Interest Expense Inventory Investments Retained Earnings Sales Revenue Unearned Revenue Utilities Expense

Type of Account Liability Asset Liability Asset Asset Equity Asset Expense Expense Expense Liability Expense Expense Asset Asset Equity Revenue Liability Expense

Normal Balance Credit Debit Credit Debit Debit Credit Debit Debit Debit Debit Credit Debit Debit Debit Debit Credit Credit Credit Debit

Increase Credit Debit Credit Debit Debit Credit Debit Debit Debit Debit Credit Debit Debit Debit Debit Credit Credit Credit Debit

Decrease Debit Credit Debit Credit Credit Debit Credit Credit Credit Credit Debit Credit Credit Credit Credit Debit Debit Debit Credit

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-52B Date Dec.

Journal Account and Explanation Rent Expense Cash

Debit 1,200

Credit 1,200

Cash Notes Payable

25,000

Accounts Receivable Service Revenue

42,600

Supplies Accounts Payable

2,850

Cash Accounts Receivable

20,150

Cash Common Stock

50,000

Wages Expense Cash

13,825

Accounts Payable Cash

1,280

Cash Service Revenue

13,500

Utilities Expense Cash

1,975

25,000

42,600

2,850

20,150

50,000

13,825

1,280

13,500

1,975

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-53B Journal Account and Explanation

Date Sept.

Cash Common Stock

Debit 20,000

20,000

Supplies Cash

1,880

Prepaid Rent Cash

2,400

Advertising Expense Accounts Payable

1,290

Accounts Receivable Service Revenue

2,100

Cash Service Revenue

8,250

Cash Accounts Receivable Wages Expense Cash

Credit

1,880

2,400

1,290

2,100

8,250 835 835 3,970

3,970

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-53B (Continued) 2. Sept. 1 18 25 End. Bal.

Cash 20,000 1,880 8,250 2,400 835 3,970 20,835

Sept. 2 End. Bal.

Supplies 1,880 1,880

Sept. 8 End. Bal.

Sept. 2 5 30

Accounts Payable 1,290 1,290

Sept. 8 End. Bal.

Service Revenue 2,100 8,250 10,350

Sept. 13 18 End. Bal.

Accounts Receivable 2,100 835

Sept. 13

End. Bal.

1,265

Sept. 5 End. Bal.

Prepaid Rent 2,400 2,400 Common Stock 20,000 20,000

Sept. 30

Wages Expense 3,970

End. Bal.

3,970

Sept. 25

Sept. 1 End. Bal.

Advertising Expense 1,290 1,290

P 2-54B 1. a. b. c. d. e. f. g. h. i.

Asset 45,000 18,710 (18,710) 112,880 (87,300) 20,000 (10,200) 2,120 (1,200) (3,250)

Liabilities

Equity 45,000

112,880 (87,300) 20,000 (10,200) 2,120 (1,200)

(3,250)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-54B (Continued) 2. Date a.

Journal Account and Explanation Cash Common Stock

Debit 45,000

Credit 45,000

Equipment Cash

18,710

Cash Service Revenue

112,880

Wages Expense Cash

87,300

Cash Notes Payable

20,000

Rent Expense Cash

10,200

Supplies Accounts Payable

2,120

Accounts Payable Cash

1,200

Utilities Expense Cash

3,250

18,710

112,880

87,300

20,000

10,200

2,120

1,200

3,250

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-54B (Continued) 3. (a) (c) (e)

End. Bal.

Cash 45,000 18,710 112,880 87,300 20,000 10,200 1,200 3,250 57,220

(b) End. Bal.

Equipment 18,710 18,710

(i) End. Bal.

(b) (d) (f) (h) (i)

End. Bal.

(h)

Notes Payable 20,000 20,000

(e) End. Bal.

Service Revenue 112,880 112,880

Utilities Expense 3,250 3,250

(g)

Accounts Receivable 2,120

2,120 Accounts Payable 1,200 2,120 920

(g) End. Bal.

Common Stock 45,000 45,000

(a) End. Bal.

(f) End. Bal.

Rent Expense 10,200 10,200

(d) End. Bal.

Wages Expense 87,300 87,300

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-54B (Continued) 4.

Sweetwater Temporary Clerical Help Service Trial Balance December 31

Account Cash .................................................................................................... Supplies ............................................................................................... Equipment ........................................................................................... Accounts Payable ................................................................................. Notes Payable ...................................................................................... Common Stock..................................................................................... Service Revenue................................................................................... Rent Expense ....................................................................................... Utilities Expense .................................................................................. Wages Expense ....................................................................................

Debit $57,220 2,120 18,710

Credit

$ 920 20,000 45,000 112,880 10,200 3,250 87,300 $178,800

________ $178,800

P 2-55B 1 and 3. Beg. Bal. (b)

End. Bal.

Beg. Bal.

Cash 6,000 8000 699,000 379,000 9,000 28,000 13,000 26,000 10,300 5,000 226,700

Beg. Bal. (a)

Accounts Receivable 130,000 699.000 690,000

End. Bal.

121,000

Supplies 13,000 13,000

Prepaid Rent 96,000 96,000 0

(f) End. Bal.

(g) End. Bal.

Accounts Payable 14,000 14,000

Beg. Bal. End. Bal.

(c)

Interest Payable 8,000 8,000 0

(b)

Beg. Bal. End. Bal.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-55B (Continued) Notes Payable 80,000 80,000 Retained Earnings 16,000 16,000

Beg. Bal. End. Bal.

114,000 114,000

Beg. Bal. End. Bal.

Service Revenue 690,000 690,000

(a) End. Bal.

(f) End. Bal.

Rent Expense 124,000 124,000

(h) End. Bal.

Advertising Expense 26,000 26,000

(d) End. Bal.

Wages Expense 379,000 379,000

Repairs & Maintenance Expense (e) 9,000 End. Bal. 9,000

(j) End. Bal.

Interest Expense 5,000 5,000

(i) End. Bal.

Income Taxes Expense 10,300 10,300

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-55B (Continued) 2. Date a.

Journal Account and Explanation Accounts Receivable Service Revenue Cash* Accounts Receivable

Debit 690,000

690,000 699,000 699,000

Interest Payable Cash

8,000

Wages Expense Cash

379,000

Repairs & Maintenance Expense Cash

Credit

8,000

379,000 9,000 9,000

Rent Expense Prepaid Rent Cash

124,000

Supplies Cash

13,000

Advertising Expense Cash

26,000

Income Taxes Expense Cash

10,300

Interest Expense

5,000

96,000 28,000

13,000

26,000

10,300

5,000 *$570,000 + $129,000 = $699,000

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

P 2-55B (Continued) 4.

Mulberry Services Trial Balance December 31

Account Cash .................................................................................................... Accounts Receivable ............................................................................ Supplies ............................................................................................... Accounts Payable ................................................................................. Notes Payable ...................................................................................... Common Stock..................................................................................... Retained Earnings ................................................................................ Service Revenue................................................................................... Rent Expense ....................................................................................... Advertising Expense ............................................................................. Wages Expense .................................................................................... Repairs & Maintenance Expense .......................................................... Interest Expense .................................................................................. Income Taxes Expense .........................................................................

Debit $226,700 121,000 13,000 $14,000 80,000 114,000 16,000 690,000 124,000 26,000 379,000 9,000 5,000 10,300 $914,000

Credit

_______ $914,000

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

CASES Case 2-56 1.

To qualify as a transaction, the underlying events must impact a financial statement element of the company and must be able to be reliably measured. A reliable measurement is one that is reasonably free from any error and bias and is a faithful representation of what it purports to represent. Prices agreed upon in exchanges between a company and outside (unrelated) parties are usually reasonably free from any error and bias and can serve as the basis for recording the related transaction. The transfer of the building and equipment to the company from Susan Eel, the owner of the company, however, is not an exchange between the company and an outside (unrelated) party; thus, its amount may be biased and a less than faithful representation of the fair value of the building and equipment. Consequently, the amount recorded for the transfer of the building and equipment to the business is open to question. Although the accounts receivable probably involved transactions with outsiders, the absence of supporting documentation for those transactions raises a question about the correctness of their recognition. In general, the absence of source documents to support the amounts recorded for the building, equipment, and accounts receivable violates an important condition for the recording of transactions.

If assets are overstated, assets will need to be reduced so that a correct balance is reflected on the balance sheet. Because the fundamental accounting equation must remain in balance, stockholders’ equity would need to be reduced because the recorded amount for the stock Susan exchanged for the building and equipment would have to be reduced. (Instructor’s Note: Depreciation expense and accumulated depreciation would also be overstated; however, this topic is not covered until later in the text.) If receivables are overstated, sales, net income, and retained earnings are likely also overstated. If accounts payable are understated, it is likely that expenses are understated, as well as net income and retained earnings are overstated.

An independent certified public accountant should be engaged to examine Susan’s financial statements and to recommend their restatement, where necessary. Based on the restated financial statements and an assessment of the future prospects of the business, an offer could be made. Estimating the value of a business is a complex task in which data from many sources (including accounting and nonaccounting information) must be acquired and analyzed. Such estimated values are subject to considerable error.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

Case 2-57 1.

We can analyze the accounts receivable account to determine the amount of cash collected from customers. The journal entry to record credit sales would debit Accounts Receivable and credit Sales Revenue. The collection of an account receivable from a customer requires a debit to Cash and a credit to Accounts Receivable. Therefore, the amount that must be credited to Accounts Receivable to make the ending balance equal to $7,950 must be the amount that customers paid Cable. The calculation of this amount is shown with the T-account next. Beg. Bal. Credit sales End. Bal.

Accounts Receivable 6,325 93,680 92,055 7,950

Collections*

*Collections of $92,055 calculated as $6,325 + $93,680 − $7,950

The cash collected from customers would be classified in the operating section on the statement of cash flows.

We can analyze the wages payable account in a similar way. The journal entry to record the recognition of wages expense is a debit to Wages Expense and a credit to Wages Payable. Payment of wages requires a debit to Wages Payable and a credit to Cash. Therefore, the amount that must be debited to Wages Payable to make the ending balance equal to $3,625 must be the amount that Cable paid its employees.

Wage payments*

Wages Payable 4,960 50,845 49,510 3,625

Beg. Bal. Wages expense End. Bal.

*Wage payments of $50,845 calculated as $4,960 + $49,510 − $3,625

The cash paid for wages would be classified in the operating section of the statement of cash flows.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

Case 2-58 1.

Kathryn has an ethical dilemma known as a conflict of interest. As a top executive for Clean Sweep, she has a professional responsibility to the company. This responsibility to the company is in conflict with her personal responsibility to her family, specifically her son, Ben. This conflict of interest could lead to Kathryn making a decision that is not in the best interests of the company in an effort to help her family.

Kathryn has two major alternatives in this situation. First, she could bring the bookkeeping errors to the attention of the management of Clean Sweep. Such an action would allow her to correct the financial statements of Clean Sweep so that the users of Clean Sweep’s financial statements are provided accurate and reliable information on which to base their decisions. Because the financial statements have not yet been prepared, individuals outside of the company may never know of the errors, and the company will suffer little, if any, harm from these mistakes. However, such an action may have serious personal repercussions. For example, Kathryn may get reprimanded for hiring a relative who was not competent to do the job. Such a reprimand may lead to a below average performance evaluation for Kathryn, which could affect her financially. Second, Kathryn could cover up her son’s mistakes by fixing the errors without telling senior management that any errors were made. Most likely, it is entirely within Kathryn’s responsibility as chief accountant to authorize journal entries that can fix the mistakes and no one may ever question these actions. In addition, because the trial balance still balanced, outside users would have no reason to suspect any errors. If successful, Kathryn would save her family and herself potential embarrassment and financial loss while still protecting the company’s interests. However, if someone (e.g., an auditor) questions these entries and investigates their source, Kathryn would most likely face serious reprimands, and possibly the loss of her job, for covering up the mistakes. The first alternative would be the most ethical choice. Her professional responsibility to the company should come before any personal embarrassment or injury she may suffer.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

Case 2-59 1.

This information was found in the 2019 annual report for Disney on the statement of financial position (the balance sheet): Total Assets Total Liabilities Total Equity

= = =

$193,984,000,000 $100,095,000,000 $93,889,000,000

Note: Disney reports $8,963,000,000 of redeemable noncontrolling interests as "mezzanine" or "temporary equity." It also reports $5,012,000,000 of minority interest in equity of consolidated affiliates (noncontrolling interests) as part of stockholders’ equity. These topics are beyond the scope of this course. 2.

Normal balances are: a. Debit b. Credit c. Credit d. Debit e. Debit f. Debit g. Credit

Additional accounts involved in the transaction are: a. Cash (decreased as payables are paid off) b. Sales Revenue (increased as credit sales are made to customers) c. Cash (increased when more common stock is issued) d. Wages Expense (increased as wages are earned)

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

Case 2-60 1.

Assets

Liabilities

Stockholders’ Equity

Kroger

$45,256,000,000

$36,683,000,000

$8,573,000,000

Sprouts

$2,722,983,000

$2,141,031,000

$581,952,000

The accounting equation for each of these companies balances, as required of a balance sheet. 2. Kroger Beg. Bal. Sales End. Bal.

Accounts Receivable 1,589,000,000 122,286,000,000 122,169,000,000 1,706,000,000

Cash collections*

*Cash collections of $122,169,000,000 were determined as $1,589,000,000, beginning balance + $122,286,000,000 sales − $1,706,000,000 ending balance.

Sprouts Beg. Bal. Sales End. Bal.

Accounts Receivable 40,564,000 5,634,835,000 5,659,686,000 15,713,000

Cash collections*

*Cash collections of $5,656,686,000 were determined as $40,564,000, beginning balance + $5,634,835,000 sales − $15,713,000 ending balance.

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Case 2-60 (Continued) 3. Kroger Date Feb. 1

Feb. 1

Journal Account and Explanation Accounts Receivable Sales Revenue Cash Accounts Receivable

Debit 122,286,000,000

Credit 122,286,000,000

122,169,000,000 122,169,000,000

Sprouts Date Dec. 29

Dec. 29

Journal Account and Explanation Accounts Receivable Sales Revenue Cash Accounts Receivable

Debit 5,634,835,000

Credit 5,634,835,000

5,659,686,000 5,659,686,000

Case 2-61 1.

Smith is trying to recognize expenses in the period in which use of the asset (resource) contributes to the earning of revenue. When an asset is used in several periods, it is necessary to divide its cost between the periods affected, recognizing part of the total cost as expense in each period. This process is supported by the expense recognition concept as it applies to period expenses. This concept will be discussed further in Chapter 3. a. Smith should recognize as an expense the portion of the 3-year insurance coverage that expired during the year. Thus, 1 year of $2,400, or $800, should be included in insurance expense for the current year, and the remainder ($1,600) should appear on the December 31 balance sheet as an asset called Prepaid Insurance. b. Smith should recognize as expense the portion of the building’s cost associated with the current year. The simplest procedure divides the cost of the building, reduced by the anticipated residual value, equally among the 20 years in which the building is used. Thus, 1/20 of $74,000 ($80,000 − $6,000), or $3,700 would be included in depreciation expense for the current year, and the December 31 balance sheet would show accumulated depreciation on the building of $33,300 (9 years  $3,700). c.

Smith should recognize 4/12 of the $1,600 cost of the loan (4/12  $1,600 = $533) as interest expense in the current year. Since this expense is not paid until September 1 of the following year, the December 31 balance sheet must show interest payable of $533. The remaining cost of the loan ($1,600 − $533 = $1,067) is not recognized until next year and does not appear as a payable on the December 31 balance sheet.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 2: The Accounting Information System

Annual Report Problem: 1. a. Total Assets = $51,236,000,000 b. Total Liabilities = $54,352,000,000 2. a. Forecasted Total Assets = $57,384,000,000 b. Forecasted Total Liabilities = $56,256,000,000 3. (a)

Forecasted shareholder’s equity

$ 858,240,000

(b)

What date does Home Depot’s fiscal year end?

January 31, 2021

(c)

What accounting assumption does the fiscal year satisfy?

Time period assumption

(d)

Where does Home Depot discuss revenue recognition?

Note 1 to the Consolidated Financial Statements

(e)

Who is Home Depot’s auditor?

KPMG

(f)

What characteristic of useful information is most associated with the audit report?

Faithful representation

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Case 2-62 1. Date Jan.

Journal Account and Explanation 1 Cash Common Stock

Debit 16,000

Credit 16,000

1 Cash Notes Payable

25,000

1 Legal Expense Cash

1,200

1 Equipment Cash

7,000

1 Rent Expense Cash

800

25,000

1,200

7,000

800

3 Prepaid Insurance Cash

3,600

3 Supplies Accounts Payable

2,500

3,600

2,500

5 No entry necessary 8 Prepaid Rent Cash

10,000

12 Advertising Expense Cash

4,500

10,000

4,500

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Case 2-62 (Continued) Date Jan.

Journal Account and Explanation 18 Accounts Payable Cash

Debit 1,000

Credit 1,000

25 Cash Accounts Receivable Sales Revenue

400 600

25 Artist Fee Expense Cash

800

1,000

800

28 Cash Unearned Sales Revenue

3,800 3,800

30 Cash Accounts Receivable

200 200

30 Salaries Expense Cash

2,400 2,400

2. Beg. Bal. Jan. 1 1 25 28 30

End. Bal.

0 16,000 25,000 400 3,800 200

Cash 1,200 7,000 800 3,600 10,000 4,500 1,000 800 2,400

Jan. 1 1 1 3 8 12 18 25 30

Beg. Bal. Jan. 25 End. Bal.

Accounts Receivable 0 600 200 400

Beg. Bal. Jan. 3 End. Bal.

Supplies 0 2,500 2,500

Jan. 30

14,100

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Case 2-62 (Continued)

Beg. Bal. Jan. 3 End. Bal.

Prepaid Insurance 0 3,600 3,600

Beg. Bal. Jan. 1 End. Bal.

Equipment 0 7,000 7,000

Beg. Bal. Jan. 8 End Bal.

Jan. 18

Unearned Sales Revenue 0 Beg. Bal. 3,800 Jan. 28 3,800 End. Bal. Common Stock 0 16,000 16,000

Beg. Bal. Jan. 25 End. Bal.

Artist Fee Expense 0 800 800

Beg. Bal. Jan. 30 End. Bal.

Salaries Expense 0 2,400 2,400

Beg. Bal. Jan. 1 End. Bal.

Legal Expense 0 1,200 1,200

Beg. Bal. Jan. 1 End. Bal.

Prepaid Rent 0 10,000 10,000 Accounts Payable 0 1,000 2,500 1,500

Beg. Bal. Jan. 3 End. Bal.

Notes Payable 0 25,000 25,000

Beg. Bal. Jan. 1 End. Bal.

Sales Revenue 0 1,000 1,000

Beg. Bal. Jan. 25 End. Bal.

Beg. Bal. Jan. 12 End. Bal.

Advertising Expense 0 4,500 4,500

Beg. Bal. Jan. 1 End. Bal.

Rent Expense 0 800 800

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Case 2-62 (Continued) 3.

Front Row Entertainment Inc. Trial Balance January 31, 2023

Account Cash .................................................................................................... Accounts Receivable ............................................................................ Supplies ............................................................................................... Prepaid Insurance ................................................................................ Prepaid Rent ........................................................................................ Equipment……...................................................................................... Accounts Payable ................................................................................. Unearned Sales Revenue ...................................................................... Notes Payable ...................................................................................... Common Stock..................................................................................... Sales Revenue ...................................................................................... Artist Fee Expense ............................................................................... Advertising Expense ............................................................................. Salaries Expense .................................................................................. Rent Expense ....................................................................................... Legal Expense ......................................................................................

Debit 14,100 400 2,500 3,600 10,000 7,000

Credit

$1,500 3,800 25,000 16,000 1,000 800 4,500 2,400 800 1,200 $47,300

$47,300

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ACCRUAL ACCOUNTING

DISCUSSION QUESTIONS 1.

Accrual-basis accounting recognizes revenue when the company satisfies its performance obligations by delivering goods or providing services. Expenses are recognized when they are incurred. In other words, revenues and expenses are recognized when they occur rather than when cash is received (from sales) or paid (for expenses). Cash-basis accounting recognizes revenues when cash is received, regardless of when the goods are delivered or services are provided. Similarly, cashbasis accounting records expenses when cash is paid, regardless of when they are actually incurred. Accrual accounting links income measurement to selling, the principle activity of the company, while cash-basis accounting links recognition of revenues and expenses to the exchange of cash.

Under the revenue recognition principle, revenue is recognized, or recorded, in the period in which a company satisfies its performance obligation or promise within a contract. A seller satisfies a performance obligation by transferring control of a promised good or service to a customer. Control can be transferred either at a point in time or over time.

Accrual accounting, the time period assumption, the revenue recognition principle, and the expense recognition principle require a company to make adjusting entries. Accrual accounting requires that business activities be recorded when they occur. The revenue recognition principle requires that revenues be recognized when a company satisfies its performance obligations by delivering goods or performing services. The expense recognition principle requires that expenses be recognized in the same period as the revenue that it helped to generate. The time period assumption allows companies to artificially divide their operations into time periods so that it is possible to prepare meaningful financial statements (financial statements that have correct revenues, expenses, assets, and liabilities) that satisfy users’ demands for information.

During the accounting cycle, information is collected about business activities. This information is analyzed to determine which activities meet the criteria for recognition in the accounting records and their effect on the fundamental accounting equation. The transactions that meet these criteria are entered in the journal on an event-by-event basis. The journal entries are then posted to the ledger, which is organized on an account-byaccount basis. At the end of the accounting period, a trial balance is typically prepared. Adjusting entries are then prepared for those transactions that are partially complete (still under way) at the end of the accounting period. The adjusting entries recognize the portion of the transaction that has been completed. Next, the financial statements are prepared. Finally, the temporary accounts—revenues, expenses, and dividends—are closed, and their balances are transferred to Retained Earnings.

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Examples of transactions that begin and end at a point in time are as follows: • • • • • • •

Sale of merchandise Collection of an account receivable Purchase of goods Payment of an account payable Receipt of borrowed cash Issuance of common stock for cash Payment of a cash dividend

Examples of continuous transactions are as follows: • • • •

Use of borrowed money (accrual of interest) Use of rented buildings or equipment (rent expense) Use of owned buildings or equipment (depreciation expense) Expiration of insurance coverage (insurance expense)

Adjusting entries are journal entries made at the end of an accounting period to record the completed portion of partially completed transactions. They are necessary to apply the revenue recognition and expense recognition principles and ensure that a company’s financial statements include the proper amount for revenues, expenses, assets, liabilities, and stockholders’ equity. All adjusting entries will affect at least one income statement account and one balance sheet account. Therefore, if adjusting entries were not made, both the income statement and the balance sheet will be incorrect at year end.

Transactions that begin and end at a point in time are recorded individually as they occur or by summary entries at regular intervals. Continuous transactions are recorded at their completion, or, if the accounting period ends before completion, an adjusting entry may record the completed portion. Like point-in-time transactions, continuous transactions may be recorded individually or by summary entries. Further, adjusting entries may summarize the completed portions of a number of continuous transactions.

The four categories of adjusting entries and the business (or economic) activities that produce circumstances requiring adjustment are as follows: Accrued revenue: At year end, a continuous revenue transaction (e.g., service or rent) is partially complete. The customer has not yet paid. Revenue for the portion of the transaction that has been completed (earned) but for which no cash has yet been received must be recorded by making an adjusting entry that increases assets and revenues. Accrued expense: At year end, a continuous expense transaction is partially complete. The company has not yet paid the expense. An expense for the portion of the transaction that has been incurred but for which cash has not yet been paid must be recorded by making an adjusting entry that increases liabilities and expenses.

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Deferred revenue: At some point before year end, a customer paid in advance for goods or services that will be provided in a continuous transaction. At year end, some but not all of the goods or services have been provided; therefore, some, but not all of the revenue has been earned. An adjusting entry is necessary to recognize the portion of the revenue for which the company's performance obligation has been satisfied (the portion of the revenue that has been earned). Deferred expense: At some point before year end, the business paid in advance for an asset that will be used in a continuous transaction. At year end, some but not all of the asset has been used. An adjusting entry is necessary to recognize as an expense the portion of the asset that has been used. 9.

Accruals and deferrals are necessary because timing differences exist between when a revenue or an expense is recognized and cash is received or paid. An accrual is an entry that recognizes revenue or expense (and the effect on the balance sheet accounts) before the related cash is received or paid. That is, the cash payment comes after the recognition of the revenue or expense. A deferral is an entry that records a liability or an asset associated with an initial cash receipt or payment. A liability or an asset is recorded because the cash payment has occurred before the related revenue or expense is recognized. Deferrals lead to subsequent adjusting entries that reduce the liability or asset and increase and recognize revenue or expense.

10. (a) Accrued revenue—Assets and revenues are increased when an adjusting entry recognizes revenue before cash is received. (b) Deferred revenue—When prepayments are received from customers before a company satisfies its performance obligation (e.g., before the revenue is earned), firms normally increase a liability account (unearned revenue). When an adjustment is made to record the portion of the prepayment that has been earned, the entry will increase a revenue account and decrease the liability. (c) Deferred expense—When prepayments are made for expense items, a firm normally increases an asset account. When an adjustment is made to record the portion of the prepayment (asset) that has been transferred to customers or used in operations, the entry will increase an expense account and decrease the asset. (d) Accrued expense—Expenses and liabilities are increased when an adjustment records an expense recognized before the cash payment is made. 11. Interest expense (or interest income) on a short-term note is measured using the following formula: Interest = Principal  Interest Rate  Time where •

Principal is the amount borrowed or loaned

•

Interest rate is the annual interest rate

•

Time is the fraction of the year for which the receivable or payable is outstanding.

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12. (a) An adjustment to record an unrecorded revenue (an accrued revenue) will increase revenues and assets. The revenue increase will increase net income, which will increase stockholders’ equity by increasing retained earnings. (b) An adjusting entry to record unrecorded expense (an accrued expense) will increase expenses and liabilities. The expense increase will decrease net income, which will decrease equity by decreasing retained earnings. 13. Adjustments require estimates and other information about partially completed continuous events that are frequently costly and troublesome to obtain. Because correct account balances are usually required only when financial statements are prepared and because financial statements are prepared only at the end of the accounting period, adjustments during the accounting period are unnecessary. Most of our examples involve annual accounting periods. Of course, if a company prepares monthly financial statements (as many do), then adjustments must be made at the end of every month. 14. The purpose of the closing entries is to transfer the balances in the revenue, expense, and dividend accounts (the temporary accounts) to retained earnings (a permanent stockholders’ equity account) and to clear the revenues, expenses, and dividends (reduce their balances to zero) so they are ready to accumulate the business activities of the next accounting period. Without closing entries, these temporary accounts would accumulate the business activities of all accounting periods not just the current period, and some balance sheet (permanent) accounts would reflect incorrect account balances. 15. Steps in the closing process: Step 1: Close revenues to Retained Earnings. Step 2: Close expenses to Retained Earnings. Step 3: Close dividends to Retained Earnings. 16. Expense, revenue, and dividend accounts are temporary accounts. Asset, liability, and stockholders’ equity accounts are permanent accounts. Temporary accounts are closed to Retained Earnings. Permanent accounts are not closed to Retained Earnings but appear on the balance sheet and are carried forward as beginning balances for the next period. 17. The income statement accounts and dividends recognize the effects of one period’s business activities. Income statement and dividend accounts must be temporary so that we can identify the revenue, expense, and dividends amounts for each individual period. The balance sheet accounts are permanent and recognize the activities of every period. Balance sheet accounts must be permanent, so they can carry forward the effects of prior periods.

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18. Step 1:

Analyze transactions—Determine which business activities will be recognized in the accounting records and the accounts they affect.

Step 2:

Journalize transactions—Show which accounts are affected and by what dollar amount by putting the data collected above into a journal entry.

Step 3:

Post to the ledger—Summarize all journal entries into one place (ledger).

Step 4:

Prepare a trial balance—Prepare a listing of all accounts that have balances and have been used in the journalizing process and show current account balances. Confirm that total debits equal total credits.

Step 5:

Adjust the accounts—Make adjusting entries to properly reflect income for the period.

Step 6:

Prepare financial statements—Use the adjusted trial balance (account balances after the adjusting entries have been posted) to prepare each of the major financial statements.

Step 7:

Close the accounts—Close the temporary accounts to allow the records to start fresh at the beginning of next period.

19. Although the worksheet is an optional step in the accounting cycle, it is a useful “scratch pad” tool in the performance of the end-of-period portion of the accounting cycle—namely, the preparation of the adjusting entries, the financial statements, and the closing entries. The worksheet summarizes the information generated in the performance of these accounting cycle steps and enables the accountant to check this information for completeness and consistency. 20. The worksheet consists of one pair of debit and credit columns for each of the following sets of information: (1) (2) (3) (4) (5) (6)

unadjusted trial balances adjusting entries adjusted trial balances income statement retained earnings statement balance sheet

In addition, the worksheet provides subtotals that facilitate the calculation of income taxes expense and the preparation of closing entries.

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MULTIPLE-CHOICE QUESTIONS 3-1. 3-2. 3-3. 3-4. 3-5. 3-6. 3-7. 3-8. 3-9. 3-10. 3-11.

b c d c c d b c a b c

($625 + $150) ($15,000/12 months) = $1,250 per month  3 months ($3,600/3 months) = $1,200 per month  2 months that remain prepaid ($122,000 − $83,000 − $4,000)

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BRIEF EXERCISES BE 3-12 (1) Cash-basis revenue: Cash collected in April from April cash sales* ............................ Cash collected in April from March credit sales ......................... Cash collected in April from April credit sales............................ Total cash-basis revenue .....................................................

$30,600 12,800 29,850 $73,250

(2) Accrual-basis revenue: April cash sales* ...................................................................... April credit sales**................................................................... Total accrual-basis revenue .................................................

$30,600 52,880 $83,480

*7,650 units  $4.00 = $30,600 **13,220 units  $4.00 = $52,880

BE 3-13 (1) Cash-basis expense: May fuel costs paid in May ....................................................... Purchase of fuel inventory (to be used in future) ...................... Total cash-basis expense .....................................................

$95,450 15,000 $110,450

(2) Accrual-basis expense: May fuel costs..........................................................................

$132,600

Note: The $15,000 paid to the other supplier in May to build up the fuel supply is not an accrualbasis expense in May. Instead, it is a prepaid item that will be expensed when the fuel is used.

BE 3-14 Item a. b. c. d. e. f.

Effect on Net Income Cash-Basis of Accounting −1,000 0 0 + 3,000 −10,000 0

Accrual-Basis of Accounting $0 + 5,000 −250 0 0 −500

BE 3-15 Monthly revenue = $11,280/12 months = $940/month Heartstrings will recognize $940 of revenue in the first month (October).

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BE 3-16 (a) Cash-Basis Expense: Cash paid for supplies .............................................................. Cash paid for salaries ............................................................... Cash paid for utility services ..................................................... Total cash-basis expense .....................................................

$20,500 9,600 2,950 $33,050

(b) Accrual-Basis Expense: Supplies used ........................................................................... Salaries earned* ...................................................................... Electric service used ................................................................. Total accrual-basis expense .................................................

$18,450 11,210 2,300 $31,960

* $9,600 + $1,610 = $11,210

BE 3-17 1.

Cash-Basis Accounting Revenue: Cleaning services for Metro Corporation................................... Expenses: Supplies purchased .................................................................. Wages paid to employees ........................................................ Total expenses .................................................................... Cash-basis income ........................................................................

$24,000 $(5,000) (3,400) (8,400) $15,600

Accrual-Basis Accounting Revenue: Cleaning services for Metro Corporation................................... ($4,000* + $2,500) Expenses: Supplies used ........................................................................ Wages ................................................................................... Total expenses .................................................................... Accrual-basis income ....................................................................

$ 6,500

$1,300 $4,250** (5,550) $ 950

* Monthly revenue = $24,000/6 months = $4,000 per month ** Wages incurred = $3,400 + $850 = $4,250

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BE 3-18 a.

This transaction will not require an adjustment because a sale is complete at the time the delivery of the merchandise is made to the customer (a single point in time), and revenue is properly recorded when the merchandise is delivered to the customer. Note: Even though the time period in which the revenue from the sales is earned may be different from the time period that the cash is collected (because the sales were made on credit), this does not impact the fact that the sale is complete at a single point in time. The subsequent cash collection will increase cash and decrease the accounts receivable, but this is not an adjusting entry.

This transaction will require an adjusting entry over the life of the equipment, because depreciation is a continuous activity. The company will expense the use of the asset (depreciation) over the life of the asset, even though the entire cash payment was made when the asset was purchased.

This transaction will require an adjustment because the insurance policy continues for more than a year. The insurance policy will expire (be used) in increments, requiring an adjustment to show the portion of the insurance being used by the company each period. The expired portion will be shown as an expense, while the unexpired portion of the insurance policy will be shown as a prepaid asset.

This transaction will require an adjustment because the performance of the services is a continuous activity that is not completed at a single point in time. Revenue from providing the services will be recorded as the services are performed during the year. At the end of the accounting period, any services that have not yet been provided (revenue that has not yet been earned) will be recognized as a liability (unearned service revenue).

This transaction will most likely require an adjustment because the employees will work and earn salary continuously over time. Because salaries are most likely paid at a time that is different from when the employees work and the expense is incurred, any unpaid portion of the salaries will need to be recognized as a liability (salaries payable).

This transaction may require an adjustment later in the life of the note to account for the interest that will be incurred over time. Interest is a continuous activity that requires the recognition of an expense over the life of the note. When the interest expense is incurred at a time different than when the cash payment for interest occurs, the company will need to record a liability (interest payable).

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BE 3-19 1. Date Dec.

31 2.

Journal Account and Explanation Accounts Receivable Rent Revenue Interest Receivable Interest Income

Debit 9,880

Credit 9,880

650 650

In both of these cases, the adjusting entries record a previously unrecorded revenue for which the performance obligation is satisfied (the revenue has been earned) but for which no cash has yet been received (accrued revenue). If these adjusting entries were not made, both assets and revenues would be understated on the financial statements. In addition, because revenue is understated, net income is understated. Finally, because revenue is subsequently closed to retained earnings (the closing process is discussed later in this chapter), stockholders’ equity will also be understated.

BE 3-20 1. Date Dec.

Journal Account and Explanation 31 Salary Expense Salary Payable

Debit 5,320

Credit 5,320

31 Utilities Expense Utilities Payable

1,970

31 Interest Expense Interest Payable

925

1,970

925

In all of the cases above, the adjusting entries record a previously unrecorded expense that has been incurred but not yet paid in cash (accrued expense). If these adjusting entries were not made, both liabilities and expenses would be understated on the financial statements. In addition, due to the understatement of expenses, net income would be overstated. Finally, because expenses are subsequently closed to retained earnings (the closing process is discussed later in this chapter), stockholders’ equity will also be overstated.

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BE 3-21 Date Dec.

Journal Account and Explanation 31 Unearned Service Revenue* Service Revenue 31 Unearned Service Revenue Service Revenue

Debit 13,310

Credit 13,310

3,280 3,280

*Earned Revenue = Total Revenue ($14,520) − Unearned Revenue ($1,210)

In both of these cases, a liability (unearned service revenue) was originally created when cash was received prior to the performance obligation being satisfied (prior to the revenue being earned). The adjusting entries recognize revenue and decrease the previously created liability by the amount of revenue earned during the period. If these adjusting entries were not made, revenue would be understated and liabilities (unearned revenue) would be overstated. In addition, the understatement of revenue would result in an understatement of net income. Finally, because revenue is then closed to Retained Earnings (the closing process is discussed later in this chapter), stockholders’ equity will also be understated.

The balance in Unearned Revenue at the end of the year after the adjusting entries is $7,770 [($14,520 − $13,310) + ($9,840 − $3,280)].

BE 3-22 1. Date Dec.

Journal Account and Explanation 31 Rent Expense Prepaid Rent

Debit 2,950

Credit 2,950

31 Insurance Expense* Prepaid Insurance

6,350

31 Supplies Expense** Supplies

14,075

6,350

14,075

* $8,200 − $1,850 = $6,350 ** $2,000 + $16,200 − $4,125

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BE 3-22 (Continued) 2.

In all of these cases, a prepaid asset was originally created when cash was paid prior to an expense being incurred (deferred expense). The adjusting entries recognize an expense and decrease the previously created asset by the amount of the expense incurred during the period. If these entries were not made, expenses would be understated and assets would be overstated. In addition, the understatement of expenses would result in an overstatement of net income. Finally, because expenses are subsequently closed to Retained Earnings (the closing process is discussed later in this chapter), stockholders’ equity will also be overstated.

At the end of the period, the balance in the Prepaid Rent account is $850 ($3,800 − $2,950), the balance in the Insurance Expense account is $6,350, and the balance in supplies is $4,125.

BE 3-23 1. Date Dec. 2.

Journal Account and Explanation 31 Depreciation Expense Accumulated Depreciation

Debit 14,500

Credit 14,500

The book value of the machine on LaGarde’s books would be: Cost of the machine ...................................................................... Less: Accumulated depreciation .................................................... Book value ...................................................................................

$125,000 (14,500) $110,500

BE 3-24 Sparrow Company Income Statement For the year ending December 31 Service revenue ................................................................................... Expenses: Salaries expense ........................................................................... Rent expense ................................................................................ Depreciation expense ................................................................... Insurance expense ........................................................................ Income taxes expense ................................................................... Total expenses ......................................................................... Net income ..........................................................................................

$99,600 $49,400 17,250 4,950 2,200 5,400

(79,200) $20,400

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BE 3-25 Sparrow Company Retained Earnings Statement For the year ending December 31 Beginning retained earnings ................................................................. Add: Net income .................................................................................. Less: Dividends .................................................................................... Ending retained earnings......................................................................

$2,255 20,400 (10,500) $12,155

BE 3-26 Sparrow Company Balance Sheet December 31 Assets Current assets: Cash ............................................................................................. Accounts receivable ...................................................................... Prepaid insurance ......................................................................... Total current assets.................................................................. Property, plant, and equipment: Equipment .................................................................................... Less: Accumulated depreciation .................................................... Total property, plant, and equipment ....................................... Total assets..........................................................................................

$3,150 5,650 4,480 $13,280 $42,000 (24,000) 18,000 $31,280

$2,800 4,450 3,875 $11,125 $8,000 12,155

20,155 $31,280

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BE 3-27 1. Date Dec.

Journal Account and Explanation 31 Service Revenue Income Summary

Debit 99,600

Credit 99,600

31 Income Summary Salaries Expense Rent Expense Depreciation Expense Insurance Expense Income Taxes Expense

79,200

31 Retained Earnings Dividends

10,500

49,400 17,250 4,950 2,200 5,400

10,500

The closing process transfers temporary account balances (revenues, expenses, gains, losses, and dividends declared) to retained earnings. If the accounts were not closed, these amounts would not get properly reflected in stockholders’ equity and the accounting equation would not balance. In addition, the temporary accounts would accumulate amounts from different accounting periods, making it extremely difficult to determine the effect of business activities for a specific accounting period. The closing process increased retained earnings (a component of stockholders’ equity) by the amount of net income ($20,400) and decreased retained earnings by the amount of dividends ($10,500). The net effect on retained earnings is an increase of $9,900 ($20,400 − $10,500).

BE 3-28 The proper order of the steps of the accounting cycle is as follows: 1. Analyze transactions 2. Journalize transactions 3. Post to the ledger 4. Prepare a trial balance 5. Adjust the accounts 6. Prepare financial statements 7. Close the accounts

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EXERCISES E 3-29 1.

Cash-basis accounting: February March Supplies expense .......................................................................... — — Salaries expense ........................................................................... $4,925 $5,100 Advertising expense...................................................................... — — Total......................................................................................... $4,925 $5,100 Note: There is no supplies expense in February and March under cash-basis accounting because the cash payment is made in January. Similarly, there is no advertising expense in February or March because the cash payment is not made until April.

Accrual-basis accounting: Supplies expense* ........................................................................ Salaries expense ........................................................................... Advertising expense...................................................................... Total .........................................................................................

February $4,575 4,925 — $9,500

March $ 4,575 5,100 850 $10,525

*$9,150/2 = $4,575

Accrual-basis accounting provides the most useful information for decision-makers, because it records transactions when they occur. Accrual accounting is superior to cash basis because it links income measurement to selling, the principle activity of the company. That is, revenue is recognized as a company satisfies its performance obligations, and expenses are recognized when they are incurred.

E 3-30 a. b. c. d. e.

Revenue will be recognized in January, when the gift card is redeemed and the store has satisfied its performance obligation by selling the product. Revenue will be recognized when the sale is made in June, regardless of when payment is actually received. Revenue will be recognized in March, when the services are actually provided and the airline has satisfied its performance obligation. Revenue will be recognized evenly over the entire year (1/12 of the revenue is reported each month). The theme park earns the revenue by providing the service during the entire period. Revenue will be recognized when the service is performed in October. The delivery of the package is the point in time in which the company satisfies its performance obligation.

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E 3-31 1.

Revenues should be recognized when a sale is made or a service is performed. Because Electronic Repair Company performed the services in June, the entire amount of revenue, $480 ($80 per payment  6 payments), should be recorded in June.

Expenses are recorded when they are incurred to produce revenue. Even though the supplies were purchased in May, the expense is not recognized until the television is repaired in June. According to the expense recognition principle, expenses should be recognized in the same period that the related revenue is recognized. Therefore, Electronic Repair Company would record the $120 expense in June. In addition, any labor cost would be expensed in June, the period in which the service was provided.

The first question relates to the revenue recognition principle. Revenue is recognized only when a company satisfies its performance obligation by providing the repair service. The second question relates to the expense recognition principle, stating that the expenses related to the service revenues recognized must be recorded in the same period as the revenue it helped generate.

E 3-32 1.

Accrual-basis net income: $201,700 − $114,250 − $47,325 = $40,125

Cash-basis net income: ($273,500 − $50,000) − ($164,850 − $8,000) = $66,650

Cash-basis accounting does not link recognition of revenues and expenses to the actual business activity but rather to the exchange of cash. Therefore, management can manipulate the company’s income by either accelerating or delaying the company’s purchases, which would affect the amount the company currently reports as an expense and income.

E 3-33 Sales revenue = $3,580,000 Total expenses = $2,023,400 ($1,598,240 + $425,160)

E 3-34 1.

The $3,130 cost of the toothbrushes should be allocated to the accounting periods in which they are used in proportion to the quantity used. None of the toothbrushes were used in 2023; therefore, none of the $3,130 is recognized as an expense in that year. Since 10,500 of the toothbrushes were used in 2024 (70% of the 15,000 toothbrushes purchased), then $2,191 (70% of the $3,130 cost) should be recognized as an expense in 2024.

If the remaining 4,500 toothbrushes are used in 2025, then $939 (0.30  $3,130) would be recognized as an expense in that year.

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E 3-35 1.

Partial income statement: Revenue .................................................................................. Less: Operating expenses ......................................................... Income from operations ........................................................... Less other expenses and losses: Interest expense ................................................................. Income before taxes ................................................................ Accounts receivable balance: Beginning balance .................................................................... Service performed ................................................................... Less: Cash received .................................................................. Ending balance* .......................................................................

Beginning balance Service performed on account Ending balance*

Accounts Receivable 45,800 695,100 708,700

$ 695,100 (437,600) $ 257,500 (133,400) $ 124,100 $ 45,800 695,100 (708,700) $ 32,200

Cash collections

*Ending balance = x = $32,200

Supplies balance: Beginning balance................................................................... Purchases ............................................................................... Less: Ending balance (given in problem) .................................. Supplies used..........................................................................

Beginning balance Purchase

Supplies 13,350 14,600 y

Ending balance

2,230

$13,350 14,600 (2,230) $ 25,720

Supplies used**

** Supplies used = y = $25,720

Accounts payable: Beginning balance................................................................... Purchases…………………………………………… ................................... Less: Payments ....................................................................... Ending balance*** ..................................................................

Payments

Accounts Payable 8,150 19,300 14,600 z

$8,150 14,600 (19,300) $3,450

Beginning balance Purchase Ending balance***

***Ending balance = z = $3,450

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E 3-35 (Continued) 3.

Accrual accounting provides the underlying basis as to why these three accounts exist. The underlying principles of accrual accounting are the revenue recognition principle, the expense recognition principle, and the time period assumption. Because the cash receipts and payments do not necessarily occur in the same period as accrual accounting demands that revenues and expenses be recognized, accounts are needed to properly reflect these timing differences. Therefore, accounts receivable reflects revenue that has been earned (performance obligations have been satisfied) but for which no cash has been collected, supplies reflects the cash purchases for which no expense has yet been recognized, and accounts payable reflects expenses that have been incurred but which have not yet been paid.

E 3-36 a. b. c. d. e. f. g. h.

Regular journal entry Adjusting entry; (1) revenue recognized before collection Regular journal entry Adjusting entry; (2) expense recognized before payment Regular journal entry Adjusting entry; (4) expense recognized after payment Adjusting entry; (3) revenue recognized after collection Adjusting entry; (4) expense recognized after payment

E 3-37 a. b. c. d. e. f. g.

No adjusting entry Adjusting entry: increase Wages Expense; increase Wages Payable Adjusting entry: increase Interest Expense; increase Interest Payable Adjusting entry: increase Rent Expense; decrease Prepaid Rent No adjusting entry; revenue is not recognized because successful completion of the job is necessary before the performance obligation is satisfied and any revenue will be earned Adjusting entry: increase Depreciation Expense; increase Accumulated Depreciation (a contra asset) Adjusting entry: increase Supplies Expense; decrease Supplies

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E 3-38 1.

Date Dec.

Journal Account and Explanation 31 Unearned Service Revenue* Service Revenue 31 Unearned Service Revenue** Service Revenue 31 Accounts Receivable*** Service Revenue

Debit 2,200

Credit 2,200

101,600 101,600 5,000 5,000

* $5,000  (110/250) = $2,200 ** ($500/50 rides)  10,160 = $101,600 *** ($7,500/3 months)  2 months = $5,000

d. 2.

No journal entry is needed.

a. Without this adjusting entry, revenue would be understated (which would understate net income and stockholders' equity) and liabilities (unearned service revenue) would be overstated. b. Without this adjusting entry, revenue would be understated (which would understate net income and stockholders' equity) and liabilities (unearned service revenue) would be overstated. c. Without this adjusting entry, revenue would be understated (which would understate net income and stockholders’ equity) and assets (accounts receivable) would be understated as well. d. No journal entry is needed. There has been no cash exchanged or services performed, so there is not a recordable transaction yet. Cumulatively, if these transactions were not made, revenue would be understated by $108,800 ($2,200 + $101,600 + $5,000).

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E 3-39 1.

Date Dec.

Journal Account and Explanation 31 Insurance Expense* Prepaid Insurance

Debit 1,620

Credit 1,620

31 Utilities Expense Utilities Payable

1,520

31 Rent Expense Rent Payable

1,440

31 Advertising Expense** Prepaid Advertising

2,900

1,520

1,440

2,900

* Insurance coverage is $405 per month ($4,860/12 months). From September 1 through December 31, 4 months’ insurance coverage will be used. Therefore, $1,620 ($405 per month  4 months) must be removed from Prepaid Insurance and added to Insurance Expense. ** Advertising expense is $1,450 per month ($4,350 per quarter/3 months), or $2,900($1,450 per month  2 months) for 2 months.

a. If this entry were not made, expenses would be understated and assets would be overstated. Additionally, because of the understatement of expenses, net income and stockholders’ equity would be overstated. b. If this entry were not made, expenses would be understated and liabilities would be understated. Additionally, because of the understatement of expenses, net income and stockholders’ equity would be overstated. c. If this entry were not made, expenses would be understated and liabilities would be understated. Additionally, because of the understatement of expenses, net income and stockholders’ equity would be overstated. d. If this entry were not made, expenses would be understated and assets would be overstated. Additionally, because of the understatement of expenses, net income and stockholders’ equity would be overstated. Cumulatively, if these entries were not made, expenses would be understated by $7,480 ($1,620 + $1,520 + $1,440 + $2,900).

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E 3-40 1. Date Mar.

May

July

Nov.

Journal Account and Explanation 1 Prepaid Insurance Cash

Debit 10,500

Credit 10,500

1 Cash Unearned Rent Revenue

30,000

31 Cash Unearned Rent Revenue

240,000

1 Prepaid Security Services Cash

4,500

30,000

240,000

4,500

a. The monthly insurance expense is $875 ($10,500/12 months). At year end, 2 months of insurance ($1,750) is prepaid and 10 months has expired ($8,750). The adjustment must leave $1,750 in Prepaid Insurance and remove $8,750, adding that amount to Insurance Expense. The calculation is illustrated as follows: Prepayment

Prepaid Insurance 10,500 x

Ending balance

1,750

Insurance expense incurred*

*Insurance used = x = $10,500 − $1,750 = $8,750

The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Insurance Expense Prepaid Insurance

Debit 8,750

Credit 8,750

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E 3-40 (Continued) b.

The monthly rent for the office is $2,500 ($30,000/12 months). At year end, 4 months’ rent ($10,000) is unearned and 8 months has been earned ($20,000). The adjustment must leave $10,000 in Unearned Rent Revenue and remove $20,000, adding that amount to Rent Revenue. The calculation is illustrated as follows:

Rent revenue earned*

Unearned Rent Revenue x 30,000

Receipt of rent in advance

10,000

Ending balance

*Rent revenue = x = $30,000 − $10,000 = $20,000

The adjustment is as follows: Date Dec. c.

Journal Account and Explanation 31 Unearned Rent Revenue Rent Revenue

Debit 20,000

Credit 20,000

The monthly rent for the office complex is $40,000 ($240,000/6 months). At year end, 1 month’s rent ($40,000) is unearned and 5 months has been earned ($40,000). The adjustment must leave $40,000 in Unearned Rental Revenue and remove $200,000, adding that amount to Rent Revenue. The calculation is illustrated as follows:. Rent revenue earned*

Unearned Rent Revenue x 240,000

Receipt of rent in advance

40,000

Ending balance

*Rent revenue = x = $240,000 − $40,000 = $200,000

The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Unearned Rent Revenue Rent Revenue

Debit 20,000

Credit 20,000

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E 3-40 (Continued) b.

Unearned Rent Revenue x 30,000

Receipt of rent in advance

10,000

Ending balance

*Rent revenue = x = $30,000 − $10,000 = $20,000

The adjustment is as follows: Date Dec. c.

Journal Account and Explanation 31 Unearned Rent Revenue Rent Revenue

Debit 20,000

Credit 20,000

Unearned Rent Revenue x 240,000

Receipt of rent in advance

40,000

Ending balance

*Rent revenue = x = $240,000 − $40,000 = $200,000

The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Unearned Rent Revenue Rent Revenue

Debit 200,000

Credit 200,000

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E 3-40 (Continued) d.

The monthly rate for the security service is $1,500 ($4,500/3 months). At year end, 1 month’s security service ($1,500) is prepaid and 2 months’ ($3,000) has been used. The adjustment must remove $3,000 from Prepaid Security Services (transferring that amount to Security Services Expense), leaving a balance of $1,500 in Prepaid Security Services. The calculation is illustrated as follows: Prepaid Security Services 4,500 x

Prepayment

Ending balance

Professional services incurred*

1,500

*Security services expense = x = $4,500 − $1,500 = $3,000

The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Security Service Expense Prepaid Security Services

Debit 3,000

Credit 3,000

a. If this entry were not made, expenses would be understated (which would overstate net income and stockholders’ equity) and assets (prepaid insurance) would be overstated. b. If this entry were not made, revenues would be understated (which would understate net income and stockholders’ equity) and liabilities (unearned rent revenue) would be overstated. c. If this entry were not made, revenues would be understated (which would understate net income and stockholders’ equity) and liabilities (unearned rent revenue) would be overstated. d. If this entry were not made, expenses would be understated (which would overstate net income and stockholders’ equity) and assets (prepaid security services) would be overstated. The cumulative effect on the income statement and the balance sheet if these adjustments were not made is to understate revenues by $220,000($20,000 + $200,000), understate expenses by $11,750 ($8,750 + $3,000),understate net income by $208,250 ($220,000 − $11,750), overstate assets by $11,750 ($8,750 + $3,000), overstate liabilities by $220,000 ($20,000 + $200,000), and understate retained earnings by $208,250 (the amount of understated net income).

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E 3-41 1. Date Apr.

Oct.

Nov.

Journal Account and Explanation 1 Prepaid Rent Cash

Debit 6,600

6,600

1 Prepaid Insurance Cash

4,200

15 Supplies Cash

5,250

1 Prepaid Repairs & Maintenance Cash

Credit

4,200

5,250 600 600

a. The monthly rent for the building is $550 ($6,600/12 months). At year end,3 months’ rent ($1,650) is unused and 9 months’ rent ($4,950) has been used. The adjustment must remove $4,950 from Prepaid Rent and add that amount to Rent Expense. The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Rent Expense Prepaid Rent

Debit 4,950

Credit 4,950

b. The monthly insurance expense is $350 ($4,200/12 months). At year end, 9 months’ insurance ($3,150) is unused and 3 months insurance ($1,050) has been used. The adjustment must remove $1,050 from Prepaid Insurance and add that amount to Insurance Expense. The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Insurance Expense Prepaid Insurance

Debit 1,050

Credit 1,050

c. At year end, $1,085 of office supplies are unused and $4,165 ($5,250 − $1,085) have been used. The adjustment must remove $4,165 from Supplies and add that amount to Supplies Expense. The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Supplies Expense Supplies

Debit 4,165

Credit 4,165

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E 3-41 (Continued) d. The monthly rate for maintenance on the computer is $50 ($600/12 months). At year end, 10 months’ maintenance ($500) is prepaid and 2 months’ maintenance ($100) has been used. The adjustment must remove $100 from Prepaid Repairs & Maintenance and transfer that amount to Repairs & Maintenance Expense. The adjustment is as follows: Date Dec.

Journal Account and Explanation 31 Repairs & Maintenance Expense Prepaid Repairs & Maintenance

Debit 100

Credit 100

If the adjusting entries were not made, expenses would be understated by $10,265 ($4,950 + $1,050 + $4,165 + $100), and, therefore, net income (and stockholders’ equity) would be overstated by $10,265. Assets also would be overstated by $10,265.

E 3-42 1. Supplies, January 1......................................................................... Add: Supplies purchased ................................................................ Supplies available for use ............................................................... Less: Supplies, December 31 ........................................................... Supplies expense ........................................................................... Beginning balance Purchase

Supplies 4,150 12,690 x

Ending balance

5,220

$ 4,150 12,690 $ 16,840 (5,220) $ 11,620

Supplies used*

*Supplies expense = x = $4,150 + $12,690 − $5,220 = $11,620

2. Date Dec.

Journal Account and Explanation 31 Supplies Expense Supplies

Debit 11,620

Credit 11,620

Assets would be overstated by $11,620 and net income and stockholders’ equity would also be overstated (because expenses were understated) by $11,620.

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E 3-43 a.

Adjusting entries: Date Dec.

Journal Account and Explanation 31 Interest Expense* Interest Payable

Debit 3,200

Credit 3,200

*$120,000  0.08  4/12 = $3,200

b. Date Dec. c.

Journal Account and Explanation 31 Accounts Receivable Service Revenue

Debit 2,700

Credit 2,700

The supplies expense is $6,730, computed as the excess of the cost of supplies available for use ($7,700) over the cost of the supplies on hand. Supplies $1,220 6,480 $7,700 (970) $6,730

Balance, January 1 ........................................................................ Purchases ..................................................................................... Available for use ........................................................................... Less: Balance, December 31 .......................................................... Supplies expense (used) ................................................................

Beginning balance Purchase Ending balance

Supplies 1,220 6,480 x

Supplies used***

970

*** Supplies expense = x = $1,220 + $6,480 − $970 = $6,730

Date Dec.

Journal Account and Explanation 31 Supplies Expense Supplies

Debit 6,730

Credit 6,730

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E 3-43 (Continued) d.

The service revenue for this item is $2,550 ($7,650  3/9); that is, $850 per month ($7,650/9) for the months of October, November, and December. Unearned Revenue Preadjustment balance ................................................................. $ 7,650 Adjustment (earned)..................................................................... 2,550 Adjusted balance (unearned) ........................................................ $5,100

Earned revenue*

Unearned Revenue 7,650 2,550

Preadjustment balance

5,100

Ending balance

*$7,650  3/9 = $2,550

Date Dec.

Journal Account and Explanation 31 Unearned Service Revenue Service Revenue

Debit 2,550

Credit 2,550

The effect on the balance sheet and income statement of the above entries is as follows: a. Net income and stockholders’ equity would be overstated (expenses understated) and liabilities would be understated. b. Net income and stockholders’ equity would be understated (revenues understated) and assets would be understated. c. Net income and stockholders’ equity would be overstated (expenses understated) and assets would be overstated. d. Net income and stockholders’ equity would be understated (revenues understated) and liabilities would be overstated.

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E 3-44 1.

Adjusting entries: a. Date Dec.

Journal Account and Explanation 31 Depreciation Expense Accumulated Depreciation

Debit 132,500

Journal Account and Explanation 31 Insurance Expense* Prepaid Insurance

Debit 2,040

Journal Account and Explanation 31 Accounts Receivable Service Revenue

Debit 5,450

Journal Account and Explanation 31 Rent Expense** Rent Payable

Debit 390

Credit 132,500

b. Date Dec.

Credit 2,040

*$12,240  4/24 = $2,040

c. Date Dec.

Credit 5,450

d. Date Dec.

Credit 390

** (12 terminals  $65 per month)  1/2 month = $390

e. Date Dec.

Journal Account and Explanation 31 Unearned Rent Revenue Rent Revenue

Debit 1,810

Credit 1,810

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E 3-44 (Continued) 2.

The effect of the above entries on the income statement and balance sheet is: a. Net income and stockholders’ equity would be overstated (expenses understated) and assets would be overstated. b. Net income and stockholders’ equity would be overstated (expenses understated) and assets would be overstated. c. Net income and stockholders’ equity would be understated (revenues understated) and assets would be understated. d. Net income and stockholders’ equity would be overstated (expenses understated) and liabilities would be understated. e. Net income and stockholders’ equity would be understated (revenues understated) and liabilities would be overstated.

E 3-45 Prepaid Insurance: Date May

Journal Account and Explanation 5 Prepaid Insurance Cash 31 Insurance Expense* Prepaid Insurance

Debit 4,300

Credit 4,300

3,050 3,050

*$4,300 − $1,250 = $3,050

Wages Payable: Date Dec.

Journal Account and Explanation 31 Wages Expense Wages Payable

Debit 5,400

Credit 5,400

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E 3-45 (Continued) Unearned Sales Revenue: Journal Account and Explanation

Date May

Debit 9,500

10 Cash Unearned Sales Revenue

Credit 9,500

31 Unearned Sales Revenue** Sales Revenue

7,250 7,250

**$9,500 − $2,250 = $7,250

Interest Receivable: Journal Account and Explanation 31 Interest Receivable Interest Income

Date May

Debit 825

Credit 825

E 3-46 1. Assets a. b.

+ +

−

2,550

8,110

c. d.

Liabilities

3,820

5,245

Stockholders’ Equity

Revenues

Expenses

−

2,550

8,110

5,245

−

3,820

Net Income −

2,550

8,110

5,245

−

3,820

2,550

3,820

Adjusting entries involve the use of estimates. Earnings quality is generally considered higher when these estimates are relatively more pessimistic, or conservative. All things being equal, conservative estimates will lead to lower assets, higher liabilities, lower revenues, higher expenses, and lower income than more aggressive estimates. Analysts and other users tend to view conservative estimates as more useful than aggressive estimates that tend to overstate a company’s performance. Therefore, the use of conservative estimates is generally associated with higher earnings quality. However, overly conservative estimates and judgments can also impair earnings quality. The accountant should attempt to use unbiased estimates and measures of business activities in order to convey the most realistic picture of how well a company has performed.

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E 3-47 a. This was an error in adjusting an accrued expense. This error will understate expenses (which overstates income and overstates stockholders’ equity) and understate liabilities (wages payable). b. This was an error in adjusting an accrued revenue. This error will understate revenues (which understates income and understates stockholders’ equity) and understate assets (accounts receivable). c. This was an error in adjusting a deferred revenue. This error will understate revenues (which understates income and understates stockholders’ equity) and overstate liabilities (unearned sales revenue). d. This was an error in adjusting a deferred expense. This error will understate expenses (which overstates income and overstates stockholders’ equity) and overstate assets (prepaid insurance).

E 3-48 1.

Oxmoor Corporation Income Statement For the year ending December 31

Revenues: Sales revenue ...................................................................................... Expenses: Cost of goods sold......................................................................... Wages expense ............................................................................. Depreciation expense ................................................................... Rent expense ................................................................................ Interest expense ........................................................................... Income taxes expense ................................................................... Total expenses ......................................................................... Net income ..........................................................................................

$583,900 $277,000 98,250 29,000 50,000 2,700 38,085 (495,035) $88,865

E 3-49 1.

Oxmoor Corporation Retained Earnings Statement For the year ending December 31 Retained earnings, January 1, 2019 ............................................... Add: Net Income .......................................................................... Less: Dividends ............................................................................. Retained earnings, December 31, 2019 ..........................................

$45,635 88,865 (50,000) $84,500

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E 3-49 (Continued) 2. Oxmoor Corporation Income Statement For the year ending December 31 Sales revenue ...................................................................................... Cost of goods sold ................................................................................ Gross margin ....................................................................................... Operating expenses: Wages expense ............................................................................. Depreciation expense ................................................................... Rent expense ................................................................................ Total operating expenses ......................................................... Income from operations .......................................................................

$583,900 (277,000) $306,900 $98,250 29,000 50,000 (177,250) $129,650

Other income and expenses: Interest expense ........................................................................... Income before income taxes ................................................................ Income taxes expense .......................................................................... Net income ..........................................................................................

(2,700) $126,950 (38,085) $ 88,865

E 3-50 1.

Oxmoor Corporation Balance Sheet December 31 Assets

Current assets: Cash ............................................................................................. Accounts receivable ...................................................................... Inventory...................................................................................... Prepaid rent ................................................................................. Total current assets.................................................................. Long-term investments: Investment .................................................................................. Property, plant, and equipment: Equipment ................................................................................... Less: Accumulated depreciation .................................................... Equipment, net ........................................................................ Total assets..........................................................................................

$ 13,300 6,700 481,400 54,000 $555,400 110,900 $ 88,000 (23,700)

64,300 $730,600

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E 3-50 (Continued) Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Notes payable .............................................................................. Interest payable ........................................................................... Total current liabilities .............................................................

$111,700 50,000 4,400 $166,100

Long-term liabilities: Bonds payable .............................................................................. Total liabilities ......................................................................... Stockholders’ equity: Common stock .............................................................................. Retained earnings ......................................................................... Total stockholders’ equity ........................................................ Total liabilities and stockholders’ equity ...............................................

180,000 $346,100 $300,000 84,500 384,500 $730,600

E 3-51 1.

Closing entries: Date Dec.

Journal Account and Explanation 31 Sales Revenue Retained Earnings 31 Retained Earnings Salaries Expense Rent Expense Utilities Expense Supplies Expense Income Taxes Expense 31 Retained Earnings Dividends

Debit 162,820

Credit 162,820

129,473 91,660 11,250 8,415 4,348 13,800 8,400 8,400

Grand Rapids Consulting Inc. Retained Earnings Statement For the year ending December 31

Retained earnings, January 1 ................................................................ Add: Net income .................................................................................. Less: Dividends .................................................................................... Retained earnings, December 31 ..........................................................

$38,100 33,347 (8,400) $63,047

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E 3-52 1. Date Dec.

Account and Explanation 31 Sales Revenue Retained Earnings 31 Retained Earnings Cost of Goods Sold Interest Expense Wages Expense 31 Retained Earnings Dividends

Debit 59,000

Credit 59,000

42,000 31,000 3,200 8,000 5,000 5,000

The closing process increased retained earnings (a component of stockholders’ equity) by the amount of net income ($16,800) and decreased retained earnings by the amount of dividends ($5,000). The net effect on retained earnings is an increase of $11,800 ($16,800 − $5,000).

E 3-53 1.

The first entry erroneously credits (increases) a revenue account instead of debiting revenues to close the revenue account. It also credits (increases) a balance sheet account (contra asset), Accumulated Depreciation, that should not be included in the closing process. The second entry erroneously debits (increases) various expense accounts instead of crediting expenses to close them. It also decreases a balance sheet account (Accounts Payable) that should not be included in the closing process. The third entry erroneously debits (increases) the Dividends account instead of crediting dividends to close it.

Correct closing entries: Date Dec.

Journal Account and Explanation 31 Service Revenue Retained Earnings 31 Retained Earnings Depreciation Expense Income Taxes Expense Utilities Expense Wages Expense Supplies Expense 31 Retained Earnings Dividends (Close Dividends)

Debit 177,000

Credit 177,000

150,900 33,000 8,200 12,700 66,000 31,000 3,200 3,200

The purpose of the closing entries is to transfer the balances in the revenue, expense, and dividends accounts (which are temporary accounts to retained earnings (a permanent account). This transfer reduces the balances of these temporary accounts to zero.

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PROBLEM SET A P 3-55A 1.

Cash-basis income: January incomea ......................................................................... February incomeb ....................................................................... March lossc ................................................................................

$6,600 65 (290)

$6,750 − $150 = $6,600 $250 − $185 = $65 c $0 − $290 = $(290) a

Accrual-basis income: January incomed ......................................................................... February incomee ....................................................................... March incomef ...........................................................................

$670 380 570

[(1/12  $6,600) + $280] − $160 = $670 [(1/12  $6,600) − $170] = $380 f [(1/12  $6,600) + $320] − $300 = $570 d e

Accrual accounting requires that the financial effects of transactions be recorded in the period in which they occur rather than only in the period in which cash flows occur. Recording revenues using accrual accounting (rather than cash-basis accounting) produces net income amounts that more closely associate the results of revenue-related activities with the periods in which those activities take place. Cash-basis accounting is likely to cause revenues to be recorded in periods different from the period in which the revenue-related activities take place, thus distorting the usefulness of the net income amount as an indicator of business performance.

P 3-56A 1.

Revenue: $1,425,700

Expenses: Expense Salaries ............................................ Supplies ........................................... General and administrative .............. Total expenses ..........................

Amount $ 988,200 59,450 26,500 $1,074,150

Calculation (if any) $82,350  12 months $2,875 + $65,800 − $9,225

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P 3-56A (Continued) 2.

Security Specialists Income Statement For the year ending December 31

Service revenue ................................................................................... Expenses: Salaries expense ........................................................................... Supplies expense .......................................................................... General and administrative expense ............................................. Total expenses ......................................................................... Net income .......................................................................................... 3.

$1,425,700 $988,200 59,450 26,500 (1,074,150) $ 351,550

The income statement was prepared using the revenue recognition and the expense recognition principles.

P 3-57A 1.

Analyzing transactions: a. Regular journal entry b. Adjusting; accrued revenue c. Adjusting; deferred revenue d. Regular journal entry (Note: While this entry is not an adjusting entry, it does defer revenue and serve as the basis for a later adjusting entry to recognize revenue.) e. Adjusting; deferred expense (depreciation) f. Adjusting; deferred expense g. Adjusting; accrued expense h. Adjusting; accrued expense i. Adjusting; deferred expense

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e. f.

Date Dec.

Journal Account and Explanation 1 Cash Notes Payable

Debit 50,000

Credit 50,000

31 Accounts Receivable Service Revenue

13,390

31 Unearned Service Revenue1 Service Revenue

16,480

31 Cash Unearned Service Revenue

40,170

31 Depreciation Expense Accumulated Depreciation 31 Insurance Expense2 Prepaid Insurance

1,875

13,390

16,480

40,170

1,875 600 600

31 Interest Expense3 Interest Payable

375

31 Salaries Expense Salaries Payable

35,480

31 Supplies Expense4 Supplies

3,450

375

35,480

3,450

$26,780 − $10,300 = $16,480 $3,600 − $3,000 = $600 3 $50,000  0.09  1/12 = $375 4 $4,200 − $750 = $3,450 1 2

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P 3-58A

Date Dec.

Journal Account and Explanation 31 Unearned Service Revenue Service Revenue

Debit 37,400

Credit 37,400

31 Accounts Receivable* Service Revenue

1,125

31 Rent Expense** Prepaid Rent

9,375

31 Depreciation Expense Accumulated Depreciation

9,400

31 Wages Expense Wages Payable

4,170

31 Supplies Expense*** Supplies

17,900

1,125

9,375

9,400

4,170

17,900

* (225  $5 per student) = $1,125 ** $22,500/12 months = $1,875 per month; $1,875  5 months = $9,375 ***Balance, 1/1 ................................................................................................. Purchases .......................................................................................................... Available for use ................................................................................................ Less: Balance, 12/31 (unused)............................................................................ Supplies expense (used)* ...................................................................................

Supplies $2,400 19,600 $22,000 (4,100) $17,900

If the accountant failed to make the above adjusting entries, net income would be overstated by $2,320 ($37,400 + $1,125 − $9,375 − $9,400 − $4,170 − $17,900).

P 3-59A Transaction a. b. c. d.

Assets

Liabilities +3,410

+8,350 −2,260 −5,150

Common Stock

Retained Earnings −3,410 +8,350 −2,260 +5,150

Revenues

Expenses +3,410

+8,350 +2,260 +5,150

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P 3-60A

Date Dec.

Journal Account and Explanation 31 Rent Expense1 Prepaid Rent

Debit 7,200

Credit 7,200

31 Supplies Expense2 Supplies

3,550

31 Depreciation Expense Accumulated Depreciation

35,250

31 Unearned Service Revenue Service Revenue3

8,080

31 Wages Expense Wages Payable

3,450

31 Interest Expense4 Interest Payable

1,000

31 Income Taxes Expense Income Taxes Payable

55,539

3,550

35,250

8,080

3,450

1,000

55,539

$9,500 − $2,300 = $7,200 $4,200 − $650 = $3,550 3 $11,200 − $3,120 = $8,080 4 $50,000  0.08  3/12 = $1,000 1 2

Rogers Corporation Income Statement For the year ending December 31 Service revenue1 .................................................................................. Less operating expenses: Rent expense2............................................................................... Wages expense3............................................................................ Depreciation expense ................................................................... Supplies expense .......................................................................... Interest expense4 .......................................................................... Income taxes expense ................................................................... Total expenses ....................................................................... Net income ..........................................................................................

$606,080 $236,200 140,450 35,250 3,550 5,500 55,539 (476,489) $129,591

$598,000 + $8,080 = $606,080 $229,000 + $7,200 = $236,200 3 $137,000 + $3,450 = $140,450 2

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$4,500 + $1,000 = $5,500

P 3-60A (Continued) Rogers Corporation Retained Earnings Statement For the year ending December 31 Retained earnings, January 1 ................................................................ Add: Net income .................................................................................. Less: Dividends .................................................................................... Retained earnings, December 31 ..........................................................

$ 37,000 129,591 0 $166,591

Rogers Corporation Balance Sheet December 31 Assets Current assets: Cash ............................................................................................. Accounts receivable ...................................................................... Supplies........................................................................................ Prepaid rent ................................................................................. Total current assets.................................................................. Property, plant, and equipment: Equipment .................................................................................... Less: Accumulated depreciation .................................................... Equipment, net ........................................................................ Other assets......................................................................................... Total assets..........................................................................................

$ 3,100 15,900 650 2,300 $21,950

$625,000 (139,250) 485,750 60,900 $568,600

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Unearned service revenue ............................................................ Wages payable ............................................................................. Interest payable............................................................................ Income taxes payable ................................................................... Total current liabilities .............................................................

$ 9,400 3,120 3,450 1,000 55,539 $ 72,509

Long-term liabilities: Notes payable .............................................................................. Total liabilities ......................................................................... Stockholders’ equity: Common stock .............................................................................. Retained earnings ......................................................................... Total stockholders’ equity ........................................................ Total liabilities and stockholders’ equity ...............................................

50,000 $122,509 $279,500 166,591

446,091 $568,600 150

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P 3-60A (Continued) 3.

Financial statements are prepared after the adjusting entries are made because the adjusting entries adjust the income statement and balance sheet accounts for continuous transactions so that they reflect the proper amounts by the end of the year. Therefore, all adjusting entries will affect at least one income statement account and one balance sheet account. Cash is never affected by adjustments.

P 3-61A 1.

(a)

Accumulated Depreciation Preadjustment $156,000 Adjustment 12,500 Adjusted $168,500

Depreciation Expense Adjusted $12,500 Preadjustment 0 Adjustment $12,500

(b)

Unearned Service Revenue Preadjustment $13,620 Adjustment 7,380 Adjusted $ 6,240

Service Revenue Adjusted Preadjustment Adjustment

(c)

Prepaid Insurance Preadjustment $23,270 Adjusted 6,150 Adjustment $17,120

Insurance Expense Preadjustment $0 Adjustment 17,120 Adjusted $17,120

(d)

Prepaid Rent Preadjustment Adjusted Adjustment

$3,600 2,100 $1,500

Rent Expense Preadjustment $29,700 Adjustment 1,500 Adjusted $31,200

$6,750 0 $6,750

Wages Expense Preadjustment Adjustment Adjusted

(e)

Wages Payable Adjusted Preadjustment Adjustment

$78,980 71,600 $ 7,380

$44,200 6,750 $50,950

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P 3-61A (Continued) 2.

Adjusting entries: Journal Account and Explanation Depreciation Expense Accumulated Depreciation

Date (a)

(b)

(c)

(d)

(e)

Debit 12,500

Credit 12,500

Unearned Service Revenue Service Revenue

7,380

Insurance Expense Prepaid Insurance

17,120

Rent Expense Prepaid Rent

1,500

Wages Expense Wages Payable

6,750

7,380

17,120

1,500

6,750

P 3-62A Date Dec.

Journal Account and Explanation Service Revenue Retained Earnings Retained Earnings Salaries Expense Wages Expense Rent Expense Depreciation Expense (Equipment) Utilities Expense Supplies Expense Interest Expense Income Taxes Expense Retained Earnings Dividends

Debit 612,900

Credit 612,900

540,950 148,250 183,500 27,600 45,300 48,800 51,900 4,800 30,800 6,000

6,000

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P 3-62A (Continued) 2.

Round Grove Alarm Company Income Statement For the year ending December 31

Revenues ............................................................................................. Expenses: Wages expense ............................................................................. Salaries expense ........................................................................... Supplies expense .......................................................................... Utilities expense ........................................................................... Depreciation expense (equipment) ............................................... Rent expense ................................................................................ Interest expense ........................................................................... Income taxes expense ................................................................... Total Expenses ......................................................................... Net income ..........................................................................................

$612,900 $183,500 148,250 51,900 48,800 45,300 27,600 4,800 30,800

(540,950) $ 71,950

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P 3-63A 1. Journal entries Date a.

Journal Account and Explanation Accounts Receivable Service Revenue Cash Service Revenue

Cash* Accounts Receivable

Debit 2,256,700

Credit 2,256,700

686,838 686,838 2,332,028 2,332,028

Prepaid Advertising Cash

138,100

Supplies Accounts Payable

27,200

Accounts Payable** Cash

39,200

Wages Payable Cash

30,200

Wages Expense Cash

666,142

138,100

27,200

39,200

30,200

666,142

No journal entry required

* $361,500 + $2,256,700 − $286,172 = $2,332,028 ** $17,600 + $27,200 − $5,600 = $39,200

Date h.

Journal Account and Explanation Interest Expense*** Cash

Debit 30,000

Credit 30,000

Property Taxes Expense Cash

170,000

Dividends Cash

25,000

170,000

25,000

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***$1,000,000  0.06  6/12 = $30,000

P 3-63A (Continued) 2.

Adjusting entries: Date Dec.

Journal Account and Explanation 31 Supplies Expense* Supplies

Debit 38,115

Credit 38,115

31 Depreciation Expense Accumulated Depreciation (Building)

70,000

31 Depreciation Expense Accumulated Depreciation (Equipment)

145,000

31 Wages Expense Wages Payable

60,558

31 Interest Expense** Interest Payable

30,000

31 Advertising Expense*** Prepaid Advertising

125,226

31 Income Taxes Expense Income Taxes Payable

482,549

70,000

145,000

60,558

30,000

125,226

482,549

* $24,600 + $27,200 − $13,685 = $38,115 ** $1,000,000  0.06  6/12 = $30,000 *** $2,000 + $138,100 − $14,874 = $125,226

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P 3-63A (Continued) 1. and 2.

Bal.

Cash 92,100 138,100 686,838 39,200 2,332,028 30,200 666,142 30,000 170,000 25,000 2,012,324

Bal. (d) Bal.

Supplies 24,600 38,115 27,200 13,685

Bal.

Building (Warehouse 2,190,000

Bal.

2,190,000

Bal. (a) (b)

Bal.

Equipment 795,000

Bal.

795,000

Bal.

Land 304,975

Bal.

304,975

Adj.

Bal. (a)

Accounts Receivable 361,500 2,332,028 2,256,700

Bal.

286,172

Bal. (c) Bal.

Prepaid Advertising 2,000 125,226 138,100 14,874

(b)

Adj.

Accumulated Depreciation (Building) 280,000 Bal. 70,000 Adj. 350,000 Bal. Accumulated Depreciation (Equipment) 580,000 Bal. 145,000 Adj. 7,000 Bal.

(e)

Accounts Payable 39,200 17,600 27,200 5,600

Bal. (d) Bal.

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P 3-63A (Continued)

(f)

Wages Payable 30,200 30,200 60,558 60,558

Bal. Adj. Bal.

Income Taxes Payable 482,549 482,549

Adj. Bal.

Common Stock 1,400,000 1,400,000

Interest Payable 30,000

Adj.

30,000

Bal.

Notes Payable 1,000,000 1,000,000

Bal. Bal.

Retained Earnings 462,375 462,375

Bal. Bal.

(a) (a) Bal.

(j)

Dividends 25,000

Bal.

25,000

Service Revenue 2,256,700 686,838 2,943,538

(f) Adj. Bal.

Wages Expense 666,142 60,558 726,700

(h) Adj. Bal.

Interest Expense 30,000 30,000 60,000

(i)

Property Taxes Expense 170,000

Adj.

Supplies Expense 38,115

Bal.

38,115

Bal.

170,000

Adj. Adj. Bal.

Depreciation Expense 70,000 145,000 215,000

Adj. Bal.

Advertising Expense 125,226 125,226

Adj. Bal.

Bal. Bal.

Income Taxes Expense 482,549 482,549

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P 3-63A (Continued) 3.

Tarkington Freight Service Income Statement For the year ending December 31

Service revenue ................................................................................... Expenses: Wages expense ............................................................................. Depreciation expense ................................................................... Property tax expense .................................................................... Advertising expense...................................................................... Interest expense ........................................................................... Supplies expense .......................................................................... Income tax expense ...................................................................... Total expenses ......................................................................... Net income .......................................................................................... 4.

$2,943,538 $726,700 215,000 170,000 125,226 60,000 38,115 482,549 (1,817,590) $1,125,948

Tarkington Freight Service Retained Earnings Statement For the year ending December 31

Retained earnings, beginning .............................................................. Add: Net income .................................................................................. Less: Dividends declared ...................................................................... Retained earnings, ending .................................................................... 5.

$ 462,375 1,125,948 (25,000) $1,563,323

Tarkington Freight Service Balance Sheet December 31 Assets

Current assets: Cash ............................................................................................. Accounts receivable ...................................................................... Supplies........................................................................................ Prepaid advertising ....................................................................... Total current assets.................................................................. Property, plant, and equipment: Land ............................................................................................. Building ......................................................... $2,190,000 Less: Accumulated depreciation (Building) ................................................... (350,000)

$2,012,324 286,172 13,685 14,874 $2,327,055 $304,975

1,840,000 Equipment ...................................................... $795,000 Less: Accumulated depreciation (Equipment)............................................... (725,000) Equipment, net ..................................... Total property, plant, and equipment .......................................

70,000

2,214,975

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Total assets............................................................

$4,542,030

P 3-63A (Continued) Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Wages payable ............................................................................. Interest payable............................................................................ Income taxes payable ................................................................... Total current liabilities .............................................................

$5,600 60,558 30,000 482,549 $578,707

Long-term liabilities: Notes payable .............................................................................. Total liabilities…....................................................................... Stockholders’ equity: Common stock .............................................................................. Retained earnings ......................................................................... Total stockholders’ equity ........................................................ Total liabilities and stockholders' equity ........................................ 6.

$1,400,000 1,563,323 2,963,323 $4,542,030

Closing entries: Date Dec.

Journal Account and Explanation 31 Service Revenue Retained Earnings 31 Retained Earnings Wages Expense Interest Expense Property Taxes Expense Supplies Expense Depreciation Expense25,000 Income Taxes Expense Advertising Expense 31 Retained Earnings Dividends Declared

1,000,000 $1,578,707

Debit 2,943,538

Credit 2,943,538

1,817,590 726,700 60,000 170,000 38,115 215,000 482,549 125,226 25,000 25,000

Transaction (g) was not recorded because it had to do with the personal transaction of a shareholder and not a company transaction.

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P 3-64A (Continued) 2.

Marsteller Properties Inc. Income Statement For the year ending December 31

Rent revenue ....................................................................................... Expenses: Depreciation expense ................................................................... Interest expense ........................................................................... Wages expense ............................................................................. Repairs and maintenance expense ................................................ Advertising expense...................................................................... Insurance expense ........................................................................ Utilities expense ........................................................................... Supplies expense .......................................................................... Income taxes expense ................................................................... Total expenses ......................................................................... Net income ..........................................................................................

$663,800 $204,250 180,000 90,400 73,200 58,700 12,000 3,700 3,300 5,738 (631,288) $32,512

Marsteller Properties Inc. Retained Earnings Statement For the year ending December 31 Retained earnings, January 1 ................................................................ Add: Net income .................................................................................. Retained earnings, December 31 ..........................................................

$39,200 32,512 $71,712

Marsteller Properties Inc. Balance Sheet December 31 Assets Current assets: Cash ............................................................................................. Rent receivable............................................................................. Supplies........................................................................................ Prepaid insurance ......................................................................... Total current assets ................................................................. Property, plant, and equipment: Land…………………………………………………………… ............................. …. Buildings ...................................................................................... Accumulated depreciation (buildings) ........................................... Buildings, net .......................................................................... Other assets......................................................................................... Total assets..........................................................................................

4,600 36,300 1,400 48,000 $ 90,300 274,000

$4,560,000 (1,219,250)

3,340,750 26,100 $3,731,150

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P 3-64A (Continued) Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Wages payable ............................................................................. Interest payable............................................................................ Income taxes payable ................................................................... Total current liabilities .............................................................

$ 57,600 6,100 90,000 5,738 $ 159,438

2,000,000 $2,159,438 $1,500,000 71,712 1,571,712 $3,731,150

Closing entries: Date Dec.

Journal Account and Explanation 31 Rent Revenue Retained Earnings 31 Retained Earnings Repairs & Maintenance Expense Advertising Expense Wages Expense Utilities Expense Supplies Expense Depreciation Expense Insurance Expense Interest Expense Income Taxes Expense

Debit 663,800

Credit 663,800

631,288

73,200 58,700 90,400 3,700 3,300 204,250 12,000 180,000 5,738

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PROBLEM SET B P 3-55B 1.

Cash-basis income: January incomea .............................................................................................................. February incomeb..................................................................... March incomec .........................................................................

$2,035 2,175 2,910

$3,200 − $1,165 = $2,035 $2,475 − $300 = $2,175 c $2,910 − $0 = $2,910 a

Accrual-basis income: January incomed ...................................................................... February incomee ..................................................................... March incomef .........................................................................

$1,885 2,895 2,395

$2,800 − $915 = $1,885 $3,500 − $605 = $2,895 f $3,275 − $880 = $2,395 d e

P 3-56B 1.

Revenue: $228,500 Expenses: Expense Salaries ................................................... Supplies .................................................. Selling and administrative........................ Total expenses ........................................

Amount $49,900 11,020 10,800 $71,720

Calculation (if any) $1,200 + $12,640 − $2,820

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P 3-56B (Continued) 2.

Aunt Bea’s Catering Service Income Statement For the year ending December 31

Service revenue ................................................................................... Expenses: Salaries expense ........................................................................... Supplies expense .......................................................................... Selling and administrative expense ............................................... Total expenses ......................................................................... Net income .......................................................................................... 3.

$228,500 $49,900 11,020 10,800 (71,720) $156,780

The income statement was prepared using the revenue recognition and expense recognition principles.

P 3-57B 1.

Analyzing transactions: a. Regular journal entry (Note: While this entry is not an adjusting entry made at the end of the period, it does defer revenue and serves as the basis for a later adjusting entry.) b. Adjusting entry; deferred revenue c. Regular journal entry d. Adjusting entry; deferred expense e. Adjusting entry; accrued revenue f. Regular journal entry g. Adjusting entry; deferred expense h. Adjusting entry; accrued expense

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P 3-57B (Continued)

e. f.

Date Jan.

Journal Account and Explanation 1 Cash Unearned Service Revenue

Debit 4,125

Credit 4,125

31 Unearned Service Revenue* Service Revenue

3,300

20 Wages Expense Cash

1,415

3,300

1,415

31 Insurance Expense** Prepaid Insurance

500

31 Accounts Receivable Rent Revenue 10 Supplies Cash

400

31 Supplies Expense*** Supplies

265

31 Utilities Expense Utilities Payable

770

500

400 350 350

265

770

*$4,125 − $825 = $3,300 **$3,000/6 months = $500 ***$350 − $85 = $265

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P 3-58B Date Jan.

Journal Account and Explanation 31 Unearned Service Revenue* Service Revenue

Debit 28,800

Credit 28,800

31 Accounts Receivable** Service Revenue

17,640

31 Depreciation Expense (Golf Carts) Accumulated Depreciation (Golf Carts)

11,250

31 Other Expense Accounts Payable

1,795

31 Supplies Expense Supplies

661

17,640

11,250

1,795

661

*16 guests  4/10 days  $4,500 per guest = $28,800 **21 guests  $280 per guest  3 nights = $17,640

Balance, 1/1......................................................................................... Purchases ............................................................................................ Available for use .................................................................................. Less: Balance at 1/31 (unused) ............................................................. Amount used ....................................................................................... 2.

Office Supplies Inventory $ 0 850 $850 (189) $661

If the adjusting entries above were not made, net income would be understated by $32,734 ($28,800 + $17,640 − $11,250 − $1,795 − $661).

P 3-59B Transaction a. b. c. d.

Assets

Liabilities +1,875

+1,150 −2,560 −4,680

Common Stock

Retained Earnings −1,875 +1,150 −2,560 +4,680

Revenues

Expenses +1,875

+1,150 +2,560 +4,680

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P 3-60B 1.

Adjusting entries:

Date Dec.

Journal Account and Explanation 31 Insurance Expense* Prepaid Insurance

Debit 9,020

Credit 9,020

31 Depreciation Expense Accumulated Depreciation

10,130

31 Interest Expense** Interest Payable

5,000

31 Wages Expense Wages Payable

4,950

31 Income Taxes Expense Income Taxes Payable

11,370

10,130

5,000

4,950

11,370

*$11,200 − $2,180 = $9,020 **$150,000  0.10  4/12 = $5,000

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P 3-60B (Continued) 2.

Mitchell Pharmacy Income Statement For the year ending December 31

Service revenue ................................................................................... Less operating expenses: Wages expense* ........................................................................... Interest expense** ....................................................................... Depreciation expense ................................................................... Insurance expense ........................................................................ Income taxes expense ................................................................... Total expenses ......................................................................... Net income ..........................................................................................

$ 950,420 $(876,370) (17,000) (10,130) (9,020) (11,370) (923,890) $26,530

*$871,420 + $4,950 = $876,370 **$12,000 + $5,000 = $17,000

Mitchell Pharmacy Retained Earnings Statement For the year ending December 31 Retained earnings, January 1 ................................................................ Add: Net income .................................................................................. Less: Dividends .................................................................................... Retained earnings, December 31 ..........................................................

$41,200 26,530 0 $67,730

Mitchell Pharmacy Balance Sheet December 31 Assets Current assets: Cash ............................................................................................. Accounts receivable ...................................................................... Inventory...................................................................................... Prepaid insurance ......................................................................... Total current assets............................................. ………………….. Property, plant, and equipment: Land ............................................................................................. Building ........................................................................................ Less: Accumulated depreciation .................................................... Building, net ............................................................................ Other assets......................................................................................... Total assets..........................................................................................

$3,400 64,820 583,400 2,180 $653,800 31,200 $230,000 (54,130)

175,870 25,990 $886,860

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P 3-60B (Continued) Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Interest payable............................................................................ Wages payable ............................................................................. Income taxes payable ................................................................... Total current liabilities .............................................................

$47,810 5,000 4,950 11,370 $69,130

150,000 $219,130 $600,000 67,730 667,730 $886,860

P 3-61B 1.

(a)

Prepaid Insurance Preadjustment .............. $15,390 Adjustment ................... 11,246 Adjusted ....................... $ 4,144

Insurance Expense Adjusted ....................... $12,746 Preadjustment .............. 1,500 Adjustment ................... $11,246

(b)

Interest Payable Preadjustment .............. $0 Adjustment ................... 4,175 Adjusted ....................... $4,175

Interest Expense Adjusted ....................... $5,300 Preadjustment .............. 1,125 Adjustment ................... $4,175

(c)

Wages Payable Preadjustment .............. $0 Adjustment ................... 17,600 Adjusted ....................... $17,600

Wages Expense Adjusted ....................... $41,800 Preadjustment .............. 24,200 Adjustment ................... $17,600

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P 3-61B (Continued)

(d)

Unearned Service Revenue Preadjustment.............. $12,250 Adjusted ...................... 2,620 Adjustment .................. $9,630

Service Revenue Preadjustment .............. $122,500 Adjustment .................. 9,630 Adjusted....................... $132,130

(e)

Accumulated Depreciation Adjusted ...................... $103,000 Preadjustment.............. 92,500 Adjustment .................. $10,500

Depreciation Expense Preadjustment .............. $ 0 Adjustment .................. 10,500 Adjusted....................... $10,500

Adjusting entries: Date (a)

(b)

Interest Expense Interest Payable

Date (c)

(b)

(e)

Journal Account and Explanation Insurance Expense Prepaid Insurance

Journal Account and Explanation Wages Expense Wages Payable

Debit 11,246

Credit 11,246

4,175 4,175

Debit 17,600

Credit 17,600

Unearned Service Revenue Service Revenue

9,630

Depreciation Expense Accumulated Depreciation

10,500

9,630

10,500

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P 3-62B

Date Dec.

Journal Account and Explanation 31 Sales Revenue Interest Income Retained Earnings 31 Retained Earnings Wages Expense Insurance Expense Rent Expense Depreciation Expense (Equipment) Utilities Expense Supplies Expense Interest Expense Income Taxes Expense

Date Dec.

Journal Account and Explanation 31 Retained Earnings Dividends Declared

Debit 692,500 7,600

Credit

700,100 650,850 405,300 94,300 28,800 20,000 12,300 68,350 9,500 12,300

Debit 7,800

Credit 7,800

Port Austin Boat Repair Inc. Income Statement For the year ending December 31

Revenues: Sales revenue ............................................................................... Interest revenue ........................................................................... Total revenues ......................................................................... Expenses: Wages expense ............................................................................. Insurance expense ........................................................................ Supplies expense .......................................................................... Rent expense ................................................................................ Depreciation expense (equipment) ............................................... Utilities expense ........................................................................... Interest expense ........................................................................... Income tax expense ...................................................................... Total expenses ......................................................................... Net income ..........................................................................................

$692,500 7,600 $700,100 $405,300 94,300 68,350 28,800 20,000 12,300 9,500 12,300

(650,850) $ 49,250

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P 3-63B 1.

Journal entries: Date a.

Journal Account and Explanation Accounts Receivable Service Revenue

Debit 210,300

Credit 210,300

Cash Service Revenue*

62,300

Cash Accounts Receivable**

199,100

62,300

199,100

* $41,800 + $20,500 = $62,300 ** $4,400 + $210,300 − $15,600 = $199,100

Date c.

i. j.

Journal Account and Explanation Supplies Accounts Payable

Debit 62,900

Credit 62,900

Supplies Cash

7,400

Wages Payable Cash Wages Expense Cash

14,200

7,400

14,200 112,000 112,000

Income Taxes Payable Cash

15,100

Accounts Payable Cash

73,000

Interest Expense Interest Payable Cash*** No journal entry required

2,700 2,700

Property Taxes Expense Cash

17,000

Dividends Declared Cash

7,200

15,100

73,000

5,400

17,000

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*** $60,000  0.09 = $5,400

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P 3-63B (Continued) 2.

Adjusting entries: Date Dec.

Journal Account and Explanation 31 Supplies Expense* Supplies

Debit 67,700

Credit 67,700

31 Depreciation Expense (Building) Accumulated Depreciation (Building)

6,000

31 Depreciation Expense (Equipment) Accumulated Depreciation (Equipment)

5,500

31 Wages Expense Wages Payable

4,000

31 Interest Expense** Interest Payable

2,700

31 Income Taxes Expense Income Taxes Payable

16,500

6,000

5,500

4,000

2,7000

16,500

* $27,800 + $62,900 + $7,400 − $30,400 = $67,700 ** $60,000  0.09  6/12 = $2,700

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P 3-63B (Continued) 1. and 2.

Bal.

Cash 2,200 7,400 62,300 14,200 199,100 112,000 15,100 73,000 5,400 17,000 7,200 12,300

Bal. (c) (d) Bal.

Supplies (Feed & Straw) 27,800 67,700 62,900 7,400 30,400

Bal. (a) (b)

Bal.

Buildings 115,000

Bal.

115,000

Bal.

Equipment 57,000

Bal.

57,000

(g)

(h)

(d) (e) (e) (f) (g) (h) (j) (k)

Adj.

Bal. (a)

Accounts Receivable 4,400 199,100 210,000

Bal.

15,600

Bal.

Land 167,000

Bal.

167,000

(b)

Accumulated Depreciation (Buildings) 36,000 Bal. 6,000 Adj. 42,000 Bal. Accumulated Depreciation (Equipment) 16,500 Bal. 5,500 Adj. 22,000 Bal.

Accounts Payable 73,000 23,000 62,900 13,600

Bal. (c) Bal.

Interest Payable 2,700 2,700 2,700 2,700

Bal. Adj. Bal.

(f)

Income Taxes Payable 15,100 15,100 16,500 16,500

Bal. Adj. Bal.

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P 3-63B (Continued) (e)

Wages Payable 14,200 14,200 4,000 4,000

Bal. Adj. Bal.

Common Stock 150,000 150,000

Bal. Bal.

(k)

Dividends 7,200

Bal.

7,200

Notes Payable 60,000

Bal.

60,000

Bal.

Retained Earnings 55,200 55,200

Bal. Bal.

Service Revenue 210,300 62,300 272,600

(a) (a) Bal.

(e) Adj. Bal.

Wages Expense 112,000 4,000 116,000

(h) Adj. Bal.

Interest Expense 2,700 2,700 5,400

(j) Bal.

Property Tax Expense 17,000 17,000

Adj. Bal.

Supplies Expense 67,700 67,700

Adj. Adj. Bal.

Depreciation Expense 6,000 5,500 11,500

Adj.

Income Taxes Expense 16,500

Bal.

16,500

Wilburton Riding Stables Income Statement For the year ending December 31 Service revenue ................................................................................... Expenses: Wages expense ............................................................................. Supplies expense .......................................................................... Property taxes expense................................................................. Depreciation expense ................................................................... Interest expense ........................................................................... Income taxes expense ................................................................... Total expenses ........................................................................ Net income ..........................................................................................

$272,600 $116,000 67,700 17,000 11,500 5,400 16,500

(234,100) $38,500

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P 3-63B (Continued) 4.

Wilburton Riding Stables Retained Earnings Statement For the year ending December 31 Retained earnings, beginning ............................................................... Add: Net income ................................................................................. Less: Dividends declared ...................................................................... Retained earnings, ending .................................................................... 5.

$ 55,200 38,500 (7,200) $86,500

Wilburton Riding Stables Balance Sheet December 31 Assets

Current assets: Cash ..................................................................... Accounts receivable .............................................. Supplies (feed & straw) ......................................... Total current assets.......................................... Property, plant, and equipment: Land ..................................................................... Buildings .............................................................. Less: Accumulated depreciation (Buildings) ....................................................... Buildings, net ................................................... Equipment ............................................................ Less: Accumulated depreciation (Equipment) ........ Equipment, net ................................................ Total property, plant, and equipment ............... Total assets ..........................................................

$12,300 15,600 30,400 $58,300 $167,000 $115,000 (42,000) 73,000 $57,000 (22,000)

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Income taxes payable ................................................................... Interest payable............................................................................ Wages payable ............................................................................. Total current liabilities .............................................................

35,000 275,000 $333,300

$13,600 16,500 2,700 4,000 $36,800

60,000 $96,800 $150,000 86,500

236,500

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Total liabilities and stockholders’ equity ............................................... 6.

Closing entries: Date Dec.

Journal Account and Explanation 31 Service Revenue Retained Earnings 31 Retained Earnings Wages Expense Interest Expense Property Taxes Expense Supplies Expense Depreciation Expense Income Taxes Expense 31 Retained Earnings Dividends Declared

$333,300

Debit 272,600

Credit 272,600

234,100 116,000 5,400 17,000 67,700 11,500 16,500 7,200 7,200

Transaction (i) was not recorded because it had to do with the personal transaction of a shareholder and not a company transaction.

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P 3-64B (Continued) 2.

Flint Inc. Income Statement For the year ending December 31

Service revenue ................................................................................... Expenses: Royalties expense ........................................................................ Utilities expense ........................................................................... Depreciation expense (equipment) ............................................... Miscellaneous expense ................................................................. Wages expense ............................................................................. Interest expense ........................................................................... Depreciation expense (building) .................................................... Property taxes expense................................................................. Supplies expense .......................................................................... Income taxes expense ................................................................... Total expenses ......................................................................... Net income ..........................................................................................

$1,079,000 $398,000 36,800 150,000 44,000 196,000 21,667 20,000 10,500 3,500 49,633 (930,100) $ 148,900

Flint Inc. Retained Earnings Statement For the year ending December 31 Retained earnings, January 1 ................................................................ Add: Net income .................................................................................. Less: Dividends declared ...................................................................... Retained earnings, December 31 ..........................................................

$14,700 148,900 (28,000) $135,600

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P 3-64B (Continued) Flint Inc. Balance Sheet December 31 Assets Current assets: Cash ......................................................... Accounts receivable .................................. Supplies.................................................... Total current assets.............................. Property, plant, and equipment: Land ......................................................... Building .................................................... Accumulated depreciation (building) ......... Building, net ........................................ Equipment ................................................ Accumulated depreciation (equipment) .... Equipment, net ................................................ Total property, plant, and equipment ... Other assets..................................................... Total assets......................................................

$2,000 183,000 1,500 $186,500 $37,000 $ 209,000 (60,000) 149,000 794,000 (412,000) 382,000 568,000 19,700 $ 774,200

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Interest payable............................................................................ Income taxes payable ................................................................... Total current liabilities .............................................................

$32,300 6,667 49,633 $88,600

250,000 $338,600 $300,000 135,600

435,600 $774,200

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P 3-64B (Continued) 3.

Closing entries: Date Dec.

Journal Account and Explanation 31 Service Revenue Retained Earnings

Debit 1,079,000

Credit 1,079,000

31 Retained Earnings Royalties Expense Property Taxes Expense Utilities Expense Wages Expense Miscellaneous Expense Supplies Expense Depreciation Expense (Building) Depreciation Expense (Equipment) Interest Expense Income Taxes Expense

930,100

31 Retained Earnings Dividends Declared

28,000

398,000 10,500 36,800 196,000 44,000 3,500 20,000 150,000 21,667 49,633

28,000

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CASES Case 3-65 The Financial Accounting Standards Board believes that earnings measured using accrual accounting provides a better indication of company performance than does net income measured using cashbasis accounting. Accrual accounting requires that the financial effects of transactions be recorded in the period in which they occur rather than only in the period in which cash flows occur. Recording revenues using accrual accounting (rather than cash-basis accounting) produces net income amounts that more closely associate the results of revenue-related activities with the periods in which those activities take place. Cash-basis accounting is likely to cause revenues to be recorded in periods different from the period in which the revenue-related activities take place, thus distorting the usefulness of the net income amount as an indicator of business performance.

Case 3-66 1.

Early revenue recognition will result in early reporting of net income. Because both lenders and stockholders are more willing to provide financing to companies that demonstrate higher net income (everything else being the same), it may be that Mr. Murphy plans to seek additional financing and believes that he can do so under more favorable terms if revenue recognition is accelerated. It is also possible that his current or future personal salary or bonus from the business is influenced by the amount of income reported by the business.

Argument against proposal to recognize revenue when the contract is signed: Under generally accepted accounting principles, an agreement—even a written agreement—cannot be recognized and recorded in the accounting records until one of the parties to the agreement has performed his or her obligation under the agreement. Although the written agreement establishes the amounts to be paid for the services and the nature of the services to be provided, such contracts are open to cancellation. Once one of the parties to the contract performs under its terms, however, the contract is likely to stand, and generally accepted accounting principles allow recognition to the extent of that performance. Because neither Blooming Colors nor Eastern State University performs under the terms of the contract by signing (Blooming Colors performs no services for Eastern and Eastern pays no cash to Blooming Colors), it is inappropriate to recognize any contract revenue or to make any accounting entry for the contract when it is signed. Argument against proposal to recognize revenue as cash is collected: Under generally accepted accounting principles, service revenue should be recognized when the seller has provided the promised service. When the service is provided over time, generally accepted accounting principles require that revenue be recognized over the time period in relation to the services performed. Thus, Blooming Colors should recognize an equal amount of revenue from the Eastern contract in every month.

The balance sheet at December 31 (prior to the services being provided) will not reflect the contract the contract has not been recognized in the accounting system. The balance sheet at January 31 (after the first month of service is provided) will include a liability corresponding prepayment by Eastern State University for services not yet rendered. Such a liability represents the obligation of Blooming Colors to provide future services; it is called unearned revenue. Cash on the balance sheet will include the portion received from Eastern that has not yet been spent. Retained earnings will include the revenue earned by Blooming Colors during January.

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Case 3-67 1.

The discussion of revenue recognition indicates that revenues should be recognized when a company satisfies its performance obligation by transferring goods or providing services to customers. In this situation, services will be transferred to customers over the entire 3 years rather than in just the first year. Therefore, it would not be appropriate to record the entire$750,000 as revenue in the first year of operations. Rather, revenue recognition should be spread over the entire 3 years, consistent with the pattern of usage that customers are expected to make of the club. If the customers are expected to use the club more heavily in the early part of the 3-year period, that expectation would be a basis for recognizing more of the $750,000 of revenue in the early part of the3-year period. However, unless Melaney can demonstrate that she expects all of the usage to occur in the first year, it is not appropriate to recognize all of the revenue in that period. The fact that the cash has been collected is not the determining factor for the recognition of revenue under accrual accounting.

If the $3,000 fee were nonrefundable, the answer would not change. Revenue would still have to be recognized as the services for which the money was collected are performed. This means that there is no change in the revenues being equally recognized over the 3-year period, unless it is shown that most of the services will be performed in the first year and not evenly throughout the time period.

Case 3-68 The expense recognition concept requires that expenses be identified with (recorded in) periods in which the related revenues are recorded. The $550,000 was a “direct and incremental” cost that was expended to secure leases that will provide $550,000 of rental revenues each year for 4 years. Therefore, the $550,000 should be expensed, probably in $137,500 increments each year, over the entire 4-year period in which revenues produced by the expenditure will be earned. Note that if the costs were not considered to be “direct and incremental,” the costs would have been incurred regardless of Newman's ability to secure tenants. As such, these costs would not be matched to specific lease revenue, and, therefore, it would be appropriate to immediately expense the entire $550,000 in the current period.

Case 3-69 Note to Instructor: Although the accounting standards associated with motion picture revenues are more involved than most introductory accounting students are prepared to master, this scenario does provide an easily understood context for analysis and discussion of adjusting entries related to the deferral and recognition of revenue. The first contract illustrates the year end adjustment for the recognition of the entire deferred amount plus an additional amount. The second contract illustrates the continuing deferral of a previously recorded amount of unearned revenue, which requires no adjusting entry. The third contract illustrates recognition of the entire deferral prior to the end of the contract.

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Case 3-69 (Continued) In general, accounting standards allow the recognition of revenue when the company has satisfied its performance obligation. When a minimum guarantee exists, revenue related to the guarantee may be recognized once the performance obligation is satisfied. Any excess of the guarantee is recognized as the motion picture is shown and the amount can be determined. The descriptions of adjustments and the statements of supporting arguments might be presented as follows: a.

For Contract A, the prepaid minimum guarantee can be recognized as revenue once the exhibition of the film begins, because the performance obligation has been satisfied at that time. An adjusting entry can be made that decreases the unearned revenue account and increases revenue to recognize the full amount of the minimum guarantee that has already been received. For the amount in excess of the guarantee that has not yet been received, an adjusting entry can be made that increases a receivable and a revenue account (accrued revenue) for the amount due from the first week of exhibition.

Contract B pertains to a film that has not yet been exhibited by the licensee. Since exhibition is required for revenue recognition, no adjusting entry should be made for the contract, and the entire prepaid guaranteed minimum should be reported as unearned revenue at year end. One might argue that the prepayment of the nonrefundable guarantee constitutes partial performance by the licensee and meets the test of being reasonably measurable. However, events could still nullify the contract. For example, prints of the film could fail to arrive, or the licensee could decide to withdraw from the contract.

The effective exhibition period for Contract C is entirely within 2023. Consequently, the entire advance payment should be recognized as revenue in 2023. This recognition is accomplished by an adjustment that decreases unearned revenue and increases the revenue account.

Case 3-70 1.

No. After the initial periods, the amounts of expenses remain constant, and sales are mainly for cash. Therefore, Don’s financial statements would not be affected significantly by adjustments.

Transactions that require adjustments that would affect the financial statements would include: (1) revenues arising from continuous transactions involving provision of services when the amount of service provided varies and when a large number of transactions are incomplete at year end and (2) expenses that vary from year to year and that arise from continuous transactions that are unrecorded or deferred at year end. Depreciation can also produce adjustments that affect statements if there are changes in the assets that underlie the depreciation computation. Interest expense or interest revenue can be affected by adjusting entries if the amount of money loaned or borrowed or the interest rates change. The financial statements for businesses that provide or consume large amounts of services would be most likely to be affected by these kinds of adjustments.

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Case 3-71 1.

FedEx recognizes revenue over time as they perform delivery services because of continuous transfer of control to the customer. Customers receive the benefit of the delivery services as the goods are transported from one location to another. As control transfers over time, revenue is recognized based on the extent of progress toward completion of the performance obligation.

Accounts on the income statement that may have required adjustments include the following: Revenue: deferral Salaries and employee benefits: accrual Depreciation and amortization: deferral Interest expense: accrual Interest income: accrual Accounts on the balance sheet that may have required adjustments include the following: Deferred income taxes: deferral Prepaid expenses: deferral Accumulated depreciation: deferral Accrued expenses: accrual Accrued salaries and employee benefits: accrual Accounts payable: accrual Self-insurance accruals; accrual Deferred lease obligations; deferral Deferred gains; deferral

Accrued salaries and employee benefits = $1,741,000,000

Credit to Retained Earnings is closing of revenues = $69,752,000,000 ($69,693,000,000 revenues + $59,000,000 interest income) Debit to Retained Earnings is closing of expenses = $69,212,000,000 ($65,227,000,000 operating expenses + $588,000,000 interest expense + $3,282,000,000 other expenses + $115,000,000 tax expense).

Income tax expense = “Provision for Income Taxes” = $115,000,000. Cash paid for income taxes = $407,000,000 (from Note 15). The major difference between these two numbers is that a portion of the taxes has been deferred (see Note 12). This arises because income tax expense is based on income computed under GAAP, while the cash payment is based on the taxable income computed under the Internal Revenue Code. The subject of deferred taxes is addressed in Intermediate Accounting. In addition, some of the current tax payable has not been paid and is reflected in income tax payable (see Note 5).

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Case 3-72 1.

Kroger recognizes revenue consistent with the revenue recognition principle which states that revenue should be recorded when it has satisfied its performance obligations. According to Note 1 to its financial statements, Kroger recognizes revenue at the point of sale, which is generally when the customer takes possession of the goods. Sprouts also recognizes revenue consistent with the revenue recognition principle. According to Note 1 to its financial statements, Sprouts recognizes revenue when goods are transferred to the customer, which is the point of sale.

Kroger Prepaid expenses: deferral Deferred income taxes: deferral Accounts payable: accrual Accrued salaries and wages: accrual Operating, general, and administrative expenses (for salaries): accrual Interest expense: accrual Depreciation expense Provision for income taxes (income tax expense): accrual Sprouts Prepaid expenses: deferral Deferred income taxes: deferral Accounts payable: accrual Accrued salaries: accrual Selling, general, and administrative expenses (for salaries): accrual Interest income: accrual Interest expense: accrual Depreciation and amortization Income taxes: accrual

Kroger—for the year ending February 1, 2020: Credit to Income Summary = $122,766,000,000 (to close revenues and gains), computed as $122,286,000,000 (revenues) + $480,000,000 (other gains). Debit to Income Summary = $121,107,000,000 (to close expenses) computed as$95,294,000,000 (cost of goods sold) + $21,208,000,000 (operating, general and administrative expense+ $884,000,000 (rent expense) + $2,649,000,000 (depreciation and amortization) + $603,000,000 (interest expense) + $469,000,000 (income tax expense)

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Case 3-72 (Continued) Sprouts—for the year ending December 29, 2019: Credit to Income Summary = $5,634,835,000 (to close revenues) Debit to Income Summary = $5,485,206,000 (to close expenses) computed as$3,740,017,000 (cost of sales) + $1,549,707,0000 (selling, general, and administrative expenses) + $ 127,751,000 (other operating expenses) + $21,192,000 (interest expense) + $46,539,000 (income tax expense) 4.

Kroger Income tax expense = $469,000,000 Cash paid for income taxes = $706,000,000 (see supplemental information on the statement of cash flows) Sprouts Income tax expense = $46,539,000 Cash paid for income taxes = $44,637,000 (see supplemental information on the statement of cash flows) The difference between these two numbers occurs because income tax expense is based on income computed under GAAP, while the cash payment is based on the taxable income computed under the Internal Revenue Code. This creates a deferred tax, which is addressed in Intermediate Accounting.

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Annual Report Problem (amounts in millions) 1,494 2,116 22,090

1. Salaries Payable Deferred Revenue Accumulated Depreciation 2. Forecasted balances Salaries Payable Deferred Revenue Accumulated Depreciation

1,524 2,201 22,753 Debit

3 Salaries Expense Salaries Payable Deferred Revenue Sales Revenue Depreciation Expense Accumulated Depreciation 4. 5. 6. 7.

Credit 14 $

$ 378 $ 378 $ 253 $ 253

Accrual basis Accrued expense Contra-asset Gift cards

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Case 3-74 1. Date Feb.

Journal Account and Explanation 1 Cash Unearned Sales Revenue 1 Rent Expense Cash

Debit 28,400

Credit 28,400

800 800

2 Accounts Payable Cash

1,500

6 Prepaid Rent Cash

30,150

1,500

30,150

9 Cash Accounts Receivable

325

12 Supplies Accounts Payable

475

15 Cash Sales Revenue 15 Artist Fee Expense Cash

3,400

20 Cash Unearned Sales Revenue

10,125

21 Cash Sales Revenue

5,100

21 Artist Fee Expense Cash

12,620

325

475

3,400 9,000 9,000

10,125

5,100

12,620

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Case 3-74 (Continued) 2.

Note: Beginning balances in the accounts are obtained from the solution to the Continuing Problem for Chapter 2. Cash 14,100 28,400 800 325 1,500 3,400 30,150 10.125 9,000 5,100 12,620 7,380

Bal. Feb. 1 9 15 20 21 Bal.

Bal.

Bal. Feb. 1 2 6 15 21

Prepaid Insurance 3,600

Bal.

3,600

Bal.

Equipment 7,000

Bal.

Bal. Feb. 12 Bal.

Bal. Feb. 6 Bal.

10,000 30,150 40,150

Prepaid Rent

7,000 Unearned Sales Revenue 3,800 Bal. 28,400 Feb. 1 10,125 20 42,325 Bal.

Bal. Feb. 15 21 Bal.

Common Stock 16,000

Bal.

16,000

Bal.

Artist Fee Expense 800 9,000 12,620 22,420

75 Supplies 2,500 475 2,975

Feb. 2 Bal.

Accounts Receivable 400 325 Feb. 9

Accounts Payable 1,500 1,500 475 475

Bal. Feb. 12 Bal.

Notes Payable 25,000

Bal.

25,000

Bal.

Sales Revenue 1,000 3,400 5,100 9,500

Bal. Feb. 15 21 Bal.

Rent Expense Bal. Feb. 1

800 800

Bal.

1,600

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Case 3-74 (Continued)

Bal. Bal.

Salaries Expense 2,400 2,400

Bal. Bal.

Legal Expense 1,200 1,200

Bal. Bal.

Advertising Expense 4,500 4,500

Front Row Entertainment Inc. Trial Balance February 28

Account Cash ................................................................................................ …. Accounts Receivable ................................................................... ………. Supplies… ............................................................................................ Prepaid Insurance ................................................................................ Prepaid Rent ........................................................................................ Equipment ........................................................................................... Accounts Payable ................................................................................. Unearned Sales Revenue ...................................................................... Notes Payable ...................................................................................... Common Stock..................................................................................... Sales Revenue ...................................................................................... Artist Fee Expense ............................................................................... Advertising Expense ...................................................................... ……. Salaries Expense .................................................................................. Rent Expense ....................................................................................... Legal Expense ...................................................................................... Totals ...........................................................................................

Debit $7,380 75 2,975 3,600 40,150 7,000

Credit

$475 42,325 25,000 16,000 9,500 22,420 4,500 2,400 1,600 1,200 $93,300

_______ $93,300

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Case 3-74 (Continued) 4.

Date Feb.

Journal Account and Explanation 28 Interest Expensea Interest Payable 28 Supplies Expenseb Supplies

Debit

Credit 375 375

1,150 1,150

28 Insurance Expensec Prepaid Insurance

600

28 Depreciation Expensed Accumulated Depreciation

360

600

360

28 Rent Expensee Prepaid Rent

5,000

28 Unearned Sales Revenuef Sales Revenue

34,150

28 Salaries Expenseg Salaries Payable

2,400

28 Utilities Expense Utilities Payable

435

5,000

34,150

2,400

435

$25,000  0.09  2/12 = $375 $2,975 − $1,825 = $1,150 c $3,600  2/12 = $600 d $180  2 = $360 e $10,000  2/4 = $5,000 f $42,325 − $8,175 = $34,150 g $1,200  2 = $2,400 a

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Case 3-74 (Continued)

Bal. Bal.

Cash 7,380 7,380 Supplies 2,975 1,150 1,825 Prepaid Rent 40,150 5,000 35,150

Bal. Bal.

Accounts Receivable 75 75

Bal.

Prepaid Insurance 3,600 600 3,600

Bal.

Equipment 7,000

Bal.

7,000

Bal. (b)

(c)

(e)

Accumulated Depreciation 360 360

(d) Bal.

Accounts Payable 475 475

Bal. Bal.

Salaries Payable 2,400 2,400

(g) Bal.

Interest Payable 375 375

(a) Bal.

Utilities Payable 435

(h) Bal.

Unearned Sales Revenue 42,325 34,150 8,175

Bal. Bal.

Common Stock 16,000 16,000

(f) 435 Notes Payable 25,000 25,000

Bal. Bal.

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Case 3-74 (Continued) Sales Revenue 9,500 34,150 43,650

Bal. (e) Bal.

Rent Expense 1,600 5,000 6,600

Bal. (g) Bal.

Salaries Expense 2,400 2,400 4,800

Bal. Bal.

Legal Expense 1,200 1,200

Insurance Expense 600 600

(a) Bal.

Interest Expense 375 375

Bal. (f) Bal.

Bal.

Artist Fee Expense 22,420

Bal.

22,420

Bal.

Advertising Expense 4,500

Bal.

4,500

(b) Bal.

Supplies Expense 1,150 1,150

(h) Bal.

Utilities Expense 435 435

(d) Bal.

Depreciation Expense 360 360

If the adjusting entries were not made, expenses would have been understated by $10,320 ($375 + $1,150 + $600 + $360 + $5,000 + $2,400 + $435) and revenues would have been understated by $34,150. Therefore, net income would have been understated by $23,830 ($34,150 − $10,320).

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Case 3-74 (Continued) 6.

Front Row Entertainment Inc. Income Statement For the 2-month period ending February 28 Sales revenue…………………………………………………………………………………………….. Expenses: Artist fee expense ......................................................................... $22,420 Rent expense ................................................................................ 6,600 Salaries expense ........................................................................... 4,800 Advertising expense...................................................................... 4,500 Legal expense ............................................................................... 1,200 Supplies expense .......................................................................... 1,150 Insurance expense ........................................................................ 600 Utilities expense ........................................................................... 435 Interest expense ........................................................................... 375 Depreciation expense ................................................................... 360 Total expenses ......................................................................... Net income………………………………………………………………………………………… .

$43,650

42,440 $ 1,210

Front Row Entertainment Inc. Retained Earnings Statement For the 2-month period ending February 28 Retained earnings, January 1 ................................................................ Add: Net income .................................................................................. Less: Dividends .................................................................................... Retained earnings, February 28 ............................................................

$ 0 1,210 0 $1,210

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Case 3-74 (Continued) Front Row Entertainment Inc. Balance Sheet February 28 Assets Current assets: Cash ............................................................................................. Accounts receivable ...................................................................... Supplies........................................................................................ Prepaid insurance ......................................................................... Prepaid rent ................................................................................. Total current assets.................................................................. Property, plant, and equipment: Equipment .................................................................................... Less: Accumulated depreciation .................................................... Equipment, net ........................................................................ Total assets..........................................................................................

$7,380 75 1,825 3,000 35,150 $47,430

$ 7,000 (360) 6,640 $54,070

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.......................................................................... Salaries payable ............................................................................ Interest payable............................................................................ Utilities payable............................................................................ Unearned sales revenue................................................................ Total current liabilities ............................................................. Long-term liabilities: Notes payable ...................................................................................... Total liabilities ......................................................................... Stockholders’ equity: Common stock .............................................................................. Retained earnings ......................................................................... Total stockholders’ equity ........................................................ Total liabilities and stockholders’ equity ...............................................

$ 475 2,400 375 435 8,175 $11,860 25,000 $36,860 $16,000 1,210

17,210 $54,070

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Case 3-74 (Continued) 7. Date Feb.

Journal Account and Explanation 28 Sales Revenue Retained Earnings 28 Retained Earnings Artist Fee Expense Rent Expense Salaries Expense Advertising Expense Legal Expense Supplies Expense Insurance Expense Utilities Expense Interest Expense Depreciation Expense

Debit 43,650

Credit 43,650

42,440

22,420 6,600 4,800 4,500 1,200 1,150 600 435 375 360

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Making the Connection:

INTEGRATIVE EXERCISE (Chapters 1–3) 1. a.

THE ACCOUNTING CYCLE Journal Date Account and Explanation Dec. 31 Rent Expense Prepaid Rent

Debit 9,100

Credit 9,100

31 Wages Expense Wages Payable

12,500

31 Depreciation Expense* Accumulated Depreciation

2,000

31 Interest Expense** Interest Payable

1,800

12,500

2,000

1,800

* $14,300 − $12,300 = $2,000 ** $160,000  0.0675  2/12 = $1,800

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University Street Parking Garage Income Statement For the year ended December 31, 2023

Service revenue, parking ................................................. Service revenue, repair.................................................... Total revenue .......................................................... Operating expenses: Wages expensea....................................................... Rent expenseb.......................................................... Supplies expense ..................................................... Depreciation expense (equipmentc) ......................... Total operating expenses .................................. Income from operations .................................................. Other income (expense): Interest income ....................................................... Interest expensed ..................................................... Total other income (expense) ........................... Income before income taxes............................................ Income tax expense ........................................................ Net income .....................................................................

$224,600 208,100 $432,700 $246,100 103,500 36,900 14,300 (400,800) $ 31,900 $ 4,100 (18,300) (14,200) $ 17,700 (2,700) $ 15,000

$233,600 + $12,500 = $246,100 $94,400 + $9,100 = $103,500 c $12,300 + $2,000 = $14,300 d $16,500 + $1,800 = $18,300 b

University Street Parking Garage Retained Earnings Statement For the year ended December 31, 2023 Retained earnings, January 1, 2023.................................. Add: Net income ............................................................. Less: Dividends ............................................................... Retained earnings, December 31, 2023 ............................

$43,000 15,000 (6,300) $51,700

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University Street Parking Garage Balance Sheet December 31, 2023 ASSETS Current assets: Cash .......................................................... Accounts receivable ................................... Inventory................................................... Prepaid renta ............................................. Total current assets Investments ...................................................... Equipment ........................................................ Less: Accumulated depreciationb ....................... Equipment (net)......................................... Total assets .......................................................

$ 6,700 39,200 4,900 27,300 $ 78,100 35,000 $269,500 (38,800) 230,700 $343,800

LIABILITIES & STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable...................................... Wages payablec ........................................ Interest payabled ...................................... Income tax payable ................................... Total current liabilities ....................... Long-term liabilities: Notes payable........................................... Total liabilities ................................... Stockholders’ equity: Capital stock, 20,000 issued and outstanding .......................................... Retained earnings ..................................... Total stockholders’ equity.................. Total liabilities and stockholders’ equity ...........

$ 16,700 12,500 1,800 1,100 $ 32,100 160,000 $192,100

$100,000 51,700 151,700 $343,800

$36,400 − $9,100 = $27,300 $36,800 + $2,000 = $38,800 c $0 + $12,500 = $12,500 d $0 + $1,800 = $1,800 a

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INTERNAL CONTROL AND CASH

DISCUSSION QUESTIONS 1.

The purpose of an internal control system is to provide reasonable assurance that the company’s objectives are being met in three areas: (1) effectiveness and efficiency of operations, (2) reliability of financial reporting, and (3) compliance with applicable laws and regulations.

Internal control systems include all policies and procedures established by top management and the board of directors to provide reasonable assurance that the company’s objectives are being met in three areas: (1) effectiveness and efficiency of operations, (2) reliability of financial reporting, and (3) compliance with applicable laws and regulations.

Section 404 of the Sarbanes–Oxley Act increased top management’s responsibility by requiring management to produce an internal control report. This report must acknowledge that management is responsible for establishing and maintaining an adequate internal control system and procedures for financial reporting. Management is also responsible for assessing the effectiveness of these controls.

The five components of internal control are (1) the control environment, (2) risk assessment, (3) control activities, (4) communication and information, and (5) monitoring.

“Tone at the top” is the notion of leading by example. The idea is that top management first sets a good example and the rest of the organization will then follow management’s behaviors. If top management effectively communicates controls to subordinates, the rest of the organization is more likely to execute proper internal control policies and procedures.

Strategic risks are possible threats to the organization’s success in accomplishing its objectives. These risks are external and are often classified around industry forces or macro factors. Industry forces that imply strategic risks include competitors, customers, substitute products or services, suppliers, and the threat of new competitors. Macro factors include political, economic, social, and technological environments.

Business process risks are the risks associated with the internal processes of the company—specifically, the risks associated with how the company allocates its resources to meet its objectives. Business process risks are commonly associated with internal processes, such as materials acquisition, production, logistics and distribution, branding and marketing, and human resources. The nature and relative importance of the business processes will vary from company to company based on their specific objectives.

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The five categories of control activities are (1) clearly defined authority and responsibility, (2) segregation of duties, (3) adequate documents and records, (4) safeguards over assets and records, and (5) checks on recorded amounts by independent parties.

(1) By clearly defining authority and responsibility for important duties, management makes it unlikely that an employee can take on a collection of responsibilities that make it possible to misappropriate assets or misstate account balances without detection. It also motivates individuals to perform well and facilitates corrective action if someone fails to perform satisfactorily. (2) Segregating duties—particularly segregating record keeping from operating and other administrative duties—makes it difficult for a single employee to misappropriate assets and to conceal the misappropriation by altering records. Intentional misstatements of account balances are similarly made more difficult to conceal. It also reduces the likelihood of unintentional record-keeping errors remaining undiscovered. (3) Adequate documents and records facilitate the evaluation and monitoring of performance by persons both inside and outside the entity. (4) Safeguards over assets and records discourage theft, misuse, and misappropriation of assets as well as tampering with records intended to conceal such theft, misuse, or misappropriation. (5) Checks on recorded amounts by independent parties discourage misappropriation, theft, and misuse of assets and can lead to the discovery of such failures of the control system.

10. Control activities play a crucial role in the accounting system by helping to prevent errors and reduce the risk of asset misappropriation. For example, fraud and employee error can be reduced by restricting access to the accounting system to only certain qualified individuals. Asset misappropriation can also be reduced to a level below materiality by conducting annual independent audits (a check on recorded amounts). 11. Cash requires a more detailed system of internal controls because cash is easier to misappropriate than most other assets and is frequently the asset most sought after by those who would misappropriate. 12. By segregating the duties of handling cash and maintaining accounting records, the risk of theft in this process is reduced. Those who handle the cash can no longer steal the money and record a fictitious amount in the accounting system to cover up the theft. 13. The first advantage in reconciling the cash account to the bank statement is that it serves as a control function by identifying errors and providing an inspection of detailed records that deters theft. Second, reconciliations serve as a transaction

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detection function by identifying transactions performed by the bank, so the business can make the necessary entries in its records. 14. A cash account may differ from its associated bank account because of (1) transactions recorded by the business but not recorded by the bank in time to appear on the current bank statement (deposits in transit and outstanding checks), (2) transactions recorded by the bank but not yet recorded by the business (debit memos, credit memos, NSF checks, and service charges), and (3) errors in recording transactions on either set of records. 15. The following items require the firm to record adjusting entries: (1) An NSF check is a check written against an account that does not have sufficient funds. Such a check is initially recorded as a cash receipt but is subsequently deducted from cash and recorded as a receivable until collected or written off. (2) Bank service charges are fees charged by banks for their services. Service charges are generally based on the number of transactions processed by the bank and are deducted from the account by the bank. The company usually does not know the precise amount of the charges until the bank statement is received. (3) A debit memo is a document prepared by the bank and describes reductions in the checking account for items other than those associated with checks and service charges. (4) A credit memo is a document prepared by the bank and describes increases in the checking account balance for items other than those associated with deposits. Since the items above are not known by the depositor until the bank statement arrives, each requires the depositor to make an adjusting journal entry upon receipt of the bank statement. 16. The cash over and short account is used to record discrepancies between the amount of cash in the register and the amount of cash that was recorded on the register tape. Noting differences between the amount of cash in the register and the corresponding register tape can discourage theft and carelessness and is thus a form of internal control. 17. Checks are costly to use. They cost money to print, mail, and process. Thus, issuing checks to pay for small dollar items usually proves more costly than beneficial. To reduce such costs, a company may establish a petty cash fund to pay for small dollar amount items. 18. Cash equivalents are assets held by a company that are (1) easily convertible into known amounts of cash and (2) close enough to maturity that they are relatively insensitive to changes in interest rates. 19. Companies invest their cash in short-term investments because these short-term investments earn a greater rate of return than cash sitting in a bank account. Yet,

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short-term investments are highly liquid, which allows them to be easily turned into cash as needed. 20. The operating cycle is the elapsed time between the purchase of goods for resale (or the purchase of materials to produce salable goods or services) and the collection of cash from customers (presumably a larger amount of cash than was invested in the goods sold). 21. Cash management principles entail delaying payment to suppliers (unless a discount is offered for quick payment), so a company can earn as much interest on its cash as possible, speeding up collection from customers in order to invest the cash sooner, and earning the greatest return on any excess cash. 22. Many companies hold short-term investments as part of a program of liquidity management. Such investments provide a return on funds that are available for short periods of time without impeding access to the invested funds. Some businesses, particularly financial institutions, buy and sell short-term investments in order to profit from day-to-day changes in the prices of such investments.

204

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 4: Internal Control and Cash

MULTIPLE-CHOICE QUESTIONS 4-1.

4-2.

4-3.

4-4.

4-5.

4-6.

4-7.

4-8.

4-9.

4-10.

4-11.

4-12.

4-13.

4-14.

4-15.

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BRIEF EXERCISES BE 4-16 Internal controls are important, because they provide reasonable assurance that the company’s objectives are being met in three areas: (1) effectiveness and efficiency of operations, (2) reliability of financial reporting, and (3) compliance with applicable laws and regulations. If the internal control system fails to do these things, the company may become more vulnerable to fraud, theft, and inefficient operations. A company may see a decrease in profits, while investors and creditors are turned away by either (1) less appealing numbers or (2) decreased reliability in the accuracy of the financial statements.

BE 4-17 The five components of internal control are (1) control environment, (2) risk assessment, (3) control activities, (4) communication and information, and (5) monitoring. The control environment refers to the collection of environmental factors that influence the effectiveness of control procedures. The control environment includes the philosophy and operating style of management, the personnel policies and practices of the business, and the overall integrity, attitude, awareness, and actions of everyone in the business. The control environment is the foundation of the internal control system. The control environment is the basis for creating the other four functions of internal control. Risk assessment is a procedure used to identify, analyze, and manage risks both internal (known as business process risks) and external (known as strategic risks) to the company. Once the risks are assessed, they are communicated throughout the company. This can change the control activities the company currently uses as well as the monitoring of these control activities. Moreover, business risks assessed during this stage of internal control can change the control environment itself. Control activities are the policies and procedures top management establishes to help ensure that its objectives are met. The five categories of control activities are (1) clearly defined authority and responsibility, (2) segregation of duties, (3) adequate documents and records, (4) safeguards over assets and records, and (5) checks on recorded amounts by independent parties. These activities are created based on the company’s assessment of risks and are monitored accordingly.

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BE 4-18

Firebird Corp. Bank Reconciliation February 28, 2019 Cash balance from bank statement ........................................ Add: Deposit in transit ........................................................... Less: Outstanding checks ....................................................... Adjusted cash balance ........................................................... Cash balance from company records ...................................... Add: Interest earned during February ........................................ Note and interest collected ($350) ..................................... Less: Recording error ($797 − $779) ........................................... Service charge ................................................................... NSF check ......................................................................... Adjusted cash balance ...........................................................

$87,392 4,785 (6,440) $85,737 $73,260 $ 875 12,350 $

(18) (100) (630)

13,225

(748) $85,737

$85,737

BE 4-19 Date

Journal Account and Explanation Accounts Receivable Cash

Debit

Credit 36 36

BE 4-20 Date

Journal Account and Explanation Bank Service Charge Expense Accounts Receivable Cash

Debit

Credit 30 235 265

BE 4-21 Garrison Corporation Bank Reconciliation May 31 Cash balance from company records .............................................. Add: Interest earned.......................................................................... Error in recording customer check .............................................. Less: NSF check.. ............................................................................ Adjusted cash balance, May 31, 2020 .............................................

$76,940 $ 55 360

415 (175) $77,180

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BE 4-22 1.

Tosh Corp. Bank Reconciliation April 30 Cash balance from bank statement ............................................ Add: Deposit in transit ............................................................... Less: Outstanding checks ........................................................... Adjusted cash balance. .............................................................. Cash balance from company records .......................................... Add: Interest earned during April ................................................... Note ($4,000) and interest ($205) collected ............................ Error recording check ($549 − $594) ....................................... Less: Service charge ....................................................................... NSF check.............................................................................. Adjusted cash balance ...............................................................

2. Date

Journal Account and Explanation Bank Service Charge Expense Cash

$86,250 2,090 (1,350) $86,990 $83,135 $ 110 4,205 45

4,360

$ 60 445

(505) $86,990

Debit

Credit 60 60

Cash Income Revenue

110

Accounts Receivable Cash

445

Cash Notes Receivable Income Revenue

4,205

Cash Accounts Payable

110

445

4,000 205

BE 4-23 Date

Journal Account and Explanation Cash Cash Over and Short Sales Revenue

Debit 42,423.67 4.15

Credit

42,427.82

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BE 4-24 Date

Journal Account and Explanation Cash Cash Over and Short Sales Revenue

Debit 7,549.77

Credit 0.81 7,548.96

BE 4-25 Date

Journal Account and Explanation Miscellaneous Expense ($4,500 − $432) Cash

Debit 4,068

Credit 4,068

BE 4-26 Date

Journal Account and Explanation Petty Cash Fund ($2,400 − $2,225) Miscellaneous Expense Cash

Debit

Credit

175 1,220 1,395

BE 4-27 Cash .............................................................................................. Customer checks pending deposit…. ............................................... Cash in saving and checking accounts.. ........................................... U.S. government bonds (mature in 3 months) ................................ Total cash and cash equivalents…................................................

$ 26,250 700 64,000 13,000 $1,03,950

BE 4-28 Deciding to sell to customers on credit can affect a company’s operating cycle by slowing it down. Allowing customers to pay the business later creates an account receivable. This increases the amount of time it takes to collect the cash from customers, and therefore increases the amount of time it takes to repay investors and creditors. If a company’s credit terms are not very strict, it may find itself unable to collect on certain accounts. If this happens to a material extent, the company may find that it is unable to pay investors and creditors.

BE 4-29 Cash management principles entail delaying payment to suppliers (unless a discount is offered for quick payment), so a company can earn as much interest on its cash as possible, speeding up collection from customers in order to invest the cash sooner, and earning the greatest return on any excess cash. It is advantageous to delay paying suppliers, because the company can then earn interest on the money that is owed (unless the supplier offers a discount for prompt payment).

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EXERCISES E 4-30 1. 2. 3. 4. 5.

b a e d c

E 4-31 1. 2. 3. 4. 5. 6. 7.

f b c g d e a

E 4-32 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

c c a e d a b d b e

E 4-33 1.

The answer to this exercise could take a variety of forms. Most students are apt to suggest that Ms. Thatcher could pocket cash and cover it up by delaying the recording of collections in slowpaying or inactive accounts. This misappropriation would be especially easy to accomplish if Ms. Thatcher were responsible for monthly billings as well as making entries in the company’s cash accounting records. The likelihood of such misappropriation could be greatly reduced by assigning the responsibilities for cash handling and cash record keeping to separate persons. This is called segregation of duties.

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E 4-34 1. Deposit ................................................................................ Cash received per records .................................................... Cash over (short) ................................................................. 2.

Journal Account and Explanation

Date Oct.

Journal Account and Explanation

Date Oct.

Cash Cash Over and Short Accounts Receivable Sales Revenue (Record cash register receipts)

10/3 $47,845 46,940 $ 905

Debit 47,845

10/4 $50,811 50,825 $ (14)

Credit 905 8,380 38,560

Debit 50,811 14

Credit

7,655 43,170

The cash shortage on October 4 is small enough to be acceptable, although such shortages and overages need to be monitored over time. A cashier who is repeatedly over and short will need to be corrected. The cash overage on October 3, on the other hand, is unacceptable and must be investigated.

E 4-35 1.

Janie Corporation Bank Reconciliation Schedule October 31 Cash balance from bank statement ............................................ Add: Deposit in transit ............................................................... Less: Outstanding checks ........................................................... Adjusted cash balance ...............................................................

$25,347 765 (2,334) $23,778

Cash balance from company records .......................................... Add: Error in recording check ($748 − $478)................................ Less: Service charge ........................................................................... NSF check .................................................................................. Adjusted cash balance ...............................................................

$23,963 270 $(105) (350)

(455) $23,778

The October 31 balance sheet will report cash of $23,778.

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E 4-36 1. 2.

Checks 8257 and 8258 are outstanding on June 30. Pitt Corporation Bank Reconciliation Schedule June 30 Cash balance from bank statement .................................... Less: Outstanding checks 8257 ............................................................................. 8258 ............................................................................. Adjusted cash balance .......................................................

$ 20,555 $(9,620) (2,735)

Cash balance from company records .................................. 3. 4.

$ 8,200

Checks 8253 and 8254 were outstanding on May 31. Pitt Corporation Bank Reconciliation Schedule May 31 Cash balance from bank statement .................................... Less: Outstanding checks 8253 ............................................................................. 8254 ............................................................................. Adjusted cash balance .......................................................

$ 34,525 $(1,720) (14,675)

Cash balance from company records .................................. 5.

(12,355) $ 8,200

(16,395) $ 18,130 $ 18,130

The presence of deposits in transit and outstanding checks at the beginning of the month may affect the total deposits in transit and outstanding checks at the end of the month. For example, if deposits in transit were $1,000 at the beginning of the month and, as in this problem, monthly deposits per books and per bank were equal, then deposits in transit would remain $1,000 at the end of the month. Similarly, without knowing that all outstanding checks at May 31 cleared during June, we are unsure of the total outstanding checks at June 30 because some checks can remain outstanding for a number of months. We need to know the total outstanding checks at May 31 to complete the bank reconciliation.

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E 4-37 Valentine Investigations Bank Reconciliation Schedule February 28 Cash balance from bank statement .................................... Add: Deposits in transit ..................................................... Less: Outstanding checks ................................................... Adjusted cash balance .......................................................

$11,610 4,580 (5,157) $11,033

Cash balance from company records* ................................ Less: Service charge .............................................................. Debit memo (electric bill) ............................................. Adjusted cash balance .......................................................

$11,883 $ (50) (800)

(850) $11,033

* $7,444 + $106,780 − $102,341 = $11,883

a. Date Feb.

Journal Account and Explanation Bank Service Charge Expense Cash (Record bank service charge)

Debit

Credit 50 50

Utilities Expense Cash (Record debit memo for payment of utilities)

800 800

$11,033

E 4-38 1.

Cash balance from bank statement .................................... Add: Deposits in transit .................................................... Less: Adjusted cash balance .............................................. Outstanding checks ...........................................................

2. Date Dec.

Journal Account and Explanation Bank Service Charge Expense Cash (Record bank service charge) Utilities Expense Cash (Record debit memo for payment of utilities)

$ 23,220 9,160 (22,066) $ 10,314

Debit

Credit 350 350

1,500

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E 4-39 a. b. c.

No journal entry needed No journal entry needed No journal entry needed Journal Account and Explanation Bank Service Charge Expense Cash (Record bank service charge)

Date d.

Debit

Credit 375 375

e. Accounts Receivable Cash (Record NSF check)

1,150 1,150

E 4-40 a. Date Aug.

b. c. d. e.

Journal Account and Explanation Petty Cash Cash (Establish petty cash fund)

Debit 1,250

Credit 1,250

Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Reimbursement claim form only; no entry in corporate accounting system.

f. Date Aug.

Journal Account and Explanation Equipment Supplies Expense Miscellaneous Expense Cash (Replenish petty cash fund and recognize expenses)

Debit

Credit 110 145 30 285

E 4-41 Cash ......................................................................................... Customer checks pending deposit ............................................. Cash in saving and checking accounts ........................................ U.S. government bonds (2 month maturity) ............................... Total cash and cash equivalents .............................................

$12,800 830 36,500 7,000 $57,130

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E 4-42 The cash line in Stony’s balance sheet would include: Change for cash registers (currency and coin) ................................... $ 4,800 Amount on deposit in checking account............................................ 6,589 Amount on deposit in savings account .............................................. 28,750 Balance in petty cash ....................................................................... 500 Checks received from customers, but not yet deposited in bank........ 340 Deposits in transit ..................................................................... 950 Outstanding checks ................................................................... (620) NSF Check ................................................................................. (430) Cash ................................................................................... $40,879 The remaining items are not included as part of Stony’s cash amount reported on the balance sheet.

E 4-43 The business purchases inventory (or raw materials used to produce salable goods or services). These goods are then sold and/or services are performed. The customer ultimately pays cash for these goods or services (either pays cash immediately or creates an account receivable and pays cash later). This cash is then used to purchase additional inventory or raw materials, and the cycle continues.

E 4-44 a.

1. Tree nursery 2. Fast food restaurant 3. Appliance store 4. Electric utility 5. Clothing store

d. Several years—a number of years are required to prepare merchandise for sale. Customers probably pay cash for most items. a. Very short—customers typically pay cash, and inventory is often held for less than 1 day. c. More than 1 year—merchandise may be in inventory for several months and most customers will pay for purchases after 1 to 2 years. e. A few months—customers pay monthly. The current assets used to provide customer services are consumed within a few months. b. A few months—merchandise is typically on hand for several weeks and some customers may use credit.

A longer operating cycle means that the company will have more money tied up in inventory and accounts receivable. To keep the balance sheet in balance, the higher inventory and accounts receivable balances must be offset by (1) lowering other assets and/or (2) increasing liability and/or stockholders’ equity balances. Consequently, longer operating cycles require companies to either forego investment alternatives that could have been made with the additional cash or increase borrowing/equity investment to obtain sufficient cash to invest in the inventory and accounts receivable.

E 4-45 Duration of operating cycle a. 7 months b. 1 week c. 8 months

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6 years

PROBLEM SET A P 4-46A Answers will vary. Suggested answers are as follows: a.

A grocery store can increase its effectiveness and efficiency by implementing a system where new items in the store can be scanned and their price entered automatically into the registers without the employees having to enter the bar code number and the price manually. This will increase efficiency by saving the employees time and eliminating the possible errors that could be made by employees when entering the items into the computer system.

Through internal controls, a grocery store could increase the reliability of its financial reporting by segregating certain financial duties. It could assign a second person the responsibility for collecting and recording the cash from each register. Having the cashier perform this duty would increase the risk of theft and inaccurate financial statements.

In order to ensure compliance with applicable laws and regulations, a grocery store may decide to have an internal audit group continually perform audit procedures that test the store’s compliance with applicable laws.

P 4-47A Answers will vary. Suggested answers are as follows: Control objective: To ensure that cash collected from customers is remitted to the business. Possible control procedures: a.

Have the capability of observing the cash register from the office.

Program the register so that it will not open unless a sale is recorded. (The cash register operator would not be able to make any change without entering a sale.)

Have the cash register amounts visible to the customer. Have all elements of the transaction appear on the display.

Give customers receipts that record the amount tendered and the change given.

Use an electronic scanner to read prices from goods sold and to record quantities sold.

Use the quantity sold information to establish the quantity that should remain on the shelf. Inventory the shelves from time to time. (A discrepancy may indicate a cash theft or shoplifting.)

Verify each cash drawer against the cash register record.

Permit only one person at a time to operate a register. Total the register record each time a cashier changes.

Require that all but a few dollars be transferred from the register to an unopenable safe each half hour. Record the time when cash is transferred to the safe.

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P 4-48A Answers will vary. Suggested answers are as follows: 1.

The inventory records would indicate the quantity of items purchased for the store. The sales records would indicate the quantity of items sold. If more items are purchased than are sold, then one of the following must be true: Inventory is increasing, shoplifting is occurring, or sales are not being recorded. A physical inventory can identify whether or not inventory is increasing. If the goods are not in inventory, then either shoplifting or unrecorded sales must be the cause. Comparison of records for the suspect store with other stores should indicate the “normal” level of shoplifting. Any inventory not accounted for by normal shoplifting can be associated with the suspected theft.

An employee could steal cash from sales by keeping the cash register open and not ringing up a sale. Then cash from that sale could be taken by the employee.

a. Have the capability of observing the cash register from the office. b. Program the register so that it will not open unless a sale is recorded. (The operator would not be able to make any change without entering a sale.) c.

cash register

Have the cash register amounts visible to the customer. Have all elements of the transaction appear on the display.

d. Give customers receipts that record the amount tendered and the change given. e. Use an electronic scanner to read prices from goods sold and to record quantities sold. f.

Verify each cash drawer against the cash register record.

Permit only one person at a time to operate a register. Total the register record each time a cashier changes.

h. Require that all but a few dollars be transferred from the register to an unopenable safe each half hour. Record the time when cash is transferred to the safe.

P 4-49A 1.

Morse Corporation Bank Reconciliation Schedule July 31 Cash balance from bank statement ................................................ Add: Deposit in transit .................................................................. Less: Outstanding checks 191 .......................................................................................... 194 .......................................................................................... 195 .......................................................................................... Adjusted cash balance ................................................................... Cash balance from company records.............................................. Less: Service charge .......................................................................... NSF check ................................................................................. Adjusted cash balance ...................................................................

$ 3,484 3,115 $ (52) (184) (1,022)

(1,258) $ 5,341 $ 6,843

(16) (1486)

(1,502) $ 5,341

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P 4-49A (Continued) 2. Date July

Journal Account and Explanation Bank Service Charge Expense Cash (Record bank service charge) Accounts Receivable Cash (Record NSF check)

Debit

Credit 16 16

1,486 1,486

The cash amount that is presented among the assets on the July 31 balance sheet is $5,341.

P 4-50A 1.

Raymond Corporation Bank Reconciliation Schedule October 31 Cash balance from bank statement ................................................ Add: Deposit in transit .................................................................. Less: Outstanding checks 1923. ....................................................................................... $(284.77) 1924 ........................................................................................ (628.32) Adjusted cash balance ...................................................................

$5,311.70 3,408.20

Cash balance from company records.............................................. Add: Error in recording check 1922* .............................................. Less: Service charge ......................................................................... NSF check ................................................................................ Debit memo ............................................................................ Adjusted cash balance ...................................................................

$7,912.26 495.00

(290.00)

(913.09) $7,806.81

$ (20.00) (290.45) (600.45) $7,806.81

* $1,803.77 − $1,308.77 = $495.00

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P 4-50A (Continued) 2.

Journal Account and Explanation

Date Oct.

Cash Accounts Payable* (Correct error in recording check)

Debit 495.00

Credit 495.00

Bank Service Charge Expense Cash (Record bank service charge)

20.00

Accounts receivable Cash (Record NSF check)

290.45

Rent Expense Cash (Record debit memo for rent expense)

290.00

20.00

290.45

290.00

* Research should be done to determine the account originally debited and the same account should be credited to correct the error. Since no further information is available, we simply chose Accounts Payable for the solution.

The cash in bank amount on the October 31 balance sheet is $7,806.81.

P 4-51A 1.

Dixon Products Bank Reconciliation Schedule May 31 Cash balance from bank statement ................................................ Add: Deposit in transit .................................................................. Less: Outstanding checks ............................................................... Adjusted cash balance ...................................................................

$ 8,540 1,150 (2,140) $ 7,550

Cash balance from company records* ............................................ Less: Service charge ......................................................................... NSF check ................................................................................ Adjusted cash balance ...................................................................

$7,780 $ (40) (190)

(230) $7,550

* $11,800 + $37,600 − $41,620 = $7,780

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P 4-51A (Continued) 2. Date May

Journal Account and Explanation Bank Service Charge Expense Cash (Record bank service charge) Accounts Receivable Cash (Record NSF check)

Debit

Credit 40 40

190 190

The May 31 balance sheet amount for cash is $7,550.

P 4-52A a. b c. d. e.

Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system.

f. Date Nov.

Journal Account and Explanation Supplies Expense Maintenance Expense Transportation-In Other Expense Travel Expense Cash (Replenish petty cash fund and record expenses)

Debit

Credit

86 138 17 45 91

377

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PROBLEM SET B P 4-46B Answers will vary. Suggested answers are as follows: a.

A bookstore can increase its effectiveness and efficiency by implementing a system where new items in the store can be scanned and their prices entered automatically into the registers without the employees having to enter the bar code number and the price manually. This will increase efficiency by saving employees time and eliminating the possible errors that could be made by employees when entering the items into the computer system.

In order to ensure the reliability of financial reporting, the bookstore may decide to have external independent auditors audit its financial statements annually. The auditors would bring any material misstatements to the attention of the owner while giving them suggestions to improve controls to ensure better financial reporting. Moreover, having an independent auditor issue an unqualified opinion on your financial statements increases credibility in the eyes of potential creditors and investors.

To provide reasonable assurance that the bookstore is in compliance with applicable laws, the bookstore may find it useful to hire its own corporate attorney. The attorney would have the responsibility to keep the company up to date on new laws and regulations, as well as policies and procedures that should be standard in practice. Additionally, before implementing any major decisions within the company, the bookstore should consult the attorney to avoid any illegal acts. In addition, lawful policies and procedures should be stressed throughout the company and should be communicated thoroughly.

P 4-47B Control objective: To ensure that cash collected from customers is remitted to the business. The following are possible control procedures: a.

More than one employee could be assigned to the store, and both could be asked to watch for open cash registers.

Signs could be posted on the register promising customers money back or free purchases if they are not offered a receipt. Thus, the customer would have an incentive to report to a manager if the cash register is not used to record a sale.

Video cameras could be installed over cash registers to check for sales accuracy. Tapes could be reviewed for suspect stores, and knowledge of their use would deter employees from theft.

The registers could be programmed to only open when a sale is made. Then, the register tape should be compared to the cash in the drawer to make sure there are no discrepancies.

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P 4-48B Answers will vary. Suggested answers are as follows: 1.

An employee working on the cash register may simply calculate the price of a sale without ringing it up in the system (items such as compact discs may be a common sale item at the music store and employees may already have such a price memorized). The customer would simply give the employee the cash and leave with the item. The employee would then pocket the cash without ringing up the sale.

a. Have the capability of observing the cash register from the office. b. Program the register so that it will not open unless a sale is recorded. (The cash register operator would not be able to make change without entering a sale.) c. Have the cash register amounts visible to the customer. Have all elements of the transaction appear on the display. d. Give customers receipts that record the amount tendered and the change given. e. Use an electronic scanner to read prices from goods sold and to record quantities sold. f. Verify each cash drawer against the cash register record. g. Permit only one person at a time to operate a register. Total the register record each time a cashier changes. h. Require that all but a few dollars be transferred from the register to an unopenable safe each half hour. Record the time when cash is transferred to the safe.

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P 4-49B 1.

Towanda Corporation Bank Reconciliation Schedule July 31 Cash balance from bank statement ................................................ Add: Deposit in transit .................................................................. Less: Outstanding checks ............................................................... Adjusted cash balance ...................................................................

$ 5,050 950 (275) $ 5,725

Cash balance from company records.............................................. Less: Service charge ......................................................................... NSF check ................................................................................ Adjusted cash balance ...................................................................

$6,275

2. Date July

Journal Account and Explanation Bank Service Charge Expense Cash (Record bank service charge) Accounts Receivable Cash (Record NSF check)

$ (25) (525)

Debit

(550) $5,725

Credit 25 25

525 525

The cash amount presented among the assets on the July 31 balance sheet is $5,725.

P 4-50B 1.

Donald Corporation Bank Reconciliation Schedule October 31 Cash balance from bank statement .......................................... Add: Deposit in transit ............................................................. Less: Outstanding checks 1923. .................................................................................. 1924 ................................................................................... Adjusted cash balance ............................................................. Cash balance from company records ........................................ Add: Error in recording check 1922* ......................................... Less: Service charge ..................................................................... NSF check… ......................................................................... Debit memo (office furniture rental).................................... Adjusted cash balance .............................................................

$5700 3,300 $ (250) (650)

(900) $8,100 $8,630 45

$ (25) (300) (250)

(575) $8,100

* $1,350 − $1,305 = $45

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P 4-50B (Continued) 2.

Journal Account and Explanation

Date Oct.

Debit

Credit

Cash Accounts Payable (Correct error in recording check)

Bank Service Charge Expense Cash (Record bank service charge)

Accounts Receivable Cash (Record NSF check)

300

Rent Expense Cash (Record debit memo for rent expense)

250

300

250

The cash in bank amount on the October 31 balance sheet is $8,100.

P 4-51B 1.

Mason Products Bank Reconciliation Schedule May 31 Cash balance from bank statement .......................................... Add: Deposit in transit ............................................................. Less: Outstanding checks ......................................................... Adjusted cash balance .............................................................

$ 8,450 3,100 (2,050) $ 9,500

Cash balance from company records* ...................................... Less: Service charge..................................................................... NSF check ........................................................................... Adjusted cash balance .............................................................

$9,700 $ (60) (140)

(200) $9,500

* $10,100 + $39,600 − $40,000 = $9,700

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P 4-51B (Continued) 2. Date May

Journal Account and Explanation Bank Service Charge Expense Cash (Record bank service charge) Accounts Receivable Cash (Record NSF check)

Debit

Credit 60 60

140 140

The May 31 balance sheet amount for cash is $9,500.

P 4-52B a. b c. d. e.

Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system. Petty cash memo only; no entry in corporate accounting system.

Journal Account and Explanation Supplies Expense Maintenance Expense Transportation-In Other Expense Travel Expense Cash (Replenish petty cash fund and record expenses)

Date Aug.

Debit

Credit

90 225 45 75 150

585

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CASES Case 4-53 1.

It is quite likely that Mr. Riley and his friend have colluded to steal merchandise from the store.

Many answers are possible. If you report your observations, Mr. Riley’s superior may or may not believe you at first but is likely to check your story. If you supply enough information about the garments removed from the store, the superior may be able to compare inventory and sales records to determine whether or not they are missing or look at security tapes with time stamps matching the cash register tape. On this basis, the supervisor may be able to confront Riley and even press charges against him and his friend. In addition, the store may revise its internal control procedures to discourage such collusive thefts. For example, procedures might require that two people be present in the department at all times and that frequent inventories be taken of expensive merchandise. A well-run store would have an established procedure known to all employees for reporting such problems and for protecting the persons who report them. Of course, it is also possible that the inventory and sales records will be inconclusive and that Riley will curtail his activities until he secures your dismissal as a troublemaker.

Again, many answers are possible. If you do not report your observations, Riley may continue to engage in collusive thefts, producing increasing losses for the store. Eventually, the inventory and sales record will signal the losses, and an investigation may reveal Riley’s thefts. In addition, you may be called in to testify as to your possible involvement in his scheme. Your failure to report your observations of wrongdoing may become a part of your employment record and may impair your ability to secure other jobs.

There is no single right answer to ethical dilemmas. Although the “right thing to do” is fairly clear in this case, there are a number of ways to approach the situation. For example, you could discuss it with Mr. Riley directly, you could inform Mr. Riley’s superior, or you could leave an anonymous note for the superior.

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Case 4-54 1.

The full-service store will have a longer operating cycle because (1) it will stock a larger number of items and more items of each type, size, color, and so on, producing a larger inventory balance that is likely to take longer to be sold and (2) it will have more receivables that are likely to be outstanding longer, lengthening the time to collect cash from sales and also increasing the possibility of not being able to collect from certain accounts.

This longer operating cycle will have to be financed by more debt and equity. The full-service store must recover the cost of carrying additional debt and equity through higher prices. Additionally, the full-service store will have to hire employees to handle the accounts receivable process.

Case 4-55 1.

It would appear that the following three general principles of internal control are violated: a. Clearly defined authority and responsibility b. Separation of duties c.

Adequate records and documentation

Campus could adopt the following procedures to strengthen its internal controls: a. Make one person responsible for approving all requests to order merchandise. b.

Develop a prenumbered internal form to be used for purchases.

Assign someone the responsibility of receiving goods. This person should verify that the goods were ordered and that the quantity received agrees with the quantity identified on the shipping documents. This person is also responsible for completing a prenumbered receiving report that describes each shipment received.

Establish an accounts payable department that assembles internal and supplier documents that indicate that: (1) goods were ordered. (2) goods were received. (3) price and quantity information are consistent with the documentation. The accounts payable department should ask the treasurer to pay bills.

Require that the accountant record the payments indicated by the documents.

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Case 4-56 Answers will vary. Suggested answer follows. The authority to collect, hold, and deposit cash must be clearly assigned to specific individuals. Whenever feasible, cash-handling activities and cash record-keeping activities should be assigned to “different” individuals. Carolyn Furniture Galleries could take the following actions to make it difficult for someone to repeat the theft. 1.

Someone other than the accountant should list all checks and cash received for cash sales. A cash register tape should provide additional documentation of the amount received. This person should deposit the receipts in the bank. The list should be transmitted to the accountant, who will record the cash receipts in the accounting records.

Credit sales data should be prepared by the sales staff and transmitted to the accountant. This documentation would be the basis for credit sales journal entries.

Cash receipts from credit customers should be listed and deposited by someone other than the accountant. The accountant would make entries from the list.

The accountant should identify customers who are behind on their payments. Some other person in the organization or some outside agency should determine when accounts are to be written off. The accountant would write off accounts only when a written notice, supported by necessary documents, was prepared.

Case 4-57 1.

Cash flow plan: Beginning cash balance............................................... Add: Expected cash receipts........................................ Less: Expected cash disbursements ............................. Balance before adjustment .........................................

July $ 20,000 2,10,000 (2,00,000) $ 30,000

August $ 20,000 2,80,000 (2,10,000) $ 90,000

September $ 20,000 2,30,000 (1,90,000) $ 60,000

Next month’s excess disbursements ........................... Add: Minimum balance .............................................. Required month-end cash balance ..............................

0 20,000 $ 20,000

$ 20,000 20,000 $ 40,000

Invest ......................................................................... Repay borrowing…. .................................................... Liquidate investments ................................................ Borrow .......................................................................

$ 65,000 5,000 0 0

$ 20,000 0 0 0

0 10,000 0 0

The main consideration is the establishment of the minimum cash balance amount. This amount may be determined by a model, trial and error, or compensating balance requirements. The analysis must consider the costs of being short of cash (e.g., lost discount or deterioration in credit rating) and balance them against the costs of holding cash and short-term investments rather than having the funds invested in other, higher-yield assets. The decision must also take into account the willingness of the business to assume the risks of getting caught short.

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Case 4-58 Students’ answers to this question will vary widely, reflecting their personal experiences with business operations. Most are likely to draw answers from their understanding of retail operations. For example, some might describe cash registers that display the amount “rung up” and also the amount of change given. If the display is obscured from the customer’s view, it might be possible for a dishonest cashier to “over-ring” items when he or she thinks a customer won’t notice and later pocket the amount of the overcharge. Most cash registers create detailed records of cash transactions that discourage the removal of cash by dishonest cashiers; in some systems, however, it may be possible to alter these detailed records to cover such removals.

Case 4-59 1. Cash and equivalents……… .......................................... Short-term investments…............................................ Total…………………………… .............................................. Total assets…………………… ............................................ 2019: $133,819/$286,556 = 46.7% 2018: $133,768/$258,848 = 51.7% Note: Values are expressed in millions.

2019 $ 11,356 122,463 $ 133,819 $ 286,556

2018 $ 11,946 121,822 $133,768 $258,848

Microsoft’s definition of a cash equivalent is “all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase." This definition appears to be consistent with other companies’ definitions.

$3,771,000,000 of Microsoft’s $11,356,000,000 in cash and equivalents is actually cash. The cash equivalent items are Commercial Paper, Certificates of Deposit (CD's), U.S. Government Securities, U.S. Agency Securities, Foreign Government Bonds, and certain (Level 1) Equity Investments.

The people who sign the certifications under Section 302 of the Sarbanes–Oxley Act are the principal executive officer (the CEO), the principal financial officer (the CFO), and persons performing similar functions. The signers in the case of Microsoft include the following: Satya Nadella, Chief Executive Officer Amy E. Hood, Chief Financial Officer

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Case 4-60 1. 2019 Cash and cash equivalents ..................................... Short-term investments ...................................... Total ............................................................. Total assets.............................................................. Percent of total assets .........................................

Kroger $399 0 $399 ÷ 45,256 0.9%

Sprouts $ 85,314 0 $ 85,314 ÷2,722,983 3.1%

2018 Cash and cash equivalents ..................................... Short-term investments ...................................... Total ............................................................. Total assets.............................................................. Percent of total assets .........................................

$429 0 $429 ÷ 38,118 1.1%

1,588 0 $ 1,588 ÷ 1,675,614 0.1%

Note: Above values are expressed in millions for Kroger and in thousands for Sprouts. 2.

Sprouts has a significantly higher portion of its total assets in cash and cash equivalents at the end of 2019. This increase could represent a strategic decision on the part of management, but more likely signals a temporary cash surplus in 2019 or cash deficit in 2018.

According to the audit opinions, Kroger’s and Sprouts' internal control systems were evaluated based on the criteria of obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. The audits of internal control also include performing such other procedures considered necessary in certain circumstances.

Annual Report Problem (amount in millions) 1

3 4 5 6

Cash and cash equivalents Short-term investments Total assets Forecasted balances for fiscal year 2020 Cash and cash equivalents Short-term investments Total Assets Credit risk Item 9A Management Unqualified

1,936.00 13,925.00 22,375.00 1,916.64 14,203.50 23,270.00

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Case 4-61 1.

An internal control system is designed to provide reasonable assurance that the company’s objectives are being carried out with regard to the effectiveness and efficiency of its operations, the reliability of its financial reporting, and its compliance with applicable laws and regulations. The establishment of an effective system of internal controls makes it less likely that an employee will be able to misappropriate assets or misstate account balances without detection. Because cash is easier to misappropriate than most other assets, the adequate safeguard of cash is critical. In addition, an internal control system motivates individuals to perform well, and the documentation and record-keeping requirements facilitate the evaluation and monitoring of performance. With regard to Front Row’s current system of accounting for cash, several deficiencies are noted: ● There was no clearly defined authority or responsibility. Checks could be written and deposits made by either Cam or Anna. ● There does not appear to be an adequate separation of duties, with both Cam and Anna having the ability to deposit and withdraw cash as well as maintain any accounting records. ● There appears to be inadequate safeguards over cash since it is physically kept in a file cabinet in the office where anyone could access it. ● No independent checks of recorded amounts appear to have been performed. Front Row Entertainment Bank Reconciliation April 30, 2023 Cash balance from bank statement ................................................ Add: Deposits in transit ................................................................. Less: Outstanding checks ............................................................... Adjusted cash balance ................................................................... Cash balance from company records.............................................. Add: Interest earned ..................................................................... Less: Debit memo for utilities ........................................................ Bank service charge ............................................................... NSF check..............................................................................

$ 3,250 4,370 (1,160) $ 6,460 $ 7,495 450 (845) (50) (590)

Adjusted cash balance

$ 6,460

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Case 4-61 (Continued) 3.

Journal Account and Explanation

Date Apr.

Debit

Credit

Cash Interest Income (Record interest earned)

450

Utilities Expense Cash (Record utilities used)

845

Bank Service Charge Expense Cash (Record bank service charge)

Accounts Receivable Cash (Record NSF check received)

590

450

845

590

The failure to perform a bank reconciliation led to Front Row Entertainment not recording the proper amount of income (interest collected by the bank) nor the proper amount of expense (such as service charges and utilities). In addition, the amount of cash actually available could not be correctly determined without preparing a bank reconciliation.

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SALES AND RECEIVABLES

DISCUSSION QUESTIONS 1.

Revenue is recognized when the performance obligation is satisfied.

A performance obligation is satisfied when the goods are provided to the customer or the services are performed for the customer.

Sales revenue should be recorded using the net method if the customer is expected to pay within the discount period and using the gross method if the customer is not expected to pay within the discount period.

To encourage prompt payment, businesses may offer a sales discount. This discount is a reduction of the normal selling price and is attractive to both the seller and the buyer. For the buyer, it is a reduction to the cost for goods and services. For the seller, the cash is more quickly available and collection costs are reduced.

Sales returns are merchandise or goods that have been returned by the customer to the business.

Sales allowances are price reductions on merchandise that are granted by the seller to the purchaser because the merchandise is slightly defective, is shipped late, or has some other attribute that makes the merchandise less valuable to the purchaser. Sales discounts, in contrast, are price reductions granted by the seller to encourage prompt payment by the purchaser.

A trade discount is a reduction in the selling price granted by the seller to a particular class of customers, for example, customers who purchase goods for resale rather than for use. A quantity discount is a reduction in the selling price granted by the seller because the large size of a purchase transaction incurs lower selling costs per unit than would many smaller-size transactions.

A receivable is money due from another business or individual. First, a distinction is made between “accounts” receivable and “notes” receivable. Another dimension on which receivables are distinguished is whether they are current or noncurrent. Finally, receivables are also distinguished by whether they are trade or nontrade receivables.

Bad debt expense is estimated and recorded in the period of the sales so that the expense arising from defaults by credit customers is matched with sales revenue (the expense is thus recorded in the same period as the corresponding sales for the period).

10. The direct write-off method is not GAAP because it fails to match the bad debt expense to the sales revenue that it helped generate and does not show accounts receivable at net realizable value on the balance sheet.

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11. The percentage of credit sales method estimates the amount to be shown as bad debt expense on the income statement. The aging method estimates the amount to be shown as the allowance for doubtful accounts on the balance sheet. 12. Allowance for doubtful accounts is a contra-asset account. It is subtracted from accounts receivable on the balance sheet to get to net realizable value of accounts receivable. The allowance for doubtful accounts represents the dollar amount of receivables thought to be uncollectible at the balance sheet date. 13. There is no question that the inability to collect an account receivable is a serious problem. However, most wholesalers have come to accept bad debts as just another business expense. Certainly, no company would grant credit knowing that the specific customer will never pay for the goods purchased. Nonetheless, granting credit is a “necessary evil”—something that must be done to generate repeat business and maintain a competitive position. 14. a.

$10,000  0.12  2/12 = $200

$42,000  0.14  5/12 = $2,450

$18,000  0.13  4/12 = $780

$37,000  0.11  6/12 = $2,035

15. The total interest on the note ($200) is the excess of the total amount repaid ($600  2 = $1,200) over the amount borrowed ($1,000). The principal amount of the note is the amount actually borrowed ($1,000). 16. Total interest on the note will be $120 ($1,000  0.12  1). The amount of the single payment will be $1,120 ($1,000 + 120). 17. Factoring is the sale of accounts receivable to a financial institution. Factoring accelerates the inflow of cash from accounts receivable. The buyer of the receivables, the factor, will charge a fee to compensate for the time value of money, the risk of uncollectibility, and the tasks of billing and collection. When receivables are factored, the seller receives an immediate cash payment reduced by the factor’s fees. 18. First, sellers receive the money immediately. Second, they avoid bad debts because as long as the credit card verification procedures are followed, the credit card company absorbs the cost of customers who do not pay. Third, recordkeeping costs lessen because employees are not needed to manage these accounts. Fourth, sellers believe that by accepting credit cards, their sales will increase. 19. A “note” is a legal document given by a borrower to a lender stating the timing of repayment and the amount (principal and/or interest) to be repaid. Accounts receivable, on the other hand, do not have a formal note and do not specify the date of repayment, principal, and interest. Both are classified as current assets, but accounts receivable are normally due within 30–60 days, while notes are typically due within 3–12 months.

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20. A sale and its associated receivable are recorded only when the order, shipping, and billing documents are all present. 21. The following documents usually underlie the recording of sales: (1) order prepared by customer, (2) shipping document prepared by seller, and (3) billing document (invoice) prepared by seller. Errors or misstatements in any of these documents or failure of any of the related internal control procedures may indicate that invalid sales are being recorded. For example, phony invoices that are not supported by valid orders or shipping documents could be an attempt to conceal the misappropriation of merchandise. 22. Sales revenue is a key component of a company’s success, so analysts are interested in many ratios that incorporate sales. These ratios attempt to measure the return the company is earning on sales. Each of these ratios (gross profit margin ratio, operating margin ratio, and net profit margin ratio) reveals information about a company’s strategy and the competition it faces. Also, the operating margin ratio and net profit margin ratio show how much is left from a sales dollar after paying for the product and all its operations. 23. Asset management refers to how efficiently a company is using the resources at its disposal. One of the most widely used asset management ratios is the accounts receivable turnover, which provides a measure of how many times average trade receivables are collected during the period. A higher number is better, because it indicates that the company is more quickly collecting cash (through sales) from its inventory.

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MULTIPLE-CHOICE QUESTIONS 5-1.

5-2.

5-3.

5-4.

5-5.

5-6.

5-7.

5-8.

5-9.

($3,000  0.5  0.99) + ($3,000  0.5) = $2,985

5-10. d 5-11. c 5-12. c 5-13. b 5-14. a 5-15. d 5-16. d 5-17. a 5-18. b 5-19. c 5-20. d

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BRIEF EXERCISES BE 5-21 Unearned Revenue* Revenue **

= =

$24,500 $17,500

* *Seven months of unearned revenue for January 1 to July 31 of subsequent year. The balance sheet will show $24,500 ($42,000  7/12) as unearned revenue (a liability account). ** August 1−December 31 is 5 months of service revenue for the current year. The income statement will show $17,500 ($42,000  5/12).

BE 5-22 Unearned Revenue Revenue

= =

$27,000 $81,000 ($108,000 − $27,000)

BE 5-23 The net method is used because Buddy expects Gordon to pay within the discount period. Journal Date Account and Explanation Debit Credit Accounts Receivable 59,878 Sales Revenue ($61,100  98%) 59,878 (Record sale) Paid in discount period: Date

Journal Account and Explanation Cash ($61,100  0.98) Accounts Receivable (Record collection within discount period)

Debit 59,878

Credit 59,878

BE 5-24 1. Date

Journal Account and Explanation Cash Accounts Receivable Sales Revenue ($61,100  2%) (Record collection after discount period)

Debit 61,100

Credit 59,878 1,222

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BE 5-25 1. Date

2. Date

Journal Account and Explanation Allowance for Doubtful Accounts Accounts Receivable (Record write-off of defaulted account) Journal Account and Explanation Bad Debt Expense ($700,000  0.032) Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Debit

Credit 750 750

Debit 22,400

Credit 22,400

BE 5-26 1. Date

2. Date

Journal Account and Explanation Allowance for Doubtful Accounts Accounts Receivable (Record write-off of defaulted account) Journal Account and Explanation Bad Debt Expense ($750,000  0.045) Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Debit 3,300

Credit 3,300

Debit 33,750

Credit 33,750

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BE 5-27 1.

Preadjustment balance

Accounts Receivable 1,280,000 18,500,000 17,945,000 60,000 $1,775,000

Write-offs Preadjustment balance

Allowance for Doubtful Accounts 44,000 60,000 16,000

Beginning balance Sales

3. Date

Journal Account and Explanation Bad Debt Expense Allowance for Doubtful Accounts

Write-offs Preadjustment balance

Allowance for Doubtful Accounts 60,000 44,000 16,000 68,000 52,000

Collections Write-offs

Beginning balance

Debit 68,000

Credit 68,000

Beginning balance Amount needed to achieve desired ending balance Desired ending balance

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BE 5-28 1. Beginning balance Sales

Preadjustment balance 2. Write-offs

3. Date

Write-offs

Accounts Receivable 478,000 3,075,000 2,715,000 4,280 833,720 Allowance for Doubtful Accounts 7,900 4,280 3,620

Journal Account and Explanation Bad Debt Expense ($6,800 − $3,620) Allowance for Doubtful Accounts (Record adjusting entry for allowance for doubtful accounts estimate) Allowance for Doubtful Accounts 7,900 4,280 3,620 3,180 6,800

Collections Write-offs

Beginning balance Preadjustment balance

Debit 3,180

Credit 3,180

Beginning balance Preadjustment balance Amount needed to achieve desired ending balance Desired ending balance

BE 5-29 Ending balance in bad debt expense: $970,000  0.030 = $29,100

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BE 5-30 Journal Account and Explanation Accounts Receivable Allowance for Doubtful Accounts (Reverse portion of write-off)

Date

Cash Accounts Receivable (Record collection of accounts receivable)

Debit

Credit 450 450

450 450

BE 5-31

Accounts Receivable 315,700 ??? 2,427,000 298,900 $2,410,200

Accounts Receivable 24,975 247,520 217,750 ??? $54,745

Beginning balance Sales Ending balance Sales

Collections

BE 5-32 Beginning balance Sales Ending balance Ending balance

Collections

BE 5-33 Beginning balance Sales Ending balance Collections

Accounts Receivable 147,990 1,872,530 ??? 142,720 $1,877,800

Collections

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BE 5-34 Date

Journal Account and Explanation Cash* Accounts Receivable Service Charge Expense** Sales Revenue*** (Record sales)

* Cash: $2,630 − $600 − $28.05 = $2,001.95 ** Service Charge Expense: MasterCard Visa card Sales: $657 + $923 + $450 + $600 = $2,630.00

Debit 2,001.95 600.00 28.05

Credit

2,630.00

$657  0.016 $923  0.019

$10.51 17.54

$28.05

BE 5-35 1. Date

Journal Account and Explanation Notes Receivable Sales Revenue (Record sale with note)

Debit 27,000

Credit 27,000

Interest = Principal  Annual Interest Rate  Fraction of 1 Year = $27,000  0.06  4/12 = $540

3. Date

Journal Account and Explanation Cash Interest Income Notes Receivable (Record collection of note plus interest)

Debit 27,540

Credit 540 27,000

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BE 5-36 1. Date

Journal Account and Explanation Notes Receivable Sales Revenue (Record sale)

Interest = Principal  Annual Interest Rate  Fraction of 1 Year = $124,000  0.08  6/12 = $4,960.00 Journal Date Account and Explanation Cash Interest Income Notes Receivable (Record collection of note plus interest)

Debit 124,000

Credit 124,000

Debit 128,960.00

Credit 4,960.00 124,000.00

BE 5-37 Gross Profit Net Sales $111,000 = $179,000 = 62%

Gross Profit Ratio =

Net Profit Margin Ratio =

Net Income Net Sales $64,500 = $179, 000 = 36%

BE 5-38 Net Sales Average Net Trade Accounts Receivable $8, 425,000 = $780 , 000 = 10.80

Accounts Receivable Turnover =

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BE 5-39 Net Sales Average Net Trade Accounts Receivable $9,700,000 = $1, 057, 000 = 9.18

Accounts Receivable Turnover =

Net Profit Margin Ratio =

Net Income Net Sales $425, 000 = $9,700, 000 = 4.38%

BE 5-40 1. Date

2. Date

3. Date

Journal Account and Explanation Accounts Receivable Sales Revenue (Record sale) Journal Account and Explanation Cash ($65,000  0.99) Sales Revenue ($65,000  0.010) Accounts Receivable (Record sale within discount period) Journal Account and Explanation Cash Accounts Receivable (Record sale after discount period)

Debit 65,000

Credit 65,000

Debit 64,350 650

Credit

65,000

Debit 65,000

Credit 65,000

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BE 5-41 Date 1.

Journal Account and Explanation Accounts Receivable Sales Revenue (Record sale)

Debit 25,000

Credit 25,000

Cash* Sales Revenue** Accounts Receivable (Record collection within discount period)

24,500 500

Cash Accounts Receivable (Record collection after the discount period)

25,000

* $25,000  0.98 = $24,500 ** $25,000  0.02 = $500

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EXERCISES E 5-42 January revenue: February revenue:

$174,000 ($146,000 + $28,000) $0

All of the revenue will be recognized in January because that is when the performance obligation was satisfied (i.e., car titles were turned over to the customers).

E 5-43 Sales revenue should be recorded in December because that is when the performance obligation was satisfied (i.e., possession of the TV was turned over to the customer.

E 5-44 August revenue: Cash sales: $11,050 − $1,500 = Credit sales: 8  $405 =

$ 9,550 3,240 $12,790

E 5-45 1.

Sales

= $682,680

Discount payments Regular payments Total cash collected

$477,180 205,500 $682,680

* Discount payments: $482,000  0.01 = $4,820 discount $482,000 − $4,820 = $477,180

3. Date

Journal Account and Explanation Accounts Receivable Sales (Record sale) Cash Sales Revenue* Accounts Receivable (Record collection within discount period)

Debit 680,625

Credit 680,625

682,680 2,055 680,625

* $482,000  0.01 = $4,820

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E 5-46 1. Date a.

Journal Account and Explanation Accounts Receivable Sales Revenue (Record sale)

Debit 32,250

Credit 32,250

Cash Unearned Sales Revenue (Record collection of cash for future services)

6,105

Sales Revenue Accounts Receivable (Record allowance due to inadequate service being provided)

1,600

Unearned Sales Revenue Cash Sales Revenue ($6,105 − $410) (Record recognition of sales revenue and allowance)

6,105

1,600

410 5,695

Given that Gold is a service provider, a significant increase in sales allowances suggests that customers are unhappy with aspects of the service provided. Gold management should investigate the causes of this dissatisfaction. For example, in transaction d the services were provided late. Perhaps Gold is understaffed in certain functions. Not only will understaffing cause delays, but it could also create quality problems as staff hurry to meet deadlines and become fatigued from increased overtime.

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E 5-47 1.

Year 2015 2016 2017 2018 Totals

Credit Sales $ 883,000 952,000 1083,000 1,189,000 $4,107,000

Uncollectible Account Losses $13,125 14,840 16,790 16,850 $61,605

Total Losses from Uncollectible Accounts Credit Sales $61,605 = $4,107,000 = 0.015 or 1.5%

Average Percentage =

$1,260,000  0.015 = $18,900

Yes, it appears relatively reasonable. Over the last 4 years, the annual losses have ranged from 1.56% (2016) to 1.42% (2018).

If losses were much higher in 2018 ($30,000), perhaps the weighted percentage that includes information from 2015 to 2018 is not appropriate as the abnormally high percentage of losses from uncollectible accounts in 2018 will artificially inflate the average. Management should investigate why the percentage increased so much in 2018. Possible explanations include more lenient credit granting policies, failed controls over credit granting, or perhaps 2018 is an anomaly. If 2018 is an anomaly, then management should consider using just the information from 2015 to 2017 as the basis for the 2019 estimate. However, if the circumstances for the increase in losses from uncollectible accounts in 2018 have not changed and persist into 2019, the 2018 percentage may be the most appropriate.

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E 5-48 Date 1.

Journal Account and Explanation Allowance for Doubtful Accounts Accounts Receivable (Record write-off of defaulted account) Bad Debt Expense* Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Debit 9,650

Credit 9,650

11,264 11,264

* $512,000  0.022 = $11,264

Bad debt expense would not have changed because Gilmore is using the percentage of credit sales method.

Increase in sales Gross margin percentage Increase in gross margin

$150,000 20% $ 30,000

Total credit sales Bad debt percentage Bad debt Increase in income from operations

$512,000 2.20% 11,264 $ 18,736

E 5-49 1.

Bad debt expense = $547,900  0.027 =

2. Beginning balance Credit sales

Ending balance

Write-offs

$ 14,793

Accounts Receivable 42,340 547,900 489,770 14,250 86,220 Allowance for Doubtful Accounts 8,740 14,250 14,793 9,283

Collections Write-offs

Beginning balance Bad debt expense Ending balance

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E 5-50 1. Write-offs Preadjustment balance

Allowance for Doubtful Accounts 62,400 58,620 3,780 15,663 11,883

2. Date

Journal Account and Explanation Bad Debt Expense Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Beginning balance Amount needed to achieve desired ending balance Desired ending balance

Debit 15,663

Credit 15,663

Bad debt expense would have increased by $27,600 ($90,000 − $62,400) because the write-off debit to the Allowance for Doubtful Accounts would be $90,000.

E 5-51 1.

The desired postadjustment balance in Allowance for Doubtful Accounts is the sum of the products of the receivable amount in each age category multiplied by the proportion expected to default. $384,500  0.004 = $ 1,538 187,600  0.015 = 2,814 41,800  0.085 = 3,553 21,400  0.200 = 4,280 Desired ending balance $12,185

Beginning balance

480 12,665* 12,185

Adjustment entry to achieve desired ending balance Desired ending balance

* $12,185 + $480 = $12,665

Beginning balance Adjustment Ending balance

Bad Debt Expense 0 12,665 12,665

The amount of the bad debt expense: $12,665

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E 5-52

Write-offs

Allowance for Doubtful Accounts 10,670 ??? 42,550 11,240

Beginning balance Adjustment entry Ending balance

Write-offs* = $41,980 * ($10,670 + $42,550) − $11,240 = $41,980

The amount of receivables that Maher wrote off during the year is $41,980.

E 5-53 Date

Journal Account and Explanation Accounts Receivable Allowance for Doubtful Accounts (Reverse portion of write-off) Cash Accounts Receivable (Record collection of accounts receivable)

Debit

Credit 350 350

350

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E 5-54 1.

The new bookkeeper did not make the correct entry. The entry that the bookkeeper made increased accounts receivable rather than decreasing it. In addition, the bookkeeper decreased bad debt expense instead of decreasing the allowance for doubtful accounts.

There are two options for correcting the bookkeeper’s error: One option is to reverse the incorrect entry and make the correct entry as follows: Date

Journal Account and Explanation Bad Debt Expense Accounts Receivable (Reverse error) Allowance for Doubtful Accounts Accounts Receivable (Record write-off of defaulted account)

Debit 1,710

Credit 1,710

1,710 1,710

The other option is to fix the error (this really just combines the above two entries into one entry): Date

Journal Account and Explanation Bad Debt Expense (to reverse the incorrect debit) Allowance for Doubtful Accounts (to make the correct debit) Accounts Receivable (to reverse the incorrect debit and make the correct credit) (Write off defaulted account and correct error)

Debit 1,710

Credit

1,710

3,420

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E 5-55 Journal Account and Explanation

Date 2019 Nov.

Dec.

2020 Apr.

Notes Receivable Sales Revenue (Record issuance of the note) Interest Receivable* Interest Income (Record accrued interest income) Cash Notes Receivable Interest Receivable Interest Income** (Record collection of note receivable)

Debit

Credit

125,000 125,000

938 938

129,688 125,000 938 3,750

* $125,000  0.09  1/12 = $938 ** $125,000  0.09  4/12 = $3,750

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E 5-56

Date 2022 Oct.

Dec.

2023 Feb.

Mar.

Aug.

Journal Account and Explanation 31

Notes Receivable Sales Revenue (Record sale) Interest Receivable* Interest Income (Record accrued interest income)

Debit

Credit

2,900 2,900

39 39

Notes Receivable Sales Revenue (Record sale)

3,200

Cash Notes Receivable Interest Income** Interest Receivable (Record collection of note receivable)

2,997

Cash Notes Receivable Interest Income*** (Record collection of note receivable)

3,344

3,200

2,900 58 39

3,200 144

* $2,900  8%  2/12 = $39 ** $2,900  8%  3/12 = $58 *** $3,200  9%  6/12 = $144 = Net Income/Net Sales

Retained Earnings 0 Beginning balance Dividends

# 0 0

Plug to net income to achieve desired ending balance Desired ending balance

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E 5-57 These controls protect the firm from unwarranted revenues and receivables. When any of these internal controls are not present, it is possible for valid sales to be unrecorded and for invalid sales to be recorded.

E 5-58 1.

Net Income Net Sales $36,000 = $215,000 = 16.74%

Net Profit Margin Percentage =

Net Sales Average Net Accounts Receivable $215,000 = $35, 500 ** = 6.06

Accounts Receivable Turnover =

* Net sales: Sales Sales returns Net sales ** Average Net Accounts Receivable: Beginning accounts receivable Ending accounts receivable Total Divide by 2 Average net accounts receivable

$219,000 (4,000) $215,000

$39,000 32,000 $71,000 ÷ 2 $35,500

Nash’s net profit margin percentage is 16.74%, which means they average approximately 16.74 cents on each sales dollar.

Nash’s accounts receivable turnover is approximately 6.06, which means that receivables take approximately 60 days (365 days/6.06) to be paid.

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E 5-59 1.

Gross Profit Net Sales $171,000 = $329,000 = 51.98%

Gross Profit Margin Percentage =

Gross profit: Gross sales Sales returns Net sales Cost of goods sold Gross profit

$346,000 (17,000) $329,000 158,000 $171,000 Operating Income Net Sales $25,000 = $329,000 = 7.60%

Operating Margin Percentage =

Operating expenses are: Gross profit Operating income Operating expenses

$171,000 25,000 $ 146,000

If sales increase by 30%, they will be: Net sales $329,000  1.30 = $427,700 New gross profit: Net sales Gross profit percentage Gross profit

$427,700 51.98% $222,300

New operating income: Gross profit Operating expenses Operating income

$222,300 146,000 $ 76,300

New operating margin percentage: Operating income Net sales Operating margin percentage

$ 76,300 ÷ $427,700 17.84%

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E 5-60 Date 1.

Journal Account and Explanation Accounts Receivable Sales (Record sale)

Debit 48,500

Credit 48,500

Cash* Sales Revenue** Accounts Receivable (Record collection within discount period)

47,530 970

Cash Accounts Receivable (Record collection after discount period)

48,500

* $48,500  0.98 = $47,530 ** $48,500  0.02 = $970

The customer will have to pay Nevada 1 month sooner to take advantage of the 2% discount. Two percent interest for 1 month is a 24% (0.02  12 months) annual rate. Accordingly, with the assumption of no additional costs to the loan, the customer should take out a loan at any rate below 24%.

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PROBLEM SET A P 5-61A Katie’s revenue is recognized over two different years. A student may drop out of school or decide not to rent the computer for the second semester. Therefore, Katie would be recognizing revenue on a computer rental from which she may not end up actually getting any revenue. Also, if she uses the cash basis, she will be recognizing all the revenue from two different years in 1 year. Therefore, her first year revenue will be overstated, and her second year revenue will be understated. By using accrual accounting, Katie is recognizing revenue only when the performance obligation has been satisfied.

P 5-62A 1.

$329,175 148,500 $ 477,675 (330,000) $ 147,675

2019 Gross margin: Salesd................................................................................... Cost of goods solde ............................................................... Gross margin .......................................................................

$ 393,750 (262,500) $ 131,250

The sales discount is expected to increase net sales by $83,925 ($477,675 − $393,750) and to increase gross margin byf ...............................................................................

$ 16,425

($2,200  0.7)  $225  0.95 = $329,175 ($2,200  0.3)  $225 = $148,500 c $2,200  $150 = $330,000 d $1,750  $225 = $393,750 e $1,750  $150 = $262,500 f $147,675 − $131,250 = $16,425 a

The sales discount policy will encourage prompt payment as well as additional sales. If customers pay more promptly, the length of time Compton’s money is tied up in receivables will decline.

P 5-63A 1.

Within discount period*......................................................................... Without discount ................................................................................... Total cash collected...........................................................................

$1,960,000 850,700 $2,810,700

* $2,000,000  0.98 = $1,960,000

Because all payments were made during 2020, and under the net method sales revenue is increased for customers who fail to pay within the discount period, sales revenue will be equal to the cash collected, or $2,810,700.

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P 5-64A 1.

Bill may have inflated sales by entering fictitious transactions that were later reversed by entries for sales returns or even shipped unordered goods to customers that were refused by the customers and immediately returned.

Yancy’s could delay the payment of bonuses until accounts receivable are collected or are verified as valid. Yancy’s could also strengthen internal controls by requiring all sales entries to be supported by documentation developed in part by purchase orders supplied by the purchasing company.

P 5-65A 1.

Year 2016 2017 2018 2019

Yes, the loss rate increased significantly between 2018 and 2019.

The weighted average loss rate would be ($61,466/$884,000) or 0.070. However, this rate appears too low for 2019, because the 2019 rate is considerably above the weighted average for the 4 years. A rate closer to 0.082 would be more appropriate.

Using 0.082, bad debt expense for 2020 is $32,636 ($400,000  0.082). Journal Date Account and Explanation Debit Bad Debt Expense 32,636 Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Calculations $12,608/$197,000 $13,299/$202,000 $13,285/$212,000 $22,274/$273,000

Loss Rate 0.064 0.066 0.063 0.082

Credit 32,636

In this case, The Glass House should increase its rate above the 2019 rate because the more lenient credit terms will likely result in higher default rates. The Glass House may grant more lenient credit terms because they believe that the increase in sales (and accompanying margins) will more than offset the increased bad debts.

Increase in sales for 2016−2019* ....................................................... Gross margin percentage ................................................................... Increase in gross margin ....................................................................

$442,000 25% $110,500

Losses from uncollectible accounts for 2016−2019 (taken from table in problem) ......................................................... Increase in income from operations ..................................................

61,466 $ 49,034

* $884,000  0.5 = $442,000

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P 5-66A 1. Date

Losses $86,550  0.01 = 19,400  0.06 = 10,250  0.12 = 4,900  0.25 =

Journal Account and Explanation Allowance for Doubtful Accounts Accounts Receivable (Record write-off of defaulted account)

Debit 4,600

Credit 4,600

Expected $ 866* 1,164 1,230 1,225 $4,485

* Rounded

The desired postadjustment balance in Allowance for Doubtful Accounts is $4,485. 3. Beginning balance Write-offs Balance

Beginning balance Adjustment Ending balance

Allowance for Doubtful Accounts 700 4,600 5,300 Adjustment necessary to achieve 9,785 desired ending balance 4,485 Desired ending balance Bad Debt Expense 0 9,785 9,785

Adjusting entry: Date

Journal Account and Explanation Bad Debt Expense Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Debit 9,785

Credit 9,785

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P 5-67A 1.

Accounts Receivable Age Current 1−15 days past due 16−45 days past due 46−90 days past due Over 90 days past due Totals

Proportion Expected to Default 0.01 0.02 0.08 0.15 0.30

The preadjustment balance in the allowance for doubtful accounts is a $15,620 debit.

Write-offs Preadjustment balance 3.

Amount $20,400 5,300 3,100 3,600 2,400 $34,800

Allowance Required $ 204 106 248 540 720 $1,818

Allowance for Doubtful Accounts 2,980 18,600 15,620

Beginning balance

Bad debt expense is the amount necessary to adjust Allowance for Doubtful Accounts from the $15,620 debit to the $1,818 credit calculated in the aging from Requirement 1, or $17,438.

Write-offs Preadjustment balance

Allowance for Doubtful Accounts 2,980 18,600 15,620

17,438 1,818 4. Date

Journal Account and Explanation Bad Debt Expense Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Beginning balance

Amount needed to achieve desired ending balance Desired ending balance

Debit 17,438

Credit 17,438

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P 5-68A Note from Ross Company: Date Sept.

Dec.

Mar.

Journal Account and Explanation Notes Receivable Sales Revenue (Record sale) Interest Receivable Interest Income* (Record accrued interest income) Cash Notes Receivable Interest Receivable Interest Income** (Record collection of note receivable)

Debit 10,000.00

Credit 10,000.00

233.33 233.33

10,350.00 10,000.00 233.33 116.67

* $10,000  0.07  4/12 = $233.33 ** $10,000  0.07  2/12 = $116.67

Note from Searfoss Inc.: Date Dec.

Sept.

Debit 6,000

Credit 6,000

45 45

6,405 6,000 45 360

* $6,000  0.09  1/12 = $45 ** $6,000  0.09  8/12 = $360

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P 5-69A 1.

Gross profit margin: 2022: $1,310,201/$1,930,048 = 2023: $1,376,039/$1,997,502 =

67.88% 68.89%

Operating margin: 2022: $714,975/$1,930,048 = 2023: $798,670/$1,997,502 =

37.04% 39.98%

Net profit margin: 2022: $709,255/$1,930,048 = 2023: $814,643/$1,997,502 =

36.75% 40.78%

Accounts receivable turnover: 2022: $1,930,048/[($192,691 + $180,450)/2] = 2023: $1,997,502/[($192,691 + $198,774)/2] =

10.34 10.21

The gross profit margin is higher in 2023 because net sales increased at a faster rate than cost of goods sold. The operating margin ratio is higher in 2023 because gross profit increased at a faster rate than operating expenses and because of the higher gross profit margin ratio. The net profit margin ratio is higher in 2023 because of the other income in 2023 as compared to other expense in 2022, as well as the increasing gross profit and operating margin ratios.

The gross profit margin ratio reveals the proportion of money left over from revenues after accounting for the cost of goods sold. The operating margin ratio reveals the proportion of the company’s revenues that are left over after paying for variable costs of operation. The net profit margin ratio reveals how much of every dollar of sales a company actually keeps in earnings. Accounts receivable turnover measures the company’s effectiveness in extending credit as well as in collecting debts. It appears that the company is doing slightly better in 2023 than it did in 2022. The company’s operations are improving, although several more years of data would be better to determine a trend.

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P 5-70A Date 1.

Journal Account and Explanation Accounts Receivable Sales Revenue (Record sale)

Debit 92,000

Credit 92,000

Accounts Receivable Sales Revenue (Record sale)

27,000

Cash* Sales Revenue Accounts Receivable (Record collection of cash within discount period)

91,080 920

Cash Accounts Receivable (Record collection of cash after discount period)

27,000

92,000

27,000

* $92,000  0.99 = $91,080 ** $92,000  0.01 = $920

Discount rate Discount period Net period

1% 15 30

There are two acceptable answers: An exact answer: An approximate answer (using 30-day months)

24.33% * 24% **

* 0.01  [365 ÷ (30 − 15)] = 24.33% ** 0.01  30/15  12 = 24%

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PROBLEM SET B P 5-61B Mary’s revenue is recognized over two different years. A student may drop out of school or decide not to rent the parking space for the second semester. Therefore, Mary would be recognizing revenue on a parking space rental from which she may not end up actually getting any revenue. Also, if she uses the cash basis, she will be recognizing all the revenue from two different years in 1 year. Therefore, her first year revenue will be overstated, and her second year revenue will be understated. By using accrual accounting, Mary is recognizing revenue only when the performance obligation has been satisfied.

P 5-62B 1.

Expected gross margin: Sales with discounta............................................................. Sales without discountb ....................................................... Total Sales........................................................................... Cost of goods soldc .............................................................. Expected gross margin ......................................................... Experienced gross margin: Salesd .................................................................................. Cost of goods solde .............................................................. Gross margin .......................................................................

$727,500 250,000

The sales discount is expected to increase net sales by $727,500 ($977,500 − $250,000) and to increase gross margin byf...............................................................................

$ 977,500 (7,00,000) $ 277,500 $ 750,000 (525,000) $ 225,000

$ 52,500

($2,000  0.75)  $500  0.97 = $727,500 ($2,000  0.25)  $500 = $250,000 c $2,000  $350 = $700,000 d $1,500  $500 = $750,000 e $1,500  $350 = $525,000 f $277,500 − $225,000 = $52,500 a

The sales discount policy will encourage prompt payment as well as additional sales. If customers pay more promptly, the length of time Parker’s money is tied up in receivables will decline.

P 5-63B 1.

Within discount period*.......................................................... After discount period.............................................................. Total cash collected ............................................................

$2,355,063 $322,700 $2,677,763

* $2,427,900  0.97 = $2,355,063

Because all payments were made during the year, under the net method sales revenue is increased for customers who fail to pay within the discount period, sales revenue will be equal to the cash collected, or $2,677,763.

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P 5-64B 1.

Kevin may have inflated sales by entering fictitious transactions that were later reversed by entries for sales returns or even shipping unordered goods to customers that were refused by the customers and immediately returned.

Johnson could delay the payment of bonuses until accounts receivable are collected or are verified as valid. Johnson could also strengthen internal controls by requiring all sales entries to be supported by documentation developed in part by purchase orders supplied by the purchasing company.

P 5-65B 1.

Year 2016 2017 2018 2019

Calculations $10,007/$125,900 $8,762/$102,440 $9,849/$131,120 $12,303/$149,780

Yes, the loss rate increased significantly between 2018 and 2019.

The weighted average loss rate would be ($40,921/$509,240), or 0.080. However, that rate may be too low for 2020, because the 2019 rate is above the weighted average for the 4 years. A rate closer to 0.082 would be more conservative.

Using 0.082, bad debt expense for 2018 is $14,950 ($182,000  0.082). Date

Journal Account and Explanation Bad Debt Expense Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Loss Rate 0.080 0.086 0.075 0.082

Debit 14,950

Credit 14,950

In this case, Kelly’s should increase its rate above the 2019 rate because the more lenient credit terms will likely result in higher default rates. Kelly’s may grant more lenient credit terms because they believe that the increase in sales (and accompanying margins) will more than offset the increased bad debts.

Increase in sales for 2016−2019* ................................................................ Gross margin percentage ........................................................................... Increase in gross margin ............................................................................. Losses from uncollectible accounts for 2016−2019 (taken from table in problem .................................................................. Increase in income from operations ...........................................................

$101,848 45% $ 45,832** 40,921 $ 4,911**

* $509,240  0.2 = $101,848 ** Rounded

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P 5-66B 1. Date

Journal Account and Explanation Allowance for Doubtful Accounts Accounts Receivable (Record write-off of defaulted account)

Debit 9,400

Credit 9,400

Losses $92,600  0.03 = 12,700  0.09 = 17,800  0.14 = 2,100  0.30 =

Expected $2,778 1,143 2,492 630 $7,043 The desired postadjustment balance in Allowance for Doubtful Accounts is $7,043.

3. Beginning balance Write-offs Balance

Beginning balance Adjustment Ending balance

Allowance for Doubtful Accounts 550 9,400 9,950 Adjustment necessary to achieve 16,993 desired ending balance 7,043 Bad Debt Expense 0 16,993 16,993

Adjusting entry: Date

Journal Account and Explanation Bad Debt Expense Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Debit 16,993

Credit 16,993

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P 5-67B 1.

Accounts Receivable Age Current 1−15 days past due 16−45 days past due 46−90 days past due Over 90 days past due Totals

Amount $42,350 11,200 9,600 7,200 5,480 $75,830

Allowance Required $ 424 * 448 864 1,224 1,644 $4,604

Proportion Expected to Default 0.01 0.04 0.09 0.17 0.30

* Rounded

The preadjustment balance in the allowance for doubtful accounts is a $25,350 debit.

Write-offs Preadjustment balance 3.

Allowance for Doubtful Accounts 3,640 28,990 25,350

Beginning balance

Bad debt expense is the amount necessary to adjust Allowance for Doubtful Accounts from the $25,350 debit to the $4,604 credit calculated in the aging from Requirement 1, or $29,954.

Write-offs Preadjustment balance

Allowance for Doubtful Accounts 3,640 28,990 25,350 29,454 4,604

4. Date

Journal Account and Explanation Bad Debt Expense Allowance for Doubtful Accounts (Record adjusting entry for bad debt expense estimate)

Beginning balance

Bad debt expense to achieve desired ending balance Desired ending balance

Debit 29,954

Credit 29,454

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P 5-68B Note from Majors Company: Journal Account and Explanation

Date Year 1 Oct.

Dec.

Year 2 June

Notes Receivable Sales Revenue (Record sale)

Debit 12,000

12,000

Interest Receivable Interest Income* (Record accrued interest income)

Cash Notes Receivable Interest Receivable Interest Income** (Record collection of note receivable)

Credit

240 240

12,640 12,000 240 400

* $12,000  0.08  3/12 = $240 ** $12,000  0.08  5/12 = $400

Note from Hadley Inc.: Date Year 1 Nov.

Dec.

Year 2 Sept.

Journal Account and Explanation 1

Notes Receivable Sales Revenue (Record sale) Interest Receivable Interest Income* (Record accrued interest income)

Cash Notes Receivable Interest Receivable Interest Income** (Record collection of note receivable)

Debit

Credit

9,000 9,000

150 150

9,750 9,000 150 600

* $9,000  0.1  2/12 = $150 ** $9,000  0.1  8/12 = $600

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P 5-69B 1.

Gross profit margin: 2022: $800,567/$1,691,594 = 47.33% 2023: $776,550/$1,658,426 = 46.82%

Operating margin: 2022: $303,609/$1,691,594 = 17.95% 2023: $294,500/$1,658,426 = 17.76%

Net profit margin: 2022: $300,573/$1,691,594 = 17.77% 2023: $298,034/$1,658,426 = 17.97%

Accounts receivable turnover: 2022: $1,691,594/[($293,183 + $335,252)/2] = 5.38 2023: $1,658,426/[($293,183 + $367,601)/2] = 5.02

The gross profit margin is lower in 2023 because gross profit decreased more than net sales. Operating margin is lower in 2023 because operating income decreased more than net sales. Net profit margin is higher in 2023 because net income and net sales decreased by about the same amount compared to last year.

Gross profit margin reveals the proportion of money left over from revenues after accounting for cost of goods sold. Operating margin reveals the proportion of the company’s revenues that are left over after paying for variable costs of operation. Net profit margin reveals how much of every dollar a company actually keeps in earnings. Accounts receivable turnover measures the company’s effectiveness in extending credit as well as in collecting debts. It appears that the company is doing slightly worse in 2023 than it did in 2022. The company’s operations appear to be worsening, although several more years of data would be better to reveal a possible trend.

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P 5-70B Date 1.

Journal Account and Explanation Accounts Receivable Sales Revenue (Record sale)

Debit 250,000

Credit 250,000

Accounts Receivable Sales Revenue (Record sale)

75,000

Cash* Sales Revenue** Accounts Receivable (Record collection within discount period)

242,500 7,500

Cash Accounts Receivable (Record collection after discount period)

75,000

250,000

75,000

* $250,000  0.97 = $242,500 ** $250,000  0.03 = $7,500

Discount rate Discount period Net period

3% 10 40

There are two acceptable answers: An exact answer: An approximate answer (using 30-day months)

36.50%* 36%**

* 0.03  [365/(40 − 10)] = 36.50% ** 0.03  30/30  12 Months = 36%

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CASES Case 5-71 1.

If the only thing that had been done was offering price discounts to induce customers to buy, then it would be revenue. However, the delivery to a third-party warehouse raises concerns. The primary question that must be answered is who has the risks and benefits of ownership of the inventory in the third-party warehouse. For example, if the inventory is stolen or damaged, who is responsible for the loss? If Mr. Spalding’s company is responsible, then it should not be counted as revenue. If the buyers are responsible for such loss, then it can be counted as revenue.

This behavior did not increase sales activity; it merely moved some sales from the next period into this period. As such, we would expect sales in the next period to be lower than if the price discounts had not been offered. Plus, common sense would suggest that if the price discounts were significant enough for the buyers to be willing to overstock, then the company probably traded much higher margin sales in the next period for much lower margin sales in this period.

Analysts may notice lower gross margins in the current period (compared to the previous period) due to the price discounts. If they look at quarterly filings (10-Q), they may also notice lower than anticipated sales in the first three quarters followed by unusually high sales in the fourth quarter. Analysts should be very suspicious any time this happens.

Case 5-72 1.

Early revenue recognition will result in earlier reporting of the related net income. Since both lenders and stockholders are more willing to provide financing to enterprises that demonstrate higher net income (everything else being the same), it may be that Mr. Dunlap plans to seek additional financing and believes that he can do so under more favorable terms if revenue recognition is accelerated. Further, executives are under much pressure to increase share prices, and higher net income (as long as it is perceived to be legitimate net income) leads to higher share prices. It is also possible that his current or future personal salary or bonus from the business is influenced by the amount of income reported by the business.

Argument against proposal to recognize revenue in 2023: Under GAAP, revenue is recognized when the performance obligation is satisfied. This is typically when the goods or services are provided. Argument against proposal to recognize revenue as cash is collected: As already stated, the revenue is recognized as the service is provided—not as the cash is collected. Because the service provided appears to be the same each month over the life of the contract, generally accepted accounting principles require that revenue be recognized at a constant rate over that period. Thus, New Miami should recognize an equal amount of revenue from the Western contract in every month.

The balance sheet at December 31, 2023, will show the entire down payment received on October 15 as unearned service revenue (a liability). The balance sheet at December 31, 2024, will include a liability corresponding to the prepayment by Western College for services yet to be rendered in 2025. The liability represents the obligation of New Miami to provide future services; it is called unearned revenue. The net income from 1 year of the contract will be reflected in retained earnings as of December 31, 2024.

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Case 5-73 The discussion of revenue recognition indicates that revenues should be recognized when the performance obligation is satisfied. That discussion goes on to suggest that earning occurs when goods or services are transferred to customers. In this situation, services will be transferred to customers over the entire 5 years rather than in just the first year. Therefore, it would not be appropriate to record the entire $500,000 as revenue in 2023. Rather, revenue recognition should be spread over the entire 5 years, consistent with the pattern of usage that customers are expected to make to the club. If the customers are expected to use the club more heavily in the early part of the 5year period, that expectation would be a basis for recognizing more of the $500,000 as revenue in the early part of the 5-year period. However, unless Beth can demonstrate that she expects all of the usage to occur in the first year, it is not appropriate to recognize all of the revenue in that period. The quotation from Accounting Research Bulletin 43 is intended for situations for which the collection of the selling price is not reasonably assured at the time goods are delivered. When collection of the selling price is not reasonably assured, revenue recognition should be deferred until collection occurs or becomes reasonably assured. This quotation also applies more directly to sales of goods that are presumably all delivered at the time of the sale rather than to a service that is delivered over a lengthy period.

Case 5-74 1.

Objectives of three discount policies: The gas station’s 3% discount for cash transactions gives customers an incentive to pay with cash rather than with credit cards, which reduces the merchant’s bank card fees that the station must pay for credit transactions. The home improvement store’s discount is intended to encourage prompt payment by customers. Finally, the clothing manufacturer’s discount is intended to encourage customers to purchase in bulk and sooner than they would otherwise.

All three businesses can use accounting information to assess the degree to which the discounts achieved their objectives. The gas station should make sure that the savings in merchant’s bank card fees are larger than the revenues lost to the discount. The home improvement store should make sure that its cost of carrying receivables is larger than the revenue lost to the discount. The clothing manufacturer could study accounting information about individual customer transactions to determine whether quantity discounts resulted in larger purchases. In addition, accounting information can be used to fine-tune the parameters of the discount policy.

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Case 5-75 1.

Annual sales and the balance of accounts receivable are the basis for computing the accounts receivable turnover. In addition, the annual report may contain general discussion by management of trends in sales and other events that affect the quality of receivables. In addition, a note to the statement may describe receivables and give details about factoring and securitization.

Has the receivables turnover for the stores changed in recent years? What fraction of the accounts are past due, and what is the collection rate on past-due accounts? How do the stores’ turnover and collection rate compare with industry averages? The history of receivables turnover could be obtained from past annual reports, but a more precise turnover could probably be obtained directly from the company. In addition, the company could supply an aging of accounts receivable and related industry data. It is likely that the bank would also have access to industry databases.

Case 5-76 1.

If the $100,000 of receivables are written off, the desired ending balance in Allowance for Doubtful Accounts will be smaller by $25,000 ($100,000  0.25) and the preadjustment balance in the allowance for doubtful accounts will be smaller by $100,000. These two differences will cause bad debt expense to be larger by $75,000. Net income will be smaller by $59,250 [$75,000  (1 − 0.21)] if the accounts are written off.

If uncollectible receivables are being inappropriately held in accounts receivable, the effects of this action may be apparent by examining the relationships between receivables and allowance for doubtful accounts and between bad debt expense and credit sales. If uncollectible receivables are inappropriately retained, the ratio of allowance for doubtful accounts to accounts receivable should increase, as there will be more accounts in the category with the highest proportion expected to default. The ratio of bad debt expense to credit sales should decline when uncollectible accounts are inappropriately retained. Of course, managers intent on misstating financial statements may purposely put uncollectible accounts into the wrong age category, making detection of this behavior more difficult.

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Case 5-77 1.

Note 1 says, “…establish an allowance for doubtful accounts based on a combination of specific customer circumstances, credit conditions, and the history of write-offs and collections." This indicates Whirlpool uses the aging method rather than a percentage of credit sales to estimate the allowance.

$136 million at December 31, 2018, and $136 million at December 31, 2019. This information is shown with Accounts Receivable in the Current Asset section of the Balance Sheet.

Allowance for doubtful accounts was a larger percentage of gross accounts receivable in 2019, calculated as follows:

Allowance Percentage =

Allowance (Net Accounts Receivable + Allowance)

$136 $2 , 346 * = 5.80%

2018 =

$132 $2, 330 ** = 5.67%

2019 =

* $2,210 + 136 ** $2,198 + 132

Receivables Turnover =

Net Sales Average Net Trade Accounts Receivable

$21,037 ($2,210 + $2,665)/2] $21,037 = $2, 438 = 8.63

2018 =

$20, 419 ($2,198 + $2,210)/2] $20, 419 = $2, 204 = 9.26

2019 =

Whirlpool’s receivables turnover is significantly better than the industry average of 6.62. Further, the receivables turnover improved from 2018 to 2019. The difference between a receivables turnover of 9.26 and 8.63 indicates that Whirlpool is almost 3 days faster in collecting their receivables. Given their 2019 average receivables balance of $2.204 billion and assuming net borrowing costs of 5%, this represents a savings of over $900,000 per year ($2,204,000,000  5%  (3/365)) in interest costs.

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Case 5-77 (Continued) 5.

Gross Profit Margin Ratio =

Gross Profit Net Sales

$3,537 $21, 037 = 16.81%

2018 =

$3,533 $20 , 419 = 17.30%

2019 =

Operating Margin Ratio =

Operating Income Net Sales

$279 $21,037 = 1.33 %

2018 =

$1,571 $20 , 419 = 7.69%

2019 =

Net Profit Margin Ratio =

Net Income Net Sales

(183) 21,037 = −0.87 %

2018 =

$1,184 $20 , 419 = 5.80%

2019 =

Because Whirlpool’s gross profit margin is lower than the industry average and their receivables turnover is better than the industry average, it appears as if they are pursuing a low-cost provider strategy.

While both operating and net profit margins have improved for Whirlpool, both ratios are well below industry averages, which leads us to conclude that Whirlpool should attempt to investigate reasons for this underperformance relative to the industry.

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Case 5-78 1.

According to Note 4, at the end of 2018 and 2019, the allowance for doubtful accounts was $0.4 million and $0.5 million, respectively. According to Note 3, "The Company provides an allowance for doubtful accounts when a specific account is determined to be uncollectible. " Sprouts does not follow GAAP by estimating an allowance (probably) because (1) the allowance is immaterial and (2) easier to calculate this way. Allowance Allowance Percentage = (Net Accounts Receivable + Allowance) $0.40 2018 = $40,564 * = 0.0010 % $0.50 $15,714 * * = 0.0032%

2019 =

* $40,564 + 0.40 ** $15,713 + 0.50

Receivables Turnover =

Net Sales Average Net Trade Accounts Receivable

Kroger: $122,286 [($1,706 + $1,589)/2] $122,286 = $1,648 = 74.23

2019 =

Sprouts: $5,634,835 [($15,713 + $40,564)/2] $5,634,835 = $28,139 = 200.25

2019 =

Gross Profit Ratio =

Gross Profit Net Sales

Sprouts: $1,747,475 $5,207,336 = 33.56%

2018 =

$1,894,818 $5,634,835 = 33.63%

2019 =

Not surprisingly, it appears as if Sprouts is pursuing a product differentiation strategy as is evidenced by gross profit ratios that are well above the industry average.

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Case 5-78 (Continued) 5.

Operating Margin Ratio =

Operating Income Net Sales

Kroger: $2,614 $121,852 = 2.15%

2018 =

$2,251 $122,286 = 1.84%

2019 =

Sprouts: $222,911 $5,207,336 = 4.28%

2018 =

$217,360 $2,634,835 = 8.25%

2019 =

Kroger’s operating margin ratio is below the industry average of 3.1%, while Sprouts’ is well above the industry average. While Kroger’s experiences significantly lower margins than Sprouts, it makes up for this with sales that are over 21 times more than Sprouts’ sales. Net Profit Margin Ratio = Net Income/Net Sales Kroger: $3,110 2018 = $121,852 = 2.55% $1,659 $122,286 = 1.36%

2019 =

Sprouts: $158,536 $5,207,336 = 3.04%

2018 =

$149,629 $2,634,835 = 5.68%

2019 =

Kroger’s net profit margin ratio was above the industry average in 2018, but dropped below the average in 2019. The decline certainly warrants some investigation, but is primarily due to the gain on sale of businesses Kroger experienced in 2018. If that gain of $1,782 is removed from the 2018 numbers, its net profit margin ratio would have been 1.01%. While the adjusted ratio is also well below industry averages, it does reflect Kroger’s strategy of competing on price.

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Further, Sprouts’ net profit margin being much higher than the industry average reflects its strategy of a product differentiator.

Annual Report Problem (amounts in millions) 1

Net sales Gross profit 37,572 Operating income Net income 11,242 Average accounts receivable

110,225 15,843 2,021

Net sales 116,225.00 Gross profit 43,572.00 Operating income Net income 11,992.00 Average accounts receivable

17,843.00

Accounts receivable turnover

56.38

Gross profit margin

37.49%

Operating margin

15.35%

Net profit margin

10.32%

Business strategy?

2,061.42

Differentiation

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Case 5-79 1. Date May

June

Journal Account and Explanation Other Expense Cash (Paid for fan website development)

Debit 8,500

Credit 8,500

Accounts Receivable ($550  98%) Service Revenue (Sold advertising)

539

Accounts Receivable ($450  98%) Service Revenue (Sold advertising)

441

Cash ($550  98%) Accounts Receivable (Received payment within discount period)

539

Sales Revenue ($150  98%) Accounts Receivable (Granted sales allowance to customer)

147

Accounts Receivable ($750  98%) Service Revenue (Sold advertising)

735

Cash (($450 − $150)  100%) Service Revenue Accounts Receivable ($441 − $147) (Received payment from customer)

300

Allowance for Doubtful Accounts Accounts Receivable ($750  98%) (Write off account receivable)

735

539

441

539

147

735

6 294

735

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Case 5-79 (Continued) 2.

a. Date Dec.

Journal Account and Explanation 31 Bad Debt Expense Allowance for Doubtful Accounts* (Record bad debt expense)

Debit 1,145

Credit 1,145

b. Date Dec.

Journal Account and Explanation 31 Bad Debt Expense Allowance for Doubtful Accounts** (Record bad debt expense)

Debit

Credit 900 900

* $250 + $895 = $1,145 ** $45,000  0.02 = $900

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COST OF GOODS SOLD AND INVENTORY

DISCUSSION QUESTIONS 1.

Merchandisers are companies that purchase inventory in a finished condition and hold it for resale without further processing. Merchandisers that sell directly to consumers are called retailers, while merchandisers that sell to other businesses are called wholesalers. Examples of merchandisers are Wal-Mart, Dillards, and Target. Manufacturers are companies that buy and transform raw materials into a finished product, which is then sold. Examples of manufacturers include Sony, Toyota, and Intel.

Manufacturers use three types of inventory: raw materials, work-in-process, and finished goods. Raw materials inventory are the basic ingredients used to make a product. As the raw materials are used to manufacture a product, they become part of work-in-process inventory, which consists of raw materials that are used in production as well as other production costs, such as labor and utilities. Once the production process is complete, these costs are moved to the finished goods inventory account, which represents the cost of the final product that is available for sale. Merchandisers have only one inventory account. All inventory accounts are classified as assets on the balance sheet. When sold, both types of inventory become cost of goods sold, which is an expense on the income statement.

The flow of inventory for a merchandiser is as follows: 1. Purchase goods (becomes inventory) 2. Sell goods (becomes cost of goods sold) The flow of inventory for a manufacturer is as follows: 1. Purchase material (becomes raw materials inventory) 2. Use materials in production (becomes work-in-process inventory) 3. Complete production (becomes finished goods inventory) 4. Sell goods (becomes cost of goods sold)

The components of cost of goods available for sale are as follows: Beginning inventory + Purchases + Transportation-in

Net purchases

− Purchase discounts − Purchase returns = Cost of goods available for sale

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The components of cost of goods sold are as follows: Beginning inventory + Net purchases = Cost of goods available for sale − Ending inventory = Cost of goods sold A company will start the year with an amount of inventory on hand called beginning inventory. During the year, any purchases of inventory are added to the inventory account. The sum of beginning inventory and purchases is the cost of goods available for sale. The portion of the cost of goods available for sale, which is sold, becomes cost of goods sold.

In a perpetual inventory system, balances for inventory and cost of goods sold are continually (perpetually) updated with each sale or purchase of inventory. An entry is made to the inventory account when a purchase or sale is made and to the cost of goods sold account each time a sale is made. A perpetual inventory system requires that detailed records be maintained on a transaction-by-transaction basis for each purchase and sale of inventory. In other words, a perpetual inventory system records both the revenue and the cost side of each sales transaction. In a periodic inventory accounting system, entries to the Inventory and Cost of goods sold accounts are not made during the period. Instead, a periodic system records the cost of purchases as they occur (in an account separate from the Inventory account), takes a physical count of inventory at the end of the period, and applies the cost of goods sold model to determine the balances of ending inventory and cost of goods sold. Therefore, a periodic system only produces balances for ending inventory and cost of goods sold at the end of each accounting period (periodically).

When a perpetual inventory system is employed, the accounting records must provide the information necessary to add each purchase to inventory and to add each sale to cost of goods sold. In addition, inventory will have to be simultaneously reduced for each sale. It can be quite expensive to maintain an accounting system that keeps an up-to-date record of both ending inventory and cost of goods sold at any point in time. Under a periodic inventory system, the accounting records simply accumulate the cost of purchases until the end of the accounting period. At the end of the period, cost of goods sold is allocated between ending inventory and cost of goods sold. Thus, a perpetual system requires the recording of considerably more information, which makes it more costly than a periodic system. The additional information made available during the period by a perpetual system provides management with greater control over inventory, which can be a significant and extremely valuable advantage in a competitive business environment.

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Applying the historical cost principle, companies must make adjustments to the purchase price of inventory to include the actual outflows made to make the goods ready for resale. That is, the cost of inventory should include the purchase price of the merchandise plus any cost of bringing the goods to a salable condition and location. For example, transportation charges (freight-in) incurred are added to the purchase price because the goods are not ready to sell until they are transported to the purchaser’s place of business.

The items that require adjustments in the determination of the net cost of purchases include the following: 1. Transportation-in: Expenditures made to move the inventory from the seller’s location to the purchaser’s location 2. Purchase discounts: Price reductions granted by the seller of inventory on credit to the purchaser of inventory in order to encourage prompt payment 3. Purchase returns: The cost of merchandise returned to suppliers 4. Purchase allowances: A deduction in the purchase price of goods given to the purchaser when the purchaser is dissatisfied with the merchandise in some way

10. “F.O.B. shipping point” and “F.O.B. destination” are words used on sales invoices to indicate whether the seller or the purchaser is responsible for the transportation charges. If an invoice is marked “F.O.B. shipping point,” the goods become the property of the purchaser at the shipping point, and the purchaser is responsible for paying the transportation charges. If an invoice is marked “F.O.B. destination,” the goods become the property of the purchaser at their destination, and the seller is normally responsible for the transportation charges. 11. There are two journal entries involved in every sales transaction under the perpetual inventory system because a perpetual inventory system must keep track of the inventory effect of both the sales and cost of goods sold portions of the transaction. 12. The four inventory costing methods produce different amounts for the cost of ending inventory and cost of goods sold because purchase prices are changing over time. The reason is that the costs attached to ending inventory and cost of goods sold are different depending on which cost allocation method is selected. 13. Unit costs are allocated to cost of goods sold (CGS) and to ending inventory as follows: FIFO

LIFO

Weighted Average

CGS

Oldest

Newest

Average of cost of goods available for sale

Ending inventory

Newest

Oldest

Average of cost of goods available for sale

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14. When prices are rising, the cost of goods sold will be the highest under LIFO because costs of the newer, high-cost units are allocated to cost of goods sold. Because cost of goods sold is an expense and expenses are higher, so income will be lower and so will be income taxes. 15. If prices are rising and LIFO is used, net income will be smaller than if FIFO is used. LIFO will cause the cost of the newer, high-cost units to be in cost of goods sold, while FIFO will cause the cost of the older, low-cost units to be in cost of goods sold. If prices are falling and LIFO is used, net income will be larger than if FIFO is used. LIFO will cause the cost of the newer, low-cost units to be in cost of goods sold, while FIFO will cause the cost of the older, high-cost units to be in cost of goods sold. Note that LIFO always causes the cost of the newer units to be in cost of goods sold. When prices are rising, the new units are at high prices. When prices are falling, the new units are at low prices. Neither LIFO nor FIFO is always associated with higher or lower net income because it depends on the direction of the change in the purchase price of the inventory—for example, purchase prices may be increasing (the most common scenario) or decreasing. 16. When LIFO is used and prices are rising, the cost of ending inventory will be the cost of the older, low-cost units. When FIFO is used and prices are rising, ending inventory cost will be the cost of the newer, high-cost units. Therefore, in periods of rising prices, the ending inventory amount on the balance sheet will be smaller for LIFO than for FIFO. When LIFO is used and prices are falling, the cost of ending inventory will include the cost of the older, high-cost units. If FIFO is used, the cost of ending inventory will include the cost of the newer, low-cost units. Therefore, in periods of falling prices, the ending inventory amount on the balance sheet will be larger if LIFO is used rather than FIFO. Note that neither LIFO nor FIFO always produces the higher or lower amount for ending inventory. The comparison depends on the direction of price changes. 17. If inventory were not written down to net realizable value when selling price is lower than cost, the balance sheet would present an amount for inventory that would be greater than the amount that can be realized from selling the inventory. This excess of cost over net realizable value could mislead statement users about the value of the company. The lower of cost or net realizable value (LCNRV) rule is an application of the conservatism principle. 18. In the current period, the write-down of inventory from cost to NRV causes a reduction in income and a reduction of the carrying amount of inventory on the balance sheet. However, in future periods, when the inventory is sold, a smaller cost of goods sold will be deducted from the selling price, so income will be larger than it

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otherwise would have been. Thus, the write-down recognizes the decrease in value of the company’s assets in the period in which the decrease occurs. 19. The gross profit ratio tells management the company’s ability to sell inventory at a profit. In short, this ratio tells users how many cents of every dollar are available to cover expenses other than cost of goods sold and to earn a profit. The higher the gross profit ratio, the better for the company. The inventory turnover ratio tells management how quickly inventory is purchased (or produced) and sold and provides an indicator of how much of the company’s funds are tied up in inventory. A high inventory turnover ratio indicates that a company is rapidly selling its inventory, thus reducing the amount of funds tied up in inventory. 20. A LIFO reserve is the amount that inventory would increase (or decrease) if the company had used FIFO rather than LIFO. In other words, the LIFO reserve adjusts (usually reduces) the inventory (maintained on a FIFO or weighted average basis) to a LIFO basis. The LIFO reserve is used to assist financial statement users in making comparisons between companies that prepare their financial statements under different inventory costing methods. The LIFO reserve is also called an “allowance to reduce inventory to LIFO” or the “excess of FIFO or average cost over LIFO.” 21. An error in the determination of ending inventory affects the income statement by changing the amount of cost of goods sold for the period. The cost of goods sold change flows through to net income and to ending retained earnings on the balance sheet. In addition, the error produces a change in the amount of ending inventory that is recorded on the balance sheet. Because ending inventory for one period becomes beginning inventory for a second period, the determination of cost of goods sold in the second period is also in error. Assuming no other errors are made, the amounts of the errors in cost of goods sold and net income exactly offset each other over the two periods, so that total income for the two periods is correct even though each period’s net income was incorrect. 22. The journal entries to record the purchase of goods under the periodic inventory system include the following accounts: Purchases, Purchase Discounts, Purchase Returns and Allowances, and Transportation-In. In a perpetual inventory system, these accounts aren’t used because all purchased inventory is recorded directly into the Inventory account. 23. The statement is incorrect for all costing methods except FIFO. The continuous allocation of the cost of goods available for sale to cost of goods sold and inventory under perpetual systems gives rise to a difference between perpetual and periodic results for LIFO and weighted average methods. Since FIFO always allocates the most recent cost of goods available for sale to inventory, the greater frequency of perpetual allocations does not produce a different result.

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MULTIPLE-CHOICE QUESTIONS ($20,000 + $185,000 − $30,000)

6-1.

6-2.

6-3.

6-4.

6-5.

(2 units  $31,000) + (1 unit  $27,000)

6-6.

(1,200 units  $25) + (1,500 units  $28) − [(1,200 units  $25) + (1,200 units  $28)] + (1,000 units  $30)

6-7.

(1,500 units  $28) + (900 units  $25)

6-8.

Average cost of inventory after Sale #1 of $8,000 (300 units  $26.6667*) + Cost of purchase #2 of $30,000 (1,000 units  $30)

$15,000  (1 − 0.02)

* (1,200 units  $25) + (1,500 units  $28) = $72,000; $72,000/2,700 units = $26.6667

6-9.

6-10. d 6-11. b 6-12. b 6-13. a 6-14. b 6-15. c 6-16. c

(1,200 units  $25) + (1,200 units  $28)

6-17. a

(1,200 units  $25) + (100 units  $28)

6-18. b

1,300 units  $27.5676; average cost is computed as total cost of inventory ($102,000) divided by total units available for sale (3,700 units)

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BRIEF EXERCISES BE 6-19 1.

Number of units sold: Beginning inventory…………………………………………………………………………………… Add: Purchases…………………………………………………………………………………………… Units available for sale……………………………………………………………………………….. Less: Ending inventory……………………………………………………………………………….. Units sold……………………………………………………………………………………………………

940 4,510 5,450 (770) 4,680

Cost of goods sold: Beginning inventory…………………………………………………………………………………… Add: Purchases…………………………………………………………………………………………… Cost of goods available for sale………………………………………………………………….. Less: Ending inventory………………………………………………………………………………… Cost of goods sold……………………………………………………………………………………….

$10,340 49,610 $59,950 (8,470) $51,480

BE 6-20 1.

Cost of Goods Sold

= = =

Beginning Inventory + Purchases − Ending Inventory $60,000 + $625,000 − $50,000 $635,000

Gross Margin

= = =

Sales − Cost of Goods Sold $950,000 − $635,000 (from Requirement 1) $315,000

BE 6-21 Date Apr.

Journal Account and Explanation Inventory Accounts Payable

Debit 3,100

Credit 3,100

Inventory Cash

250

Accounts Payable Inventory

800

Accounts Payable Cash* Inventory**

2,300

250

800

2,254 46

* ($3,100 − $800)  0.98 = $2,254 ** $2,300  0.02 = $46

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BE 6-22 Date Apr.

Journal Account and Explanation 1 Accounts Receivable Sales Revenue* 1 Cost of Goods Sold Inventory

Debit 3,038

Credit 3,038

2,225 2,225

8 Sales Revenue Accounts Receivable

784

8 Inventory Cost of Goods Sold

500

10 Cash** Accounts Receivable

2,254

784

500

2,254

* ($3,100  0.98) = $3,038 ** ($3,038 − $784) = $2,254

Note: The April 1 payment of freight by Mathis Company did not involve Reece Company and, therefore, is not recorded on Reece's books.

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BE 6-26 1.

FIFO

LIFO

Generally, the use of LIFO results in the most realistic amount for cost of goods sold because it matches the most current costs, which are closer to market values, to cost of goods sold. As a result, the use of LIFO is said to result in the most realistic amount for income. The use of FIFO results in the most realistic measure of ending inventory because the most current costs, which are closer to market value, are reported in ending inventory. This result would not change if inventory prices were decreasing because the most current costs would always be reported in cost of goods sold for LIFO and in ending inventory for FIFO.

BE 6-27 1.

The carrying amount of inventory using the LCNRV method applied on an item-by-item basis is $52,860 (as shown next). Product

Cost

RSK-89013 LKW-91247 QEC-57429

$22,800 19,740 13,260 $55,800

Date

Net Realizable Value (600  $38) (420  $47) (510  $26)

$28,200 $16,800 $16,320

Journal Account and Explanation Cost of Goods Sold* Inventory

(600  $47) (420  $40) (510  $32)

Debit 2,940

LCNRV $22,800 16,800 13,260 $52,860

Credit 2,940

* $55,800 − $52,860 = $2,940

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BE 6-28 1. (a)

(b)

(c)

Gross Profit Net Sales ($280,000 − $120,000) = $280,000 = 57.14 % Cost of Goods Sold Inventory Turnover Ratio = Average Inventory $120,000 = ($5,000 + $10,000)/2 $120,000 = $7,500 = 16.00 365 Average Days to Sell Inventory = Inventory Turnover 365 = 16.00 = 22.81 Gross Profit Ratio =

The gross profit ratio tells how many cents of every dollar are available to cover expenses other than cost of goods sold and to earn a profit. The inventory turnover ratio describes how quickly inventory is purchased (or produced) and sold. The average days to sell inventory gives a measure of how many days it takes to sell inventory.

BE 6-29 1.

Cost of goods sold for Year 1 = $605,000 [$620,000 − ($65,000 − $50,000)] Gross profit for Year 1 = $395,000 [($1,000,000 − $620,000) + ($65,000 − $50,000)]

For Year 1, ending inventory would be understated, resulting in gross profit (and net income) being understated. Because the understatement of net income closes to Retained Earnings, retained earnings would be understated as well. For Year 2, the understatement of ending inventory in Year 1 would cause the beginning inventory in Year 2 to be understated. The understatement of beginning inventory would cause cost of goods to be understated and net income to be overstated. This overstatement of net income would close to Retained Earnings and cancel out the understatement from Year 1. The ending inventory for Year 2 would not be affected by the earlier misstatement of inventory. Therefore, there is no overall effect on the Year 2 balance sheet.

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BE 6-30 Date Apr.

Journal Account and Explanation 1 Purchases Accounts Payable

Debit 3,100

Credit 3,100

1 Transportation-In Cash

250

8 Accounts Payable Purchase Returns and Allowances

800

250

10 Accounts Payable Cash* Purchase Discounts**

800 2,300 2,254 46

* ($3,100 − $800)  0.98 = $2,254 ** $2,300  0.02 = $46

BE 6-31 200 300 125 625

Cost of Goods Sold units  $10 = units  $12 = units  $14 = units

Ending Inventory $2,000 125 units  $14 = 3,600 1,750 $7,350 125 units

$1,750

Cost of Goods Sold units  $14 = units  $12 = units  $10 = units

Ending Inventory units  $10 =

$1,250

units

$1,250

$1,750

BE 6-32 250 300 75 625

$3,500 125 3,600 750 $7,850 125

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BE 6-33 Cost of Goods Available for Sale Units Available for Sale $9,100 = 750 = $12.1333/unit

Weighted Average Cost per Unit =

The cost of goods available for sale ($9,100) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 625 units  $12.1333 =

Ending Inventory $7,583 125 units  $12.1333 =

$1,517

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EXERCISES E 6-34 1.

Sales revenue is $10,960, computed as: 240  $13 = $ 3,120 210  $15 = 3,150 335  $14 = 4,690 Total 785 $10,960 Ending inventory: $1,520 [$8  (150 + 825 − 240 − 210 − 335)] Cost of goods sold: $6,280 (785 units sold  $8 each)

Gross margin: $4,680 [Sales Revenue − Cost of Goods Sold ($10,960 − $6,280)]

E 6-35 a. b.

$46,100 $11,200

($44,500 + $11,200 − $9,600) (Beginning Inventory for Year 2 = Ending Inventory for Year 1)

c. d.

$16,700 $16,700

($11,200 + $55,300 − $49,800) (Beginning Inventory for Year 3 = Ending Inventory for Year 2)

$54,050

($16,700 + $51,100 − $13,750)

E 6-36 1.

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E 6-37 Journal Account and Explanation Inventory* Accounts Payable

Date 1.

Debit 6,875

Credit 6,875

Inventory Cash

320

Accounts Payable Inventory**

275

Accounts Payable Cash***

6,600

320

275

6,600

* 1,250 units  $5.50 = $6,875 ** 50 units  $5.50 = $275 *** $6,875 − $275 = $6,600

Total cost of this purchase: $6,920 ($6,875 + $320 − $275)

E 6-38 Date Apr.

Journal Account and Explanation Inventory Accounts Payable

Debit 25,150

Credit 25,150

Inventory Accounts Payable

28,200

Accounts Payable Cash* Inventory**

25,150

Accounts Payable Cash

28,200

24,647 503

28,200

* $25,150  (1.00 − 0.02) = $24,647 ** $25,150  0.02 = $503

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E 6-39 Entry to record the first shipment: Date May

Journal Account and Explanation Inventory Accounts Payable Inventory Accounts Payable

Debit 142,500

Credit 142,500

8,300 8,300

Entry to record the second shipment: Date May

Journal Account and Explanation Inventory Accounts Payable

Debit 87,250

Credit 87,250

Entry to record the third shipment: Date May

Journal Account and Explanation Inventory Accounts Payable

Debit 21,650

Credit 21,650

E 6-40 1.

Total sales revenue for Stanley Company would be $9,710 ($5,460 + $4,250). The second shipment for $3,800 would not be included in sales because, under F.O.B. destination shipping terms, the company should not record a sale until the goods reach the customer.

If Stanley improperly includes the $3,800 shipment as a sale, sales revenue and net income would be overstated by $3,800. Assets (accounts receivable) and stockholders’ equity would also be overstated by $3,800. There is no effect on expenses or liabilities.

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E 6-41 Raymond Company: Date Jan.

Journal Account and Explanation 1 Inventory Accounts Payable 8 Accounts Payable Inventory

Debit 5,000

Credit 5,000

500 500

10 Accounts Payable Cash Inventory ($3,000  0.02)

3,000

30 Accounts Payable Cash*

1,500

2,940 60

1,500

* $5,000 − $500 − $3,000 = $1,500

Geeslin Company: Date Jan.

Journal Account and Explanation 1 Accounts Receivable Sales Revenue 1 Cost of Goods Sold Inventory

Debit 4,900

Credit 4,900

3,750 3,750

8 Sales Revenue Accounts Receivable

490

8 Inventory Cost of Goods Sold

375

10 Cash Accounts Receivable

2,940

30 Cash Accounts Receivable** Sales Revenue***

1,500

490

375

2,940

1,470 30

* The accounting for sales discounts was illustrated in Chapter 5. ** $4,900 − $490 − $2,940 = $1,470 *** $1,500 − $1,470

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E 6-42 1. Date

Journal Account and Explanation Inventorya Accounts Payable Accounts Payableb Inventory

Credit 91,450

930 930

Accounts Receivable Sales Revenuec

1,51,270

Cost of Goods Soldd Inventory

95,480

Sales Revenue Accounts Receivablee

2,040

Inventoryf Cost of Goods Sold

1,240

1,51,270

95,480

2,040

1,240

1,475 units  $62 = $91,450

b c

Debit 91,450

15 units  $62 = $930

(830 units  $95) + (710 units  $102) = $151,270

1,540 units  $62 = $95,480

20 units  $102 = $2,040

20 units  $62 = $1,240

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E 6-42 (Continued) 2.

The cost of ending inventory is determined by multiplying the number of units in ending inventory by the cost per unit. Units available for sale* ...................................................................................... 1,700 Less: Units returned to suppliers ......................................................................... (15) Goods available for sale ...................................................................................... 1,685 Less: Units sold** ............................................................................................... (1,540) Items returned ................................................................................................... 20 Units in ending inventory .................................................................................... 165 Cost per unit ....................................................................................................... x $62 Cost of ending inventory ..................................................................................... $10,230

* 225 units + 1,475 units = 1,700 units ** 830 units + 710 units = 1,540 units

Note: Alternatively, the cost of ending inventory can be computed by starting with beginning inventory of $13,950 (225 units  $62) and then adding or subtracting the change in inventory according to the journal entries already made. The cost of goods sold is $94,240. This amount is computed as the units sold (1,540 units) multiplied by the price per unit ($62) minus the cost of the units returned (20 units  $62). Gross profit is $54,990, computed as: Sales................................................................................................................... $151,270 Less: Sales returns and allowances ............................................................................ (2,040) Cost of goods sold............................................................................................... (94,240) Gross profit ........................................................................................................ $ 54,990

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E 6-44 (Continued) 5.

An examination of the ending inventory amounts recorded under each method reveals that FIFO will result in the highest amount of assets (ending inventory) reported on the balance sheet and the lowest amount reported as cost of goods sold on the income statement. LIFO produces the highest amount reported as cost of goods sold on the income statement and, therefore, the lowest net income and taxes paid. LIFO also produces the lowest amount reported as ending inventory on the balance sheet. The average cost method falls in between the other two for both ending inventory calculations and cost of goods sold. Because the specific identification method could result in the highest cost of goods sold or the highest ending inventory depending on which specific goods were sold and which were still on hand, no generalized statement can be made with regard to this method.

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E 6-45 (Continued) 4. Sales*……………………………………………………… Less: Cost of goods sold…………………………... Gross margin…………………………………………… Less: Operating expenses………………………… Income before taxes……………………………….. Tax rate………………………………………………….. Income tax expenses………………………………..

FIFO LIFO $ 255,450 $ 255,450 (195,490) (202,825) $ 59,960 $ 52,625 ( 21,600) (21,600) $ 38,360 $ 31,025 30% 30% $ 11,508 $ 9,308

Average cost $ 255,450 (197,239) $ 58,211 (21,600) $ 36,611 30% $ 10,983

(990 units + 975 units)  $130 = $255,450

Gross Profit Ratio =

Gross Profit Sales

Inventory Turnover =

Gross Profit Ratio Inventory Turnover

Cost of Goods Sold Average Inventory

FIFO 23.47% 6.845

LIFO 20.60% 8.148

Average Cost 22.79% 7.124

The choice of inventory method affects not only the amount reported as inventory but also the reported amount for cost of goods sold, which, in turn, affects gross profit. In a period of rising prices, FIFO produces a lower amount for cost of goods sold, higher gross profit, and higher ending inventory than LIFO. Therefore, the use of FIFO would result in a higher gross profit ratio (due to the higher reported gross profit) and a lower inventory turnover (due to lower amounts reported as cost of goods sold and higher ending inventory amounts) than LIFO. Average cost would produce ratios in between the ratios produced under FIFO and LIFO.

E 6-46 Ending inventory.............................................................................................. Cost of goods sold ............................................................................................ Gross margin ................................................................................................... Income before taxes ........................................................................................ Payments for income taxes .............................................................................. Net income ......................................................................................................

FIFO Higher Lower Higher Higher Higher Higher

LIFO Lower Higher Lower Lower Lower Lower

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E 6-47 1.

Average cost: Sales revenue ................................................................................ Less: Cost of goods sold ................................................................. Gross margin ................................................................................. Less: Operating expenses............................................................... Income from operations ................................................................ Less: Interest expense ................................................................... Income before taxes ...................................................................... Less: Income tax expense*............................................................. Net income ...................................................................................

$ 828,600 (399,050) $ 429,550 (370,400) $ 59,150 (42,100) $ 17,050 (5,797) $ 11,253

* $17,050  0.34 = $5,797

FIFO: Sales revenue ................................................................................ Less: Cost of goods sold ................................................................. Gross margin ................................................................................. Less: Operating expenses............................................................... Income from operations ................................................................ Less: Interest expense ................................................................... Income before taxes ...................................................................... Less: Income tax expense** ........................................................... Net income ...................................................................................

$ 828,600 (386,500) $ 442,100 (370,400) $ 71,700 (42,100) $ 29,600 (10,064) $ 19,536

** $29,600  0.34 = $10,064

LIFO: Sales revenue ................................................................................ Less: Cost of goods sold ................................................................. Gross margin ................................................................................. Less: Operating expenses............................................................... Income from operations ................................................................ Less: Interest expense ................................................................... Income before taxes ...................................................................... Plus: Tax savings due to loss*** ..................................................... Net income ...................................................................................

$ 828,600 (424,900) $ 403,700 (370,400) $ 33,300 (42,100) $ (8,800) 2,992 $ (5,808)

*** $8,800  0.34 = $2,992

The unit costs are different for ending inventory for each inventory method, causing cost of goods sold to be different. The differences arise because each method assumes different unit costs are allocated to cost of goods sold and ending inventory. Because the use of FIFO lead to the highest reported net income (and, conversely, the use of LIFO reported in the lowest reported income), we can infer that purchase prices have been rising during the year.

The most realistic amount for income comes from LIFO, because it matches the most current costs with revenue. The most realistic amount for ending inventory comes from FIFO, because it reports inventory at the amount closest to current market value on the balance sheet.

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E 6-49 1.

Calculation of FIFO cost of goods sold: Beginning inventory .......................................................... Add: Purchases ................................................................. Goods available for sale .................................................... Less: Ending inventory ...................................................... Cost of goods sold .............................................................

Year 1 Year 2 Year 3 $ 0 $ 2,400 $ 5,400 16,000a 32,400b 45,000c $16,000 $34,800 $50,400 (2,400)d (5,400)e (1,500)f $13,600 $29,400 $48,900

10,000 pages  $1.60 per page = $16,000 16,200 pages  $2.00 per page = $32,400 c 18,000 pages  $2.50 per page = $45,000 d 1,500 pages  $1.60 per page = $2,400 e 2,700 pages  $2.00 per page = $5,400 f 600 pages  $2.50 per page = $1,500 a

Calculation of FIFO cost of goods sold: Beginning inventory .......................................................... Add: Purchases ................................................................. Goods available for sale .................................................... Less: Ending inventory ....................................................... Cost of goods sold .............................................................

Year 1 Year 2 Year 3 0 $ 2,400 $4,800 16,000a 32,400b 45,000c $16,000 $34,800 $49,800 (2,400)d (4,800)e (960)f $13,600 $30,000 $48,840

10,000 pages  $1.60 per page = $16,000 16,200 pages  $2.00 per page = $32,400 c 18,000 pages  $2.50 per page = $45,000 d 1,500 pages  $1.60 per page = $2,400 e (1,500 pages  $1.60 per page ) + (1,200 pages  $2.00 per page) = $4,800 f 600 pages  $1.60 per page = $960 a

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E 6-49 (Continued) 3. Excess of LIFO over FIFO Cost of goods sold

Year 1

Year 2

Year 3

$ 600

$ (60)

In Year 1, the use of FIFO would result in the same cost of goods sold as LIFO because all pages available for sale and sold during Year 1 were purchased at the same unit cost. In Year 2, the use of FIFO would result in the reporting of cost of goods sold of $600 less than if LIFO were used. This difference arises because FIFO assigns the more recent, higher-cost purchases to inventory and the older, lower-cost purchases to cost of goods sold. LIFO assigns the more recent, highercost purchases to cost of goods sold. In Year 3, the use of FIFO would result in a $60 larger cost of goods sold—an unusual event during periods of rising prices—because the quantity of inventory declined by a very substantial amount. The decline released the lower costs (from Year 1) from the LIFO inventory, reducing Year 1 LIFO cost of goods sold below Year 3 FIFO cost of goods sold. This Year 3 reduction in inventory is termed as LIFO liquidation.

E 6-50 1.

Specific identification ending inventory: 40 @ $7.10 30 @ $7.20 80 @ $7.50 40 @ $7.70 Ending inventory

= = = = =

284 216 600 308 $ 1,408

= = = = =

Specific identification cost of goods sold: 70 (110 − 40) @ $7.10 545 (575 − 30) @ $7.20 600 (680 − 80) @ $7.50 190 (230 − 40) @ $7.70 Cost of goods sold 1.

497 3,924 4,500 1,463 $10,384

The carrying value of Meredith’s ending inventory using the lower of cost or NRV rule applied on an item-by-item basis is $33,390 (as computed below).

Item Cost* Window air conditioner ............................................... Dishwasher .................................................................. Refrigerator ................................................................. Microwave .................................................................. Washer (clothing) ........................................................ Dryer (clothing)............................................................ Total ......................................................................

Total Historical Total NRV** $ 4,500 $ 2,625 4,950 4,620 14,700 14,875 3,300 2,625 5,040 6,160 3,780 4,050 $36,270

Lower of Cost or NRV $ 2,625 4,620 14,700 2,625 5,040 3,780 $33,390

* Historical Cost = Number of Units  Historical Cost per Unit ** Net Realizable Value = Number of Units  (Selling Price − Costs of Disposal)

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E 6-50 (Continued) Date

Journal Account and Explanation Cost of Goods Sold* Inventory

Debit 2,880

Credit 2,880

* $36,270 − $33,390 = $2,880 3.

The lower of cost or NRV rule is an application of the conservatism principle. The LCNRV rule recognizes an expense in the period in which there is a decline in the selling price of inventory rather than in the period in which the inventory is sold.

E 6-51 1.

The carrying value of Shaw Systems' ending inventory using the lower of cost or NRV rule applied on an item-by-item basis is $84,430 (as computed below).

Item Phone ..................................................................... Stereo..................................................................... Electric shaver ........................................................ MP3 alarm clock ..................................................... Handheld game system ...........................................

Total Historical Cost* $15,000 31,860 6,450 11,700 22,800 $87,810

Total NRV** $12,500 34,200 6,020 11,250 23,940

Lower of Cost or NRV $12,500 31,860 6,020 11,250 22,800 $84,430

* Historical Cost = Number of Units  Historical Cost per Unit ** Net Realizable Value = Number of Units  (Selling Price − Costs of Disposal)

Date

Journal Account and Explanation Cost of Goods Sold* Inventory

Debit 3,380

Credit 3,380

* $87,810 − $84,430 = $3,380

In the current period, the application of the LCNRV rule would cause assets (inventory) to decrease by $3,380. In addition, cost of goods sold would increase by $3,380 which causes net income and stockholders’ equity to decrease by $3,380. In a subsequent period in which the inventory is sold, the cost of goods sold would be less due to the inventory write-down in the earlier period. Therefore, the net income reported in the subsequent period would be $3,380 higher than it would have been if the LCNRV adjustment had not been made. Note that the application of the LCNRV rule only changes the timing of when cost of goods sold is recognized.

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E 6-52 Gross Profit Net Sales ($754,690 − $528,600) = $754,690 = 29.96 %

Gross Profit Ratio =

A gross profit ratio of 29.96% means that almost 30 cents of every dollar of sales is available to cover expenses other than cost of goods sold and to earn a profit. Cost of Goods Sold Inventory Turnover Ratio = Average Inventory $528,600 = $72,200 = 7.321 The inventory turnover of 7.321 times says that McLelland purchases and sells its inventory almost 7.321 times a year. 365 Average Days to Sell Inventory = Inventory Turnover 365 = 7.321 = 49.86 days

This ratio indicates that it takes McLelland approximately 50 days to sell its inventory. Gross Profit Gross Profit Ratio = Net Sales ($754 , 690 − $555, 000) = $754 , 690 = 26.46% A gross profit ratio of 26.46% means that approximately 26 cents of every dollar of sales is available to cover expenses other than cost of goods sold and to earn a profit. Cost of Goods Sold Inventory Turnover Ratio = Average Inventory $555,000 = $45, 800 = 12.118 The inventory turnover of 12.118 times says that McLelland purchases and sells its inventory almost 12.118 times a year. 365 Average Days to Sell Inventory = Inventory Turnover 365 = 12.118 = 30.12 days This ratio indicates that it takes McLelland approximately 30 days to sell its inventory.

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E 6-52 (Continued) 3.

Because the use of LIFO resulted in a higher amount reported as cost of goods sold, the gross profit reported under LIFO is less than that under FIFO. However, LIFO also reported lower amounts for ending inventory, resulting in higher inventory turnover and a shorter average days to sell inventory. Therefore, the different methods appear to be providing somewhat conflicting information on how effective the company is at managing and controlling its inventory. In determining which method presents a better indicator of management’s ability to manage and control its inventory, remember that the use of FIFO results in a more realistic amount for inventory because it reports the most current costs (which are closer to market value) on the balance sheet. Therefore, the ratios computed under FIFO provide the most realistic assessment of management’s control over its inventory.

E 6-53 1.

2023 Sales revenue ................................... $538,200 Cost of goods sold: Beginning inventory ...................... $ 45,800* Purchases ..................................... 343,200 Cost of goods available for sale ....................... $389,000 Ending inventory .................................... (46,800) 342,200 Gross margin ............................................ $196,000 Operating expenses .................................. 167,200 Income before taxes ................................. $ 28,800

2022 $483,700 $ 32,100 292,700 $324,800 (45,800)*

279,000 $204,700 151,600 $ 53,100

* $39,300 + $6,500 = $45,800

2023 Beginning inventory......................................................................... Ending inventory ............................................................................. Stockholders’ equity ........................................................................ Cost of goods sold ........................................................................... Gross margin ................................................................................... Income before taxes ........................................................................

+0 − 6,500 − 6,500 + 6,500 − 6,500 − 6,500

2022 − 6,500 — — − 6,500 + 6,500 + 6,500

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E 6-54 Date 1.

Journal Account and Explanation Purchases* Accounts Payable

Debit 6,875

6,875

Transportation-In Cash

320

Accounts Payable** Purchase Returns and Allowances

275

Accounts Payable*** Cash

Credit

320

275 6,600 6,600

* 1,250 units  $5.50 = $6,875 ** 50 units  $5.50 = $275 *** $6,875 − $275 = $6,600

Total cost of this purchase: $6,875 + $320 − $275 = $6,920

The accounts used in the journal entries are different from Exercise 6-37 because in this example, Compass Inc. is using the periodic inventory system not the perpetual system. In a periodic system, the purchase of inventory and any transportation costs to get the merchandise to the warehouse are recorded in a purchases account and a transportation-in account, respectively, instead of directly into inventory. These two accounts are added to purchases in the determination of net purchases. In addition, under a periodic system, any purchase return is recorded as a reduction to purchases instead of as a reduction in inventory. At the end of the period, net purchases are added to beginning inventory to compute the cost of goods available for sale.

E 6-55 Raymond Company: Date Jan.

Journal Account and Explanation 1 Purchases Accounts Payable 8 Accounts Payable Purchase Returns and Allowances

Debit 5,000

Credit 5,000

500

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E 6-55 (Continued) 10 Accounts Payable Cash Inventory ($3,000  0.02)

3,000

30 Accounts Payable Cash*

1,500

2,940 60

1,500

* $5,000 − $500 − $3,000 = $1,500

E 6-56 1. Date

Journal Account and Explanation Purchasesa Accounts Payable Accounts Receivable Sales Revenueb Accounts Payablec Purchase Returns and Allowances Sales Revenue Accounts Receivabled

Debit 91,450

Credit 91,450

1,51,270 1,51,270 930 930 2,040 2,040

1,475 units  $62 = $91,450 (830 units  $95) + (710 units  $102) = $151,270 c 15 units  $62 = $930 d 20 units  $102 = $2,040 a

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E 6-56 (Continued) 2.

The cost of ending inventory is determined by multiplying the number of units in ending inventory by the cost per unit: Units in goods available for sale* ............................................... Less: Units returned to supplier .................................................. Units in cost of goods available for sale ...................................... Less: Units sold**....................................................................... Items returned........................................................................... Units in ending inventory ........................................................... Cost per unit .............................................................................. Cost of ending inventory ............................................................ Cost of goods sold: Cost of goods available for sale*** ......................................... Cost of ending inventory .........................................................

1,700 (15) 1,685 (1,540) 20 165  $62 $ 10,230 $104,470 (10,230) $ 94,240

* 225 units + 1,475 units = 1,700 units ** 830 units + 710 units = 1,540 units *** 1,685 units  $62 = $104,470

Gross profit is $54,990, computed as: Sales ............................................................................................ Less: Sales returns and allowances ................................................ Cost of goods sold ........................................................................ Gross profit .................................................................................. 3.

$151,270 (2,040) (94,240) $ 54,990

Differences in this example as compared to Exercise 6-42 are caused by the use of different inventory systems (a perpetual inventory system was used in Exercise 6-42; a periodic inventory system was used in this exercise). Under a periodic system, purchases are recorded in a purchases account instead of directly into the inventory account. In addition, cost of goods sold is not recorded at the same time as a sale. Instead, cost of goods sold is computed at the end of the period by applying the cost of goods sold model.

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E 6-57 FIFO: Cost of Goods Sold

Ending Inventory 1 $100 0 2 160 5 $260

20 units  $5 = 20 units  $8 =

units  $8 =

$ 80

units  $10 =

250 $330

LIFO: Cost of Goods Sold 25 units  $10 = 15 units  $8 =

$250 15 120 20 $370

Ending Inventory units  $8 = units  $5 =

$ 120 100 $220

Average Cost: Cost of Goods Available for Sale Units Available for Sale $590 = = $7.8667/unit 75 units

Weighted Average Cost per Unit =

The cost of goods available for sale ($590) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 40 units  $7.8667 =

Ending Inventory $315 35 units  $7.8667 =

$275

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 6: Cost of Goods Sold and Inventory

E 6-58 1.

Goods available for sale: Units Beginning inventory .................... Purchase 1, Feb. 21...................... Purchase 2, July 15 ...................... Purchase 3, Sept. 30 .................... Total purchases ...................... Goods available for sale ..............

400 5,200 4,800 8,500

Cost per Unit $20 24 28 30

18,500 18,900

Total Cost $ 8,000 $124,800 134,400 255,00 514,200 $522,200

Sales were 18,500 units. Therefore, ending inventory is 400 units (18,900 − 18,500). FIFO The cost of the ending inventory is the cost of the newest 400 units. The 400 newest units would be drawn from Purchase 3. Cost of ending inventory ($30  400 units) ....................................

$ 12,000

Cost of goods sold is the cost of goods available for sale minus the cost of ending inventory as shown in the following calculation: Beginning inventory ..................................................................... Add: Purchases ............................................................................ Cost of goods available for sale .................................................... Less: FIFO ending inventory* ........................................................ FIFO cost of goods sold (18,500 units) ...........................................

$ 8,000 5,14,200 $522,200 (12,000) $510,200

* 400 units  $30 = $12,000

Alternatively, FIFO cost of goods sold can be determined by computing the cost of the oldest 18,500 units in goods available for sale. The oldest 18,500 units are the 400 units from beginning inventory, 5,200 units from Purchase 1; 4,800 units from Purchase 2; and 8,100 units from Purchase 3. The cost of these units is $510,200 [(400 units  $20) + (5,200 units  $24) + (4,800 units  $28) + (8,100 units  $30)].

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E 6-58 (Continued) LIFO The cost of ending inventory is the cost of the oldest 400 units. The 400 oldest units would be drawn from beginning inventory and Purchase 1. The cost of ending inventory is $8,000 [(400 units  $20) + (0 units  $24)]. Cost of goods sold is the cost of goods available for sale minus the cost of ending inventory as shown in the following calculation: Beginning inventory ......................................................................... Add: Purchases................................................................................. Cost of goods available for sale ......................................................... Less: LIFO ending inventory .............................................................. LIFO cost of goods sold (18,500 units) ...............................................

8,000 514,200 $522,200 (8,000) $514,200

Alternatively, LIFO cost of goods sold can be determined by computing the cost of the newest 18,500 units available for sale. The newest 18,500 units are 8,500 units from Purchase 3; 4,800 units from Purchase 2; and 5,200 units from Purchase 1. The cost of these 18,500 units is $514,200 [(8,500 units  $30) + (4,800 units  $28) + (5,200 units  $24)]. Average Cost First, the weighted average cost per unit must be determined by dividing the cost of goods available for sale by the units in goods available for sale: $522,200/18,900 units ......................................................................

$ 27.6296

The cost of ending inventory is the weighted average cost per unit times the number of units: $27.6296  400 units ........................................................................

$ 11,052

Cost of goods sold is the cost of goods available for sale minus the cost of ending inventory as shown in the following calculation: Beginning inventory ......................................................................... Add: Purchases................................................................................. Cost of goods available for sale ......................................................... Less: Average cost ending inventory*................................................ Average cost of goods sold (18,500 units)..........................................

$ 8,000 514,200 $522,200 (11,052) $511,148

* 400 units  $27.6296 = $11,052

Alternatively, the weighted average cost of goods sold can be determined by multiplying the weighted average cost per unit times the number of units in cost of goods sold. The cost of goods sold is $511,148 (18,500 units  $27.6296).

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E 6-58 (Continued) 2.

Income statements:

Sales revenue* ........................................... Less: Cost of goods sold............................... Gross margin ..............................................

FIFO $ 925,000 (510,200) $ 414,800

Average Cost $ 925,000 (511,148) $ 413,852

LIFO $ 925,000 (514,200) $ 410,800

* 18,500 units  $50 = $925,000

As you can see from the above partial income statements, the use of FIFO results in a lower cost of goods sold, which leads to higher income. LIFO is the exact opposite; its use results in higher cost of goods sold and a lower income amount. The average cost method falls in between the other two methods for both the cost of goods sold and income amounts.

6-59 1.

Goods available for sale:

Beginning inventory ............................... Purchase 1, Feb. 26 ................................ Purchase 2, June 14 ............................... Total purchases ..................................... Goods available for sale .........................

Units 1,400 2,400 2,200 4,600 6,000

Cost per Unit $12 16 20

Total Cost $16,800 $38,400 44,000 82,400 $99,200

Sales were 4,200 units (2,300 units + 1,900 units). Therefore, ending inventory is 1,800 units (6,000 units − 4,200 units). Inventory Costing Method FIFO ..................................... LIFO......................................

Cost of Goods Sold $99,200 − $36,000 = $63,200 $99,200 − $23,200 = $76,000

Average Cost* ......................

$99,200 − $29,760 = $69,440

Ending Inventory 1,800  $20 = $36,000 1,400  $12 = $16,800 400  $16 = $ 6,400 $23,200 (1,800  $16.5333) = $29,760

* Weighted average cost per unit = $99,200/6,000 units = $16.5333/unit

By looking at the above calculations, you can see that when purchase prices are rising, the FIFO method results in the lowest reported amount for cost of goods sold and the largest amount for net income. Also, FIFO results in a larger inventory amount on the balance sheet relative to the other methods. The use of LIFO produces the opposite results. The application of LIFO, when purchase prices are rising, results in the largest reported amount for cost of goods sold and the smallest reported amount for net income. LIFO also produces a smaller inventory valuation on the balance sheet. The average cost method causes the dollar amounts for inventory, cost of goods sold, and net income to fall in between the other methods.

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E 6-60 1.

FIFO Cost of goods sold (5,240 units): 500 @ $9.00 = 1,600 @ $9.40 = 1,200 @ $10.20 = 1,400 @ $10.80 = 540 @ $11.30 = 5,240 Ending inventory (560 units) 560 @ $11.30 =

4,500 15,040 12,240 15,120 6,102 $ 53,002

$ 6,328

LIFO Cost of goods sold (5,240 units): 1,100 @ $11.30 = 1,400 @ $10.80 = 1,200 @ $10.20 = 1,540 @ $9.40 = 5,240

$ 12,430 15,120 12,240 14,476 $ 54,266

Ending inventory (560 units) 60 @ $9.40 500 @ $9.00 560

= =

564 4,500 $ 5,064

Average Cost $59,330/5,800 units = Cost of goods sold =

$10.2293 5,240  $10.2293 =

$ 53,602

Ending inventory =

560  $10.2293 =

$ 5,728

The use of LIFO produces the most realistic amount for income, because it matches the most current costs, which are closer to current market value, against current revenues. The use of FIFO will result in the most realistic amount for inventory because it reports the most current costs on the balance sheet.

In a period of rising prices, the use of LIFO, which expenses the most current costs, will result in the lowest amount of income and the lowest amount paid for taxes.

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PROBLEM SET A P 6-61A For Year 1 (solve in the following order): (c) = $359,620 − $116,450 = $243,170 (b) = $243,170 + $42,780 = $285,950 (a) = $285,950 − $36,800 = $249,150 For Year 2 (solve in the following order): (d) = $42,780 (Beginning Inventory for 2019 = Ending Inventory for 2018) (e) = $42,780 + $301,600 = $344,380 (f) = $344,380 − $289,700 = $54,680 (g) = $423,150 − $289,700 = $133,450

P 6-62A

Date Apr.

Journal Account and Explanation 2 Inventory Accounts Payablea

Debit 10,800

Credit 10,800

2 Inventory Cashb

195

3 Inventory Cashb

1,150

4 Inventory Accounts Payable

8,250

10 Accounts Payable Inventoryc Cashdb

10,800

15 Accounts Payable Inventory

325

20 Cash Sales Revenuee

17,104

195

1,150

8,250

216 10,584

325

17,104

360 units  $30 = $10,800 115 units  $10 = $1,150 c $10,800  0.02 = $216 d $10,800  (1.00 − 0.02) = $10,584 e (118 units  $90) + (92 units  $12) + $5,380 = $17,104 a

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P 6-62A (Continued) Date Apr.

Journal Account and Explanation 20 Cost of Goods Sold Inventory

Debit 7,580

Credit 7,580

23 Sales Revenue Cash

860

23 Inventory Cost of Goods Sold

450

25 Accounts Receivablef Cashg Sales Revenue

4,950 180

25 Cost of Goods Sold Inventory

1,800

29 Accounts Payableh Cash

7,925

860

450

8,250 5,130

1,800

7,925

55 units  $90 = $4,950 15 units  $12 = $180 h $8,250 − $325 = $7,925 f

No entry is required until the bags arrive due to the shipping terms (F.O.B. destination).

Alpharack Company Income Statement For the period ending April 30 Sales* .................................................................................................. Less: Cost of goods sold** .................................................................... Gross margin ....................................................................................... Less: Operating expenses ..................................................................... Income before income taxes ................................................................ Income tax expenses ............................................................................ Net income ..........................................................................................

$21,374 (8,930) $12,444 (8,500) $ 3,944 (1,180) $ 2,764

* $17,104 − $860 + $5,130 = $21,374 (based on journal entries) ** $7,580 − $450 + $1,800 = $8,930 (based on journal entries)

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P 6-63A (Continued) 4. Date Dec.

Journal Account and Explanation 2 Inventory Cash

Debit 193.60

Credit 193.60

5 Inventory Cash

235.30

7 Cash Sales Revenue*

380.00

7 Cost of Goods Sold Inventory

159.20

10 Cash Sales Revenue**

500.00

10 Cost of Goods Sold Inventory

223.00

12 Inventory Cash

117.60

235.30

380.00

159.20

500.00

223.00

117.60

* 19 units  $20 = $380 ** 25 units  $20 = $500

Date Dec.

Journal Account and Explanation 14 Cash Sales Revenue*** 14 Cost of Goods Sold Inventory

Debit 400.00

Credit 400.00

185.50 185.50

*** 20 units  $20 = $400

LIFO would result in the lowest amount of taxes paid, because in a period of rising prices, it produces the largest amount for cost of goods sold, which causes income before taxes to be the lowest of the three inventory methods.

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P 6-65A 1.

The carrying amount of inventory using the lower of cost or NRV approach applied on an itemby-item basis is $20,100 (as computed below). Model T-260 S-256 R-193 Z-376

Cost $ 3,750 (15  $250) 9,100 (28  $325) 4,200 (20  $210) 4,275 (15  $285) $21,325

Date

NRV $ 6,675 (15  $445) 8,400 (28  $300) 4,600 (20  $230) 3,750 (15  $250) $23,425

Journal Account and Explanation Cost of Goods Sold* Inventory

LCNRV $ 3,750 8,400 4,200 3,750 $20,100

Debit 1,225

Credit 1,225

* $21,325 − $20,100 = $1,225

In the current period, the application of the LCNRV rule would cause assets (Inventory) to decrease by $1,225. In addition, cost of goods sold would increase by $1,225, which causes net income and stockholders’ equity to decrease by $1,225. In a subsequent period in which the inventory is sold, the cost of goods sold would be less due to the inventory write-down in the earlier period. Therefore, the net income reported in the subsequent period would be $1,225 higher than it would have been if the LCNRV adjustment had not been made. Note that the application of the LCNRV rule only changes the timing of when cost of goods sold is recognized.

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P 6-64A (Continued) Gross Margin for Year 1 = Sales − Cost of Goods Sold = $21,750 − $9,602 = $12,148 Gross Margin for Year 2 = Sales − Cost of Goods Sold = $8,750 − $4,491 = $4,259 4.

The use of LIFO would result in the lowest amount paid for taxes because LIFO expenses the more current, higher cost items, which results in a lower gross margin. Lower gross margin results in lower income before taxes, which would minimize the amount of taxes due.

LIFO produces the most realistic amount for income because it matches current costs against revenues. FIFO produces the most realistic amount for inventory because it reports the inventory at the most current costs, which more accurately reflect market value.

Weighted Average

FIFO

LIFO

Year 1 Gross profit ratio*………………………… Inventory turnover**……………………

56.14% 3.59

54.34% 4.04

55.85% 3.66

Year 2 Gross profit ratio…………………………. Inventory turnover……………………….

48.69% 1.68

48.57% 1.98

48.68% 1.73

* Gross Margin/Sales ** Cost of Goods Sold/Average Inventory Balance

The choice of inventory costing method would affect these ratios because each of the ratios uses cost of goods sold or ending inventory as a part of the equation. With rising prices, the use of FIFO would result in the highest gross profit ratio, while the use of LIFO would result in the highest inventory turnover.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 6: Cost of Goods Sold and Inventory

P 6-66A (Continued) Next, the lower of cost or NRV rule must be applied to get the final inventory valuation at December 31. Inventory Method FIFO Average Cost

Cost of Inventory $4,200,000 $4,145,400

Market Value of Inventory $0.76  7,000,000 = $5,320,000 $0.76  7,000,000 = $5,320,000

The final inventory valuations, based on the lower of the two columns above for each method, are: FIFO: Average cost: 2.

$4,200,000 $4,145,400

The NRV of $0.58 is lower than the cost of the final purchase. Therefore, the application of the lower of cost or NRV rule will result in some adjustments to the cost of ending inventory. The first step is to compute the cost of the ending inventory using the appropriate costing method. Next, the lower of inventory cost or NRV rule must be applied to get the final inventory valuation. The cost of inventory is the same as calculated earlier. Inventory Method FIFO Average Cost

Cost of Inventory $4,200,000 $4,145,400

NRV of Inventory $0.58  7,000,000 = $4,060,000 $0.58  7,000,000 = $4,060,000

The final inventory valuations, based on the lower of the two columns above for each method, are: FIFO: Average cost:

$4,060,000 $4,060,000

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P 6-67A 1.

The first error understates inventory by $42,000. The second error also understates inventory by $28,500. This leads to a total understatement of ending inventory in 20Y7 of $70,500. 20Y9 20Y8 20Y7 Sales revenue……………………. $ 4,643,200 $ 4,287,500 $ 3,647,900 Cost of goods sold……………… (2,475,100) (2,252,100)* (1,935,600) Gross margin……………………… $ 2,168,100 $ 2,035,400 $ 1,712,300 Operating expense……………… (1,548,600) (1,428,400) (1,152,800) Income from operations……… $ 619,500 $ 607,000 $ 559,500 Other expenses…………………… (137,300) (123,600) (112,900) Income before taxes……………. $ 482,200 $ 483,400 $ 446,600 Income tax expense (34%)…… (163,948) (164,356) (151,844) Net income………………………….. $ 318,252 $ 319,044 $ 294,756

* $2,181,600 + $70,500 = $2,252,100 ** $2,006,100 − $70,500 = $1,935,600

Ending inventory errors will correct themselves the subsequent year. This occurs because the ending inventory for one period is the beginning inventory of the next period. Thus, the effect of an error in the valuation of ending inventory (assuming no other errors are made) will cause income to be understated in 1 year and overstated the next year. The error is said to self-correct and there will be no cumulative effect of this error on income.

As stated in the answer to Requirement 3, the inventory error corrects itself in the following year, which means the income in the third year (20Y9) will be unaffected.

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P 6-68A Units available for sale: Units sold: Units, ending inventory: 1.

70 units (10 units + 22 units + 26 units + 12 units) 64 units (19 units + 25 units + 20 units) 6 units (70 units − 64 units)

FIFO: 10 22 26 6

Cost of Goods Sold units  $8.00 units  $8.80 units  $9.05 units  $9.80

64 units 2.

$ 567.70

Ending Inventory 6 units  $9.80

$58.80

6 units

$58.80

Ending Inventory 6 units  $8.00

$48.00

6 units

$48.00

LIFO: 12 26 22 4

Cost of Goods Sold units  $9.80 units  $9.05 units  $8.80 units  $8.00

64 units 3.

$ 80.00 193.60 235.30 58.80

$ 117.60 235.30 193.60 32.00 $ 578.50

Average Cost: Cost of Goods Available for Sale Units Available for Sale $626.50 = 70 units = $8.9500/unit

Weighted Average Cost per Unit =

The cost of goods available for sale ($626.50) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 64 units  $8.9500 = $572.80

Ending Inventory 6 units  $8.9500 = $53.70

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P 6-68A (Continued) 4.

Journal Account and Explanation 2 Purchases Cash

Date Dec.

Debit 193.60

Credit 193.60

5 Purchases Cash

235.30

7 Cash Sales Revenuea

380.00

10 Cash Sales Revenueb

500.00

12 Purchases Cashc

117.60

14 Cash Sales Revenued

400.00

235.30

380.00

500.00

117.60

400.00

19 units  $20 = $380 25 units  $20 = $500 c 12 units  $9.80 = $117.60 d 20 units  $20 = $400 a

LIFO would result in the lowest amount paid for income taxes because it has the highest cost of goods sold. (LIFO expenses the more current, higher-cost items.) This higher cost of goods sold would result in a low net income, which would cause lower taxes.

The differences occur because the companies are using different inventory systems. Under a periodic system, purchases are recorded in a purchases account instead of directly into the inventory account. In addition, cost of goods sold is not recorded at the same time as a sale. Instead, cost of goods sold is recorded at the end of the period after applying the cost of goods sold model.

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P 6-69A 1.

FIFO: Year 1 Units available for sale: Units sold: Units in inventory:

200 300 370 870

Cost of Goods Sold units  $ 9 = units  $11 = units  $12 = units

1,150 units (200 units + 300 units + 500 units + 150 units) 870 units (320 units + 550 units) 280 units (1,150 units − 870 units)

$1,800 3,300 4,440 $9,540

130 150

Ending Inventory units  $12 = units  $13 =

$1,560 1,950

280

units

$3,510

Gross Margin = Sales* − Cost of Goods Sold = $21,750 − $9,540 = $12,210 * 870 units  $25 = $21,750

Year 2 Units available for sale: Units sold: Units in inventory:

130 150 70 350

Cost of Goods Sold units  $12 = units  $13 = units  $14 = units

480 units (130 units + 150 units + 200 units) 350 units (200 units + 150 units) 130 units (480 units − 350 units)

$1,560 1,950 980 $4,490

130

Ending Inventory units  $14 =

$1,820

130

units

$1,820

Gross Margin = Sales** − Cost of Goods Sold = $8,750 − $4,490 = $4,260 ** 350 units  $25 = $8,750

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P 6-69A (Continued) 2.

LIFO: Year 1 150 500 220 870

Cost of Goods Sold units  $13 = units  $12 = units  $11 = units

$ 1,950 6,000 2,420 $10,370

200 80

Ending Inventory units  $9 = units  $11 =

$1,800 880

280

units

$2,680

Gross Margin = Sales − Cost of Goods Sold = $21,750 − $10,370 = $11,380

Year 2 Cost of Goods Sold 200 units  $14 = 80 units  $11 = 70 units  $9 = 350 units

$ 2,800 880 630 $4,310

Ending Inventory 200 units  $9 =

$1,800

130 units

$1,170

Gross Margin = Sales − Cost of Goods Sold = $8,750 − $4,310 = $4,440 3. Average Cost: Year 1 Cost of Goods Available for Sale Units Available for Sale $13, 050 = 1, 150 units = $11.3478/unit

Weighted Average Cost per Unit =

The cost of goods available for sale ($13,050) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 870 units  $11.3478 = $9,873

Ending Inventory 280 units  $11.3478 = $3,177

Gross Margin = Sales − Cost of Goods Sold = $21,750 − $9,873 = $11,877

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P 6-69A (Continued) Year 2 Cost of Goods Available for Sale Units Available for Sale $5,977 * = = $12.4521/unit 480 units *$3 , 177 + $2 , 800 = $5 , 977

Weighted Average Cost per Unit =

The cost of goods available for sale ($5,977) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 350 units  $12.4521 = $4,358

Ending Inventory 130 units  $12.4521 = $1,619

Gross Margin = Sales − Cost of Goods Sold = $8,750 − $4,358 = $4,392 4.

The use of LIFO would result in the lowest amount paid for taxes because LIFO expenses the more current, higher-cost items, which results in a lower gross margin. Lower gross margin results in lower income before taxes, which would minimize the amount of taxes due.

Under conditions of rising inventory prices, companies that use LIFO may be able to increase their gross margin simply by delaying year-end purchases until the next year, or they may decrease their gross margin by increasing the quantity of year-end purchases. Delaying year-end purchases increases gross margin by causing older, lower costs to be expensed as cost of goods sold. This is known as a LIFO liquidation, and the decrease in cost of goods sold (while sales revenue remains constant) will cause an increase in gross margin. Increasing the quantity of year-end purchases will have the opposite effect because the cost of goods sold will be assigned the more current, higher costs. This would result in a lower gross margin relative to if the purchases had not been made. Manipulation of year-end purchases has no effect on gross margin when FIFO is used because the cost of goods sold amount is being calculated based on purchases from the beginning of the year rather than year end.

There are differences in the dollar amounts for cost of goods sold and ending inventory under each method, except for FIFO. These differences occur because of the different inventory costing systems used—in the first problem, a perpetual inventory system was used, whereas in this problem, a periodic inventory system was used. The answers were the same under the FIFO inventory costing method because the same units are assumed to be in ending inventory and cost of goods sold regardless of whether a perpetual or periodic inventory system was used.

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PROBLEM SET B P 6-61B For Year 1 (solve in the following order): (a) = $28,600 + $104,730 = $133,330 (c) = $104,730 + $6,940 = $111,670 (b) = $111,670 − $104,250 = $7,420 For Year 2 (solve in the following order): (d) = $6,940 (Beginning Inventory for Year 2 = Ending Inventory for Year 1) (e) = $127,500 − $6,940 = $120,560 (g) = $154,810 − $38,980 = $115,830 (f) = $127,500 − $115,830 = $11,670

P 6-62B

Date June

Journal Account and Explanation 1 Inventory Accounts Payablea

Debit 21,100

Credit 21,100

1 Inventory Cash

310

2 Inventory Cashb

5,720

6 Inventory Accounts Payablec

5,625

10 Accounts Payable Inventoryd Cashde

21,100

12 Accounts Payable Inventory

585

18 Cash Sales Revenuef

18,984

310

5,720

5,625

422 20,678

585

18,984

(100 units  $85) + (210 units  $60) = $21,100 88 units  $65 = $5,720 c 125 units  $45 = $5,625 d $21,100  0.02 = $422 e $21,100  (1.00 − 0.02) = $20,678 a

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(50 units  $116) + (92 units  $85) + (21 units  $100) + (48 units  $68) = $18,984

P 6-62B (Continued) Date June

Journal Account and Explanation 18 Cost of Goods Sold Inventory 21 Sales Revenue Cashg

Debit 13,295

Credit 13,295

1,160 1,160

21 Inventory Cost of Goods Sold

850

23 Accounts Receivableh Cashi

2,320 1,500

23 Cost of Goods Sold Inventory

2,675

30 Accounts Payable Cashj

5,040

850

3,820

2,675

5,040

10 units  $116 = $1,160 20 units  $116 = $2,320 I 15 units  $100 = $1,500 j $5,625 − $585 = $5,040 g

No entry is required until the shoes arrive due to the shipping terms (F.O.B. destination). Jordan Footwear Income Statement For the Period Ended June 30, 2017

Sales* ............................................................................................... Less: Sales returns and allowances ................................................... Net sales ........................................................................................... Less: Cost of goods sold** ................................................................. Gross margin .................................................................................... Less: Operating expenses .................................................................. Income before income taxes ............................................................. Income taxes expense ....................................................................... Net income .......................................................................................

$ 22,804 1,160 $ 21,644 $ 21,644 $ 21,644 365 $ 21,279

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P 6-62B (Continued) 2.

Jordan Footwear Income Statement For the period ended June 30

Sales* ............................................................................................... Less: Cost of goods sold** ................................................................. Gross margin .................................................................................... Less: Operating expenses .................................................................. Income before income taxes ............................................................. Income tax expenses ......................................................................... Net income .......................................................................................

21,644 (15,120) $ 6,524 (5,300) $ 1,224 (365) $ 859

* $18,984 + $3,820 − 1,160 ** $13,295 − $850 + $2,675 = $15,120 (from journal entries)

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P 6-63B (Continued) 4. Date Feb.

Mar.

Journal Account and Explanation 15 Inventory Cash 22 Inventory Cash

Apr.

May

July

Sept.

Debit

Credit 432 432 640 640

9 Cash Sales Revenuea

1,500

9 Cost of Goods Sold Inventory

594

29 Inventory Cash

774

1,500

594

774

10 Cash Sales Revenue**

2,250

10 Cost of Goods Sold Inventory

1,172

10 Inventory Cash

2,250

1,172 768 768

* 10 units  $150 = $1,500 ** 15 units  $150 = $2,250

Journal Account and Explanation

Date Oct.

15 Cash Sales Revenue*** 15 Cost of Goods Sold Inventory

Debit 1,800

Credit 1,800

1,082 1,802

*** 12 units  $150 = $1,800

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P 6-64B (Continued) Gross Margin for Year 1 = Sales − Cost of Goods Sold = $108,000 − $63,439 = $44,561 Gross Margin for Year 2 = Sales − Cost of Goods Sold = $54,000 − $35,235 = $18,765 4.

FIFO

LIFO

Average

Year 1 Gross profit ratio* .............................. Inventory turnover** .........................

41.39% 3.80

40.37% 4.00

41.26% 3.83

Year 2 Gross profit ratio ................................ Inventory turnover .............................

35.19% 0.89

34.07% 0.94

34.75% 0.92

* Gross Margin Sales ** Cost of Goods Sold Average Inventory Balance

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 6: Cost of Goods Sold and Inventory

P 6-65B 1.

The carrying amount of inventory using the lower of cost or NRV approach applied on an item-byitem basis is $22,835 (as computed below). Model RSQ535 JKY942 LLM112 KZG428

Cost $ 3,000 7,280 7,140 6,615 $24,035

Date

Net Realizable Value (30  $100) $ 3,600 (52  $140) 6,500 (84  $85) 6,720 (63  $105) 8,064 $24,884

Journal Account and Explanation Cost of Goods Sold* Inventory

(30  $120) (52  $125) (84  $80) (63  $128)

Debit 1,200

LCNRV $ 3,000 6,500 6,720 6,615 $22,835

Credit 1,200

* $24,035 − $22,835 = $1,200

In the current period, the application of the LCNRV rule would cause assets (inventory) to decrease by $1,200. In addition, cost of goods sold would increase by $1,200, which causes net income and stockholders’ equity to decrease by $1,200. In a subsequent period in which the inventory is sold, the cost of goods sold would be less due to the inventory write-down in the earlier period. Therefore, the net income reported in the subsequent period would be $1,200 higher than it would have been if the LCNRV adjustment had not been made. Note that the application of the LCNRV rule only changes the timing of when cost of goods sold is recognized.

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P 6-66B (Continued) Next, the lower of cost or NRV rule must be applied to get the final inventory valuation. Inventory Method FIFO Average Cost

Cost of Inventory $1,050 $ 993

NRV of Inventory $0.38  7,000 = $2,660 $0.38  7,000 = $2,660

The final inventory valuations, based on the lower of the two columns above for each method, are: FIFO: Average cost: 2.

$1,050 $ 993

The NRV of $0.12 is lower than some of the purchases. Therefore, the application of the lower of cost or NRV rule will result in some adjustments to the cost of ending inventory. First, compute the value of ending inventory as was shown in Requirement 1. Next, the lower of cost or NRV rule must be applied to get the final inventory valuation by comparing the cost of the inventory (previously computed) to its net realizable value. Inventory Method FIFO Average Cost

Cost of Inventory $1,050 $ 993

NRV of Inventory $0.12  7,000 = $840 $0.12  7,000 = $840

The final inventory valuations, based on the lower of the two columns above for each method, are: FIFO: $840 Average cost: $840

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P 6-67B 1.

The first error overstates inventory by $37,000. The second error overstates inventory by $12,800. This leads to a total overstatement of ending inventory in 20Y4 of $49,800.

Sales revenue……………………. Cost of goods sold…………….. Gross margin……………………… Operating expense……………… Income from operations……… Other expenses…………………… Income before taxes…………… Income tax expense (34%)…… Net income………………………….

20Y6 $ 1,168,500 (785,800) $ 382,700 (162,500) $ 220,200 (73,500) $ 146,700 (49,878) $ 96,822

20Y5 $ 998,400 (625,650)* $ 372,750 (142,800) $ 229,950 (58,150) $ 171,800 (58,412) $ 113,388

20Y4 $ 975,300 (709,600)** $ 265,700 (155,300) $ 110,400 (54,500) $ 55,900 (19,066) $ 36,894

* $675,450 − $49,800 = $625,650 ** $659,800 + $49,800 = $709,600

Ending inventory errors will correct themselves the subsequent year. This occurs because the ending inventory for one period is the beginning inventory of the next period. Thus, the effect of an error in the valuation of ending inventory (assuming no other errors are made) will cause income to be overstated in 1 year and understated the next year. The error is said to self-correct and there will be no cumulative effect of this error on income.

As stated in the answer to Requirement 3, the inventory error corrects itself in the following year, which means the income in the third year (20Y6) will be unaffected.

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P 6-68B Units available for sale: Units sold: Units, ending inventory: 1.

FIFO: 9 6 8 9 5

Cost of Goods Sold units  $58 $ 522 units  $72 432 units  $80 640 units  $86 774 units  $96 480

37 units 2.

$ 2,848

Ending Inventory 3 units  $96

$288

3 units

$288

LIFO: 8 9 8 6 6

Cost of Goods Sold units  $96 $ 768 units  $86 774 units  $80 640 units  $72 432 units  $58 348

20 units 3.

40 units (9 units + 6 units + 8 units + 9 units + 8 units) 37 units (10 units + 15 units + 12 units) 3 units (40 units − 37 units)

$ 2,962

Ending Inventory units  $58

$174

units

$174

Average cost: Cost of Goods Available for Sale Units Available for Sale $3,136 = 40 units = $78.40/unit

Weighted Average Cost per Unit =

The cost of goods available for sale ($3,136) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 37 units  $78.4000 = $2,901

Ending Inventory 3 units  $78.4000 = $235

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P 6-68B (Continued) 4. Date Feb.

Mar.

Apr.

May

July

Sept.

Oct.

Journal Account and Explanation 15 Purchases Cash 22 Purchases Cash 9 Cash Sales Revenue* 29 Purchases Cash 10 Cash Sales Revenue** 10 Purchases Cash 15 Cash Sales Revenue***

Debit

Credit 432 432 640 640

1,500 1,500 774 774 2,250 2,250 768 768 1,800 1,800

* 10 units  $150 = $1,500 ** 15 units  $150 = $2,250 *** 12 units  $150 = $1,800

LIFO would result in the lowest amount paid for income taxes because it has the highest cost of goods sold. (LIFO expenses the more current, higher cost items.) This higher cost of goods sold would result in a low net income, which would cause lower taxes.

Similarities and differences occur in the dollar amounts for cost of goods sold and ending inventory under each method. Regardless of whether a perpetual or periodic inventory method is used, the costing methods (FIFO, LIFO, and average cost) maintain the same relationship. For example, in these problems purchase prices are rising. In both cases, FIFO (relative to LIFO and average cost) produced the highest cost for ending inventory and the lowest cost of goods sold. LIFO produced the lowest cost of ending inventory and the highest cost of goods sold. However, FIFO results in the same cost of ending inventory and the same cost of goods sold regardless of whether a perpetual or periodic inventory system is used because the same costs will always be the first in and first out. However, LIFO and average cost result in different amounts under a perpetual versus a periodic system.

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P 6-69B 1.

FIFO: Year 1 Units available for sale: Units sold: Units in inventory:

100 700 400

1,700 units (100 units + 700 units + 500 units + 400 units) 1,200 units (600 units + 600 units) 500 units (1,700 units − 1,200 units)

Cost of Goods Sold units  $45 = units  $52 = units  $56 =

1,200 units

$ 4,500 36,400 22,400

100 400

Ending Inventory units  $56 = units  $58 =

$63,300

500

units

$ 5,600 23,200

$28,800

Gross Margin = Sales* − Cost of Goods Sold = $108,000 − $63,300 = $44,700 *(600 units  $90) + (600 units  $90) = $108,000

Year 2 Units available for sale: Units sold: Units in inventory:

100 300 100 100

1,400 units (100 units + 400 units + 900 units) 600 units (400 units + 200 units) 800 units (1,400 units − 600 units)

Cost of Goods Sold units  $56 = units  $58 = units  $58 = units  $62 =

600 units

$ 5,600 17,400 5,800 6,200

800

Ending Inventory units  $62 =

$49,600

$35,000

800

units

$49,600

Gross Margin = Sales** − Cost of Goods Sold = $54,000 − $35,000 = $19,000 *(400 units  $90) + (200 units  $90) = $54,000

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P 6-69B (Continued) 2.

LIFO: Year 1 Cost of Goods Sold

Ending Inventory

400

units  $58 =

$23,20 0

100

units  $45 =

$ 4,500

500

units  $56 =

28,000

400

units  $52 =

20,800

300

units  $52 =

15,600

1,20 0

unit s

$66,80 0

500

units

$25,30 0

Gross Margin = Sales − Cost of Goods Sold = $108,000 − $66,800 = $41,200 Year 2 Cost of Goods Sold 200 units  $62 = 400 units  $62 =

$12,400 24,800

600 units

$37,200

100 400 300 800

Ending Inventory units  $45 = units  $52 = units  $62 = units

$ 4,500 20,800 18,600 $43,900

Gross Margin = Sales − Cost of Goods Sold = $54,000 − $37,200 = $16,800

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P 6-69B (Continued) 3.

Average cost: Year 1 Cost of Goods Available for Sale Units Available for Sale $92,100 = 1, 700 units = $54.1765/unit

Weighted Average Cost per Unit =

The cost of goods available for sale ($92,100) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 1,200 units  $54.1765 = $65,012 Gross Margin

= = =

Ending Inventory 500 units  $54.1765 = $27,088

Sales − Cost of Goods Sold $108,000 − $65,012 $42,988

Year 2 Cost of Goods Available for Sale Units Available for Sale $82, 888 * = 1, 400 units = $59.2057/unit

Weighted Average Cost per Unit =

* (500 units  $54.1765) + (900 units  $62) = $82,888

The cost of goods available for sale ($82,888) is allocated between inventory and cost of goods sold using the average cost of the inventory as follows: Cost of Goods Sold 600 units  $59.2057 = $35,523

Ending Inventory 800 units  $59.2057 = $47,365

Gross Margin = Sales − Cost of Goods Sold = $54,000 − $35,523 = $18,477

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P 6-69B (Continued) 4.

The use of LIFO generally would result in the lowest amount paid for taxes because LIFO expenses the more current, higher cost items, which results in a lower gross margin. Lower gross margin results in lower income before taxes, which would minimize the amount of taxes due.

Under conditions of rising inventory prices, companies that use LIFO may be able to increase their gross margin simply by delaying year-end purchases until the next year, or they may decrease their gross margin by increasing the quantity of year-end purchases. Delaying year-end purchases increases gross margin by causing older, lower costs to be expensed as cost of goods sold. This is known as a LIFO liquidation, and the decrease in cost of goods sold (while sales revenue remains constant) will cause an increase in gross margin. Increasing the quantity of year end purchases will have the opposite effect because the cost of goods sold will be assigned the more current, higher costs. This would result in a lower gross margin relative to if the purchases had not been made. Manipulation of year-end purchases has no effect on gross margin when FIFO is used because the cost of goods sold amount is being calculated based on purchases from the beginning of the year rather than year end.

Similarities and differences occur in the dollar amounts for cost of goods sold and ending inventory under each method. Regardless of whether a perpetual or periodic inventory is used, the costing methods (FIFO, LIFO, and average cost) maintain the same relationship (as long as no LIFO liquidations occur). For example, in these problems purchase prices are rising. In both cases, FIFO (relative to LIFO and average cost) produced the highest cost for ending inventory, the lowest cost of goods sold, and the highest gross margin. LIFO produced the lowest cost of ending inventory, the highest cost of goods sold, and the lowest gross margin. However, note that FIFO results in the same cost of ending inventory and the same cost of goods sold regardless of whether a perpetual or periodic inventory system is used because the same costs will always be the first in and first out. However, LIFO and average cost result in different amounts under a perpetual versus a periodic system.

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CASES Case 6-70 1.

If the returned inventory had been reduced to its liquidation value, cost of goods sold would have been higher, gross margin and income from operations would have been lower, and net income would have been lower (but due to a favorable income tax effect, it would not decrease as much as income from operations).

Mary is in a difficult position. The CFO has most likely behaved unethically and in a way that will probably damage the business. The purchase of the televisions is most likely a transaction designed to improve the company's appearance to investors. Mary should carefully examine the documentation and monitor the delivery and likely return of the inventory in the next period. If she challenges the CFO’s decision, she may lose her job. If the company has a whistleblower hotline, Mary could inform the company’s internal auditors, which could take her off the hook.

Case 6-71 1.

If a company has used the LIFO method for a number of years, then a substantial reduction in inventory quantity is likely to cause older, lower inventory costs to be transferred from inventory to cost of goods sold. This reduction in inventory quantity will cause a one-time reduction in cost of goods sold and an increase in gross margin and income before taxes as these lower costs are expensed. If the company has used FIFO, then the inventory reduction will not materially affect cost of goods sold as the costs transferred from inventory to cost of goods sold will approximate current replacement costs. Once a company has adopted the just-in-time procedure and has done the necessary inventory reduction, there should be little difference between LIFO and FIFO, as cost of goods sold for both methods should be composed of primarily current period purchases due to the low inventory levels.

Case 6-72 If FIFO is used and beginning and ending inventory quantities are essentially the same, the cost of beginning inventory will be included in cost of goods sold along with the early purchases for the current year, and the cost of ending inventory will be the cost of the last purchases for the year. If LIFO is used under the same circumstances, then cost of goods sold will be the current period’s purchases, and ending inventory cost will equal beginning inventory cost. When prices are volatile, it is unlikely that the cost of FIFO beginning inventory will be the same as the cost of the last purchases for the year. Therefore, cost of goods sold using FIFO should differ from LIFO cost of goods sold. The FIFO and LIFO costs of ending inventory are also likely to differ. If the quantity of goods in inventory is also changing from period to period, FIFO cost of goods sold will continue to include beginning inventory costs and early purchases for the year. LIFO cost of goods sold will include the later current year purchases when inventory quantity is increased but will include some beginning inventory costs when ending inventory quantity is smaller than the beginning inventory quantity. FIFO ending inventory always includes the later purchases for the current year, while LIFO includes beginning inventory costs and some costs from the beginning of the current year if ending inventory quantity is larger than the beginning quantity.

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Case 6-73 1.

Because Hill Motor Company had used the LIFO inventory method for some time and because prices for inventories had increased, a reduction in the quantity of items held in inventory meant that some old, low costs were taken out of inventory and put into cost of goods sold. In 20Y9 and 20Y8, these old costs were $134 million and $294 million less than the current cost of purchasing these items. The decrease in cost of goods sold increased gross margin, income from operations, income before taxes, and net income.

No. When FIFO is used, cost of goods sold includes the ending inventory from the previous period (the last items purchased in the previous year are in ending inventory) plus purchases (in chronological order) from the current year. An inventory reduction occurs when fewer items are purchased than used. An inventory reduction when FIFO is used means that fewer items from the last purchase(s) of the current year are in ending inventory. Therefore, cost of goods sold, gross margin, income from operations, income before taxes, and net income are essentially unaffected by a decline in the quantity of inventory when FIFO is used.

Case 6-74 1.

The basic equation for calculation of cost of goods sold is:

where

BI + P − EI

CGS

BI P EI CGS

= = = =

Beginning Inventory Purchases Ending Inventory Cost of Goods Sold

If that equation is made a part of an equation that represents the income statement, the following relationship can be identified: (R − CGS − OX − OXL + ORG)  (1 − t) = NI where

R OX OXL ORG t NI

= = = = = =

Sales Revenue Operating Expenses Other Expenses and Losses Other Revenues and Gains Tax Rate Net Income

The net income effect of misstatements in ending inventory is the amount of the misstatement multiplied by (1 − Tax Rate). If ending inventory is overstated, profits are inappropriately increased. Profits are decreased by understatements of ending inventory. 2.

A manager intent on misstating income might choose ending inventory for accomplishing the misstatement because the amount of ending inventory is normally determined from a physical inventory. If the quantities in the physical inventory are increased above the quantities actually on hand, then an overstatement of ending inventory has been simply and easily accomplished. To

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make such misstatements more difficult to accomplish, generally accepted auditing standards require that the external auditor observe the physical inventory.

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Case 6-75 1.

The store manager may be reluctant to admit that the computers have little sales value because to do so would require recognition of a significant loss for the period that might adversely affect his or her performance evaluation.

Failure to recognize a decline in the value of inventory results in an overstatement of profits and inventory in the near term. Overvalued inventory may also incur storage and other costs that could be avoided if the inventory were marked down and sold.

Public accountants who participate in misrepresenting the value of inventory risk disciplinary actions by their professional associations and also risk losing their license to practice as certified public accountants. Management accountants who participate in such misrepresentations, when discovered, as they invariably are, also lose their reputation for professional integrity, which in the long run can damage their careers.

Case 6-76 1.

Inventory for 2020 was $44,435,000,000, and for 2019 it was $44,269,000,000.

Wal-Mart primarily uses LIFO, while its Sams Club segment uses weighted average. Foreign operations use FIFO. (This information is found in Note 1 of the financial statements.)

Cost of goods sold (cost of sales) for 2020 was $394,605,000,000; for 2019 it was $385,301,000,000; and for 2018 it was $373,396,000,000.

Gross Profit Net Sales ($519,926 − $394,605) = $519, 926 = 24.10%

Gross Profit Ratio (amounts in millions) =

Cost of Goods Sold Average Inventory $394 , 605 = [($44 , 269 + $44 , 435)/ 2] = 8.90%

Inventory Turnover (amounts in millions) =

Wal-Mart does use the lower of cost or NRV method. Because Wal-Mart does not mention any inventory write-downs in the notes to the financial statements, it does not seem that it will be writing down any inventory to market value in 2020.

If inventory were overstated, assets would be overstated on the balance sheet. Assuming a 1% overstatement, this would result in a $444,350,000 overstatement of assets. This would also, in turn, cause income (and stockholders’ equity) to be overstated by $444,350,000 (ignoring taxes). This effect on income would correct itself in the next fiscal year, when income would be understated.

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Case 6-77 1.

Kroger inventory: February 2, 2019 = $8,123,000,000 February 1, 2020 = $8,464,000,000 Sprouts inventory: December 28, 2017 = $264,366,000 December 29, 2019 = $275,979,000

Kroger uses lower of cost or market, where cost is determined using last-in, first-out (LIFO) (obtained from Note 1 in the “Notes to the Consolidated Financial Statements”). Sprouts uses the lower of cost or net realizable value, where cost is determined based on first-in, first-out (FIFO) (obtained from Note 1 in the “Notes to the Consolidated Financial Statements”).

Kroger’s cost of goods sold (for the year ending in): 2017 = $95,811,000,000 2018 = $95,103,000,000 2019 = $95,294,000,000 Sprout's cost of goods sold (for the year ending in): 2017 = $30,975,820,600 2018 = $3,459,861,000 2019 = $3,740,017,000

Kroger’s ratios: Gross profit: $26,992,000,000/$122,286,000,000 = 22.07% Inventory turnover = $95,294,000,000/[($8,123,000,000 + $8,464,000,000)/2] = 11.49 Sprouts’ ratios: Gross profit: $1,894,818,000*/$5,634,835,000 = 33.63% Inventory turnover = $3,740,017,000/[($275,979,000 + $264,366,000)/2] = 13.84 By looking at the above ratios, you can see that Sprouts does a better job of turning over its inventory more times each year than Kroger. Additionally, Sprouts has a higher gross profit margin on the products it sells.

Kroger uses the lower of cost or market method when valuing inventories. There is no evidence that Kroger had an inventory write-down in the 2019 fiscal year. Sprouts also uses the lower of cost or NRV method when valuing inventories. Similar to Kroger, Sprouts did not record an inventory write-down in the 2016 fiscal year.

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Annual Report Problem 1.

Net sales Beginning inventory Cost of sales Ending inventory

1,10,225,000,000 13,925,000,000 72,653,000,000 14,531,000,000

Net sales Cost of sales Purchases Beginning inventory Ending inventory

1,15,736,250,000 76,285,650,000 78,574,219,500 14,531,000,000 16,819,569,500

FIFO

Increase earnings

4.87

75 days

0.34

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Case 6-79 (Continued) 3. Date May

June

July

Aug.

Journal Account and Explanation 10 Inventory Cash

Debit 1,980.00

1,980.00

25 Cash Sales Revenuea

2,700.00

Cost of Goods Sold Inventory

1,485.00

2,700.00

1,485.00

5 Inventory Cash

2,625.00

12 Cash Sales Revenueb

2,250.00

Cost of Goods Sold Inventory

1,282.50

5 Cash Sales Revenuec

2,025.00

Cost of Goods Sold Inventory

1,181.25

8 Inventory Cash

Credit

2,625.00

2,250.00

1,282.50

2,025.00

1,181.25 1,757.50 1,757.50

180 units  $15 = $2,700 150 units  $15 = $2,250 c 135 units  $15 = $2,025 a

Date Aug.

Journal Account and Explanation 20 Cash Sales Revenued Cost of Goods Sold Inventory

Debit 1,650.00

Credit 1,650.00

980.00 980.00

110 units  $15 = $1,650

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OPERATING ASSETS

DISCUSSION QUESTIONS 1.

Operating assets differ from nonoperating assets in that operating assets (1) have useful lives longer than 1 year or one operating cycle; (2) are used to produce goods and services that are sold; and (3) are typically not sold until their service potential to the firm has been exhausted, whereas nonoperating assets (1) have useful lives shorter than 1 year or one operating cycle (current assets) and/or (2) are sold to produce revenues (inventory, investments). In short, operating assets benefit the firm by producing goods and services that the firm sells to produce revenues.

The three classifications of operating assets are (1) property, plant, and equipment; (2) intangible assets; and (3) natural resources. Property, plant, and equipment include land, buildings, machines, automobiles, and similar items. Intangible assets include patents, copyrights, trademarks, licenses, goodwill, and similar items. Natural resources include timberlands or deposits such as coal, oil, and gravel. The three types of operating assets differ in their form and in the benefits they provide. Property, plant, and equipment consists of tangible assets that are used to produce goods and services. Intangible assets generally arise from legal or contractual rights and do not have physical substance. Natural resources are assets that must be separated from the earth and then sold. All of these operating assets, however, have one thing in common—they are used by the company in the normal course of operations to generate revenue.

The cost concept requires that an operating asset be recorded at its historical cost, which includes any expenditure necessary to acquire an asset and to prepare the asset for use. Typical costs in addition to the purchase price are listed for select assets: • • •

Land: Real estate commissions, delinquent property taxes, closing costs, clearing/grading costs, costs of demolishing unwanted buildings (minus salvage) Building: Closing costs, architectural fees, cost of building permits, excavation costs, and remodeling costs Equipment: Sales taxes, transportation costs, insurance during transportation, installation costs, cost of trial runs

Because the cost principle initially capitalizes these costs as an asset, they must be allocated to expense over the asset’s useful life (a process known as depreciation). 4.

The cost of a fixed asset is any expenditure to acquire the asset and prepare the asset for its intended use. In a cash transaction, this includes the amount of cash given for the asset plus any additional expenditures made to prepare the asset for use. In a noncash transaction (such as an exchange for another asset), the cost of a fixed asset

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is the fair market value of the asset given up or the fair market value of the acquired asset, whichever is more clearly determinable. 5.

If a company incorrectly records an expense as an asset, this error will affect both the income statement and the balance sheet. Expenses will be understated, which results in an overstatement of income and stockholders’ equity (retained earnings). In addition, assets will be overstated. It was precisely this type of error that allowed WorldCom to conceal large losses and led to one of the largest financial restatements in U.S. history.

The expense recognition concept requires that the recorded cost of an operating asset be allocated as an expense among the periods in which the asset is used and revenues are generated by its use. The expense recognition principle, therefore, provides the conceptual basis for measuring and recognizing depreciation, amortization, and depletion.

The following factors must be estimated to determine depreciation expense: • • •

Cost: The historical cost of the fixed asset, which is measured as any cost necessary to acquire an asset and to prepare the asset for use Useful life (or expected life): The period of time over which the company anticipates obtaining a benefit from the use of the asset Residual value (salvage value): The amount of cash or trade-in consideration that a company expects to receive when the asset is retired from service

Accelerated depreciation methods allocate larger amounts of depreciation expense to earlier periods of an asset’s life and smaller amounts of depreciation expense to later periods of an asset’s life. Straight-line depreciation allocates an equal amount of the asset’s cost to depreciation expense for each year of the asset’s useful life. Therefore, straight-line depreciation produces a constant amount of depreciation expense for each period over the expected useful life of the asset. While these methods allocate a different amount of depreciation expense to each year of an asset’s life, the total amount of depreciation expense recognized over the asset’s life is the same under either method.

In selecting depreciation methods, management should select the depreciation method that best matches the pattern of use or of decline in service potential of the asset. By doing so, management would be able to achieve a better matching of the expense of an operating asset to the period in which the asset helped to generate revenue.

10. The depreciation method used by a company to prepare its tax return is specified by the Internal Revenue Code and does not have to be the same method used to prepare its financial statements. For tax purposes, an accelerated depreciation method that reduces the amount of current taxes that are payable is preferred. Tax depreciation rules are designed to stimulate investment in operating assets by giving companies the ability to lower current taxes, resulting in more cash available for investment. Most companies

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use the Modified Accelerated Cost Recovery System (MACRS) to compute depreciation expense for their tax returns, which is similar to the declining balance method. 11. Once an operating asset is acquired, any expenditures made after the asset is placed in service are capitalized if the expenditure will provide economic benefits beyond the current period (capital expenditures). Generally, capital expenditures are expenditures that extend the life of the asset, expand the productive capacity of the asset, and increase the efficiency or improve the quality of the product. If the expenditure benefits only the current period (does not provide future economic benefits), the expenditure is a revenue expenditure and will be expensed. These expenditures maintain the level of benefits provided by the asset, occur frequently, and typically involve relatively small dollar amounts. 12. As new or additional information becomes available, a company will need to recalculate its depreciation expense based on current estimates of useful life and/or residual value. The company should compute the book value at the date that depreciation needs to be revised. Next, the company will compute current depreciation expense using the revised amounts. Previously recorded amounts for depreciation expense are not changed. Instead, any revision of depreciation expense is accounted for in current and future periods. 13. The sale of an asset at an amount greater than its book value is recorded as a “gain on disposal.” The gain is computed as the difference between the proceeds from the sale and the book value of the asset. Gains are reported as “other revenue” on the income statement. If the equipment is sold for less than its book value, the company would recognize a “loss on disposal.” The loss would be reported as an “other expense” on the income statement. 14. The fixed asset turnover ratio (calculated as net sales divided by average net fixed assets) measures how efficiently a company is using its fixed assets to generate revenue. The ratio tells financial statement users the dollar amount of sales generated by each dollar invested in fixed assets. The more efficiently a company uses its fixed assets, the higher the ratio will be. The average age of a company’s fixed assets provides investors with information regarding the condition of a company’s fixed assets that has implications for the efficiency of the assets (e.g., older assets tend to be less efficient than newer assets). The age of a company’s fixed assets also can provide an indication of a company’s capital replacement policy and assist managers in estimating future capital expenditures. 15. The economic value of intangible assets generally results from the fact that intangible assets provide legal rights and privileges to a company. Examples are patents, copyrights, trademarks, licenses, and goodwill. A patent, for example, gives a company the legal right to restrict, control, or charge for the use of the idea or process covered by the patent. Similarly, a license gives the company the privilege to operate in a given area.

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16. In determining the amortization period of an intangible asset, a company must first determine if the asset has a finite or indefinite life. If it is determined that the asset has an indefinite life, the asset is not amortized but is reviewed at least annually for impairment. If the asset is determined to have a finite life, the company should amortize the cost of the intangible asset to expense on a straight-line basis over the shorter of the asset’s economic or legal life. Therefore, amortization, similar to depreciation, is a process that allocates the cost of an intangible asset to expense over the asset’s useful life in order to reflect the asset’s decline in service potential. 17. Depletion, similar to depreciation of tangible operating assets and amortization of intangible assets, is based on the matching principle. As a natural resource is separated from the earth, the cost of the natural resource is allocated to each unit of the natural resource that is removed. Depletion is computed by using a procedure similar to that for the units-of-production depreciation method. First, a depletion rate is computed dividing the natural resources cost (minus any residual value) by the total estimated recoverable units. Next, this depletion rate is multiplied by the number of units of the natural resource recovered during the period. As the natural resource is extracted from the earth, the intangible asset is reduced and the amount of depletion computed is added to inventory. 18. An impairment of an asset is a permanent decline in the future benefits or service potential of the asset. The impairment can be caused by many factors, including too little depreciation expense being recorded in previous years or obsolescence of the asset.

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MULTIPLE-CHOICE QUESTIONS 7-1. 7-2. 7-3.

d c a

($68,500 + $400 + $325 + $3,425)

7-4.

[($800,000 − $20,000) ÷ 5 years] = $156,000 per year  2 years

7-5.

40% is twice the straight-line rate of depreciation (1/5  2); 2019 depreciation = ($800,000  40%) = $320,000 and 2020 depreciation = ($800,000 − $320,000)  40% = $192,000

7-6. 7-7.

c d

[($800,000 − $20,000) ÷ 15,000 machine hours]  4,200 machine hours

7-8. 7-9.

c a

[(x − $12,000) ÷ 10 years = $11,000]; × = ($11,000  10) + $12,000

7-10. d

[($34,000 − $2,000) ÷ 8 years = $4,000/year; $34,000 − ($4,000  2 years) = $26,000; ($26,000 − $1,000) ÷ 4 years = $6,250]

7-11. 7-12. 7-13. 7-14. 7-15. 7-16.

a b c c a b

[$15,000 − ($55,000 − $35,000)]

$75,000 ÷ 5 years ($55,000 − $70,000)

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BRIEF EXERCISES BE 7-17 a. b. c. d. e.

Natural resources Property, plant, and equipment Intangible assets Property, plant, and equipment Intangible assets

BE 7-18 The cost of a fixed asset is any expenditure necessary to acquire the asset and to prepare it for use. Therefore, the cost of land is $152,600 ($125,000 + $9,500 + $1,800 + $3,500 + $12,800). Interest on borrowed funds is not added to the purchase price of an asset. Interest is generally viewed as resulting from a financing decision rather than from the decision to acquire the asset.

BE 7-19 Cost of video board = $5,000,000 + $100,000 + $120,000 = $5,220,000

BE 7-20 The cost of a fixed asset is any expenditure necessary to acquire the asset and to prepare it for use. Therefore, the cost of the machine is $22,300 ($20,000 + $800 + $400 + $1,100).

BE 7-21 1. 2. 3. 4. 5.

d. c. b. e. a.

Useful life Book value Accumulated depreciation Residual value Depreciation

BE 7-22 Yearly depreciation expense: ($45,000 − $3,000)/5 = $8,400/year Journal Account and Explanation

Date 2023 Dec.

2024 Dec.

Debit

Depreciation Expense Accumulated Depreciation

8,400

Depreciation Expense Accumulated Depreciation

8,400

Credit

8,400

8,4000

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BE 7-23 Depreciation expense for 2023: $45,000  (1/5  2) = $18,000 Journal Account and Explanation

Date 2023 Dec.

Debit

Depreciation Expense Accumulated Depreciation

Credit

18,000 18,000

Depreciation expense for 2024: ($45,000 − $18,000)  (1/5  2) = $10,800 Journal Account and Explanation

Date 2024 Dec.

Depreciation Expense Accumulated Depreciation

Debit

Credit

10,800 10,800

BE 7-24 Units-of-production depreciation expense: Depreciation expense for 2023: [($45,000 − $3,000)/160,000 miles]  40,000 miles = $10,500 Journal Account and Explanation

Date 2023 Dec.

Depreciation Expense Accumulated Depreciation

Depreciation expense for 2024:

2024 Dec.

Credit

10,500 10,500

[($45,000 − $3,000)/160,000 miles]  36,000 miles = $9,450 Journal Account and Explanation

Date

Debit

Depreciation Expense Accumulated Depreciation

Debit

Credit

9,450 9,450

BE 7-25 a. b. c. d. e.

Revenue expenditure Capital expenditure Neither Capital expenditure Revenue expenditure

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BE 7-26 Step 1.

Obtain the book value of the asset at the date of the revision in depreciation. Depreciation Expense for first 2 years: ($90,000 − $4,000)/10 years = $8,600 per year Book Value immediately before the overhaul: $90,000 − $8,600 − $8,600 = $72,800 Compute depreciation expense using the revised amounts for book value, useful life, and residual value. Depreciation Expense: ($72,800 + $35,000 − $2,500)/12 years = $8,775

Step 2.

BE 7-27 1.

Journal Date Apr.

Account and Explanation Accumulated Depreciation Cash Gain on Disposal of Property, Plant, and Equipment* Equipment

Debit 76,200 11,200

Credit

1,900 85,500

* Proceeds from sale of $11,200 minus book value of $9,300 ($85,500 − $76,200) = $1,900 gain.

2. Date Apr.

Journal Account and Explanation Accumulated Depreciation Cash Loss on Disposal of Property, Plant, and Equipment* Equipment

Debit 76,200 7,900 1,400

Credit

85,500

* Proceeds from sale of $7,900 minus book value of $9,300 ($85,500 − $76,200) = $1,400 loss.

BE 7-28 Net Sales Average Net Fixed Assets $4,600,000 = {[($550,000 − $170,000) + ($550,000 − $220,000)]/2} $4,600,000 = $355,000 = 12.96 times

Fixed Asset Turnover =

Accumulated Depreciation Depreciation Expense $220,000 = $50,000 = 4.4 years

Average Age of Fixed Assets =

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BE 7-29 Date Jan.

Dec.

Journal Account and Explanation Franchise Cash Amortization Expense* Franchise

Debit 85,000

Credit 85,000

8,500 8,500

* $85,000/10 years

BE 7-30 The cost of the natural resource includes all costs necessary to ready the natural resource for separation from the earth. Therefore, the iron ore is capitalized at a cost of $2,620,000 ($2,500,000 + $120,000). To calculate the rate of depletion, Luper performs the following steps: 1.

Calculate the rate of depletion: ($2,620,000 − $100,000)/2,000,000 tons = $1.26 per ton

Compute depletion: 150,000 tons  $1.26 per ton = $189,000

BE 7-31 a.

Building: Not impaired because the estimated future cash flows ($200,000) are greater than the book value ($180,000).

Equipment: impaired because the estimated future cash flows ($50,000) are less than the book value ($45,000). The impairment loss = $10,000 ($50,000 − $40,000).

Furniture: Not impaired because the estimated future cash flows ($16,000) are greater than the book value ($15,000).

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EXERCISES E 7-32 1. Included as property, plant, and equipment—not depreciated 2. Not included; current asset (accounts receivable) 3. Included as property, plant, and equipment; depreciation 4. Included as property, plant, and equipment; depreciation 5. Not included; current asset (inventory) 6. Not included; current liability (e.g., accounts payable) 7. Included as an intangible asset; amortization 8. Included as a natural resource; depletion 9. Not included; investment 10. Included as an intangible asset; however, it is not amortized, but is tested annually for impairment.

E 7-33 Office furniture—property, plant, and equipment; depreciation Delivery truck—property, plant, and equipment; depreciation Patent—intangible asset; amortization Computer assembly machine—property, plant, and equipment; depreciation Building—property, plant, and equipment; depreciation Memory chips—not an operating asset; this would be classified as raw materials inventory

E 7-34 1. 2. 3.

Included Included Not included; interest is considered a financing activity, not part of property, plant, and equipment. 4. Included 5. Included 6. Not included; ordinary repairs are considered expenses and are not capitalized. 7. Included 8. Included 9. Not included; training costs are expensed as they are incurred. 10. Included

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E 7-35 1.

The cost of the dry cleaning machine is: Cash ............................................................................................. Notes payable............................................................................... Transportation .............................................................................. Solvent for trial runs ..................................................................... Living expenses for crew* ............................................................. Total.........................................................................................

$25,000 140,000 4,250 800 1,500 $171,550

* The living expenses for the crew would be included because those costs are necessary to get the machine ready for use.

Acquisition cost includes the purchase price and only those expenditures that are necessary to ready the asset for use. The $800 worth of solvent was included because it was used strictly during the testing phase to test and adjust the machine; therefore, it was a necessary cost of getting the machine ready for its intended use. The cost of the unused solvent ($1,000 − $800 = $200) is maintained in a separate asset account (Supplies), because it was not used to ready the machine for use. Additionally, interest on the note is not part of the acquisition cost of the machine. Interest is not normally added to the purchase price of an asset but is recorded as interest expense. Interest is generally considered a result of a financing decision and not part of the decision to acquire an asset.

E 7-36 1. 2.

The cost of the digital imaging machine should be recorded as the sum of all the costs incurred to acquire the machine and prepare it for use—$13,435 ($11,200 + $150 + $1,300 + $785). The $160 bracket replacement cost is excluded from the asset account because it was not an expenditure necessary to get the asset ready for use (e.g., it was not normally necessary to incur this cost because the bracket would not have normally been broken). It should be recorded as an expense in the period that the cost was incurred.

E 7-37 1.

The two primary accounts are Land and Building. Because the land and the building represent two distinct assets with different accounting treatments (land is not depreciated but the building is), they should be maintained in separate accounts. The cost of the lumber, paint, wire and electrical supplies, doors, windows, and labor would all be added to the $277,400 cost of the building. Assuming the new roof is to be depreciated over the same expected life as the building, its cost can be added to the building account (otherwise it should be kept in a separate property, plant, and equipment account and depreciated at a separate rate). The additional inventory is not part of the cost of the land or the building; it is considered an item of inventory. The balances for the Land and the Building accounts are shown next. Land: $83,580 Building: $402,155*

* $277,400 + $74,000 + $23,200 + $515 + $4,290 + $6,400 + $3,850 + $12,500

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E 7-37 (Continued) 2.

If a portion of the cost of the building was misclassified as land, the amount reported for building would be understated and the amount reported for land would be overstated. However, in total, the initial amount reported for property, plant, and equipment would be correctly stated. Because depreciation would not be taken on the costs misclassified as land, property, plant, and equipment would be overstated in future periods. In addition, future income statements would understate depreciation expense, resulting in an overstatement of net income and stockholders’ equity.

E 7-38 1.

Cost of the cooler = $17,372 ($15,380 + $750 + $222 + $1,020) Journal Date Account and Explanation Jan. 1 Equipment Cash

2. Date Dec.

Journal Account and Explanation Depreciation Expense* Accumulated Depreciation

Debit 17,372

Credit 17,372

Debit 2,109

Credit 2,109

* ($17,372 − $500)/8 years = $2,109

Book value of the cooler at the end of the year = $17,372 − $2,109 = $15,263

If the useful life were increased to 12 years and the residual value were decreased to $800, annual depreciation expense would be $1,381 [($17,372− $800)/12 years] and the book value of the cooler at the end of the year would be $15,991 ($17,372 − $1,381). Note that when estimates of the useful life and residual value are increased, the effect is to lower the periodic depreciation expense, which results in an increased book value. Therefore, users of financial statements should pay close attention to the estimates used by management.

E 7-39 1. 2. 3. 4. 5. 6. 7.

b c a a b b a, b, c

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E7-40 1.

Straight-line method of depreciation: 2023: Depreciation expense = ($200,000 − $20,000)/4 years = $45,000 2024: Depreciation expense = $45,000 (same as 2019)

Double-declining-balance method of depreciation: 2023: Depreciation expense = $200,000  (1/4  2) = $100,000 2024: Depreciation expense = ($200,000 − $100,000)  (1/4  2) = $50,000

Units-of-production method of depreciation: 2023: Depreciation expense = [($200,000 − $20,000)/8,000 machine hours]  2,100 machine hours = $47,250 2024: Depreciation expense = [($200,000 − $20,000)/8,000 hours]  1,800 machine hours = $40,500

E 7-41 1.

Depreciation expense: a. Straight-line method: ($8,700 − $425)/5 years = b. Double-declining-balance method: 2023: $8,700  (1/5  2) = 2024: ($8,700 − $3,480)  (1/5  2) = c. Units-of-production method: 2023: [($8,700 − $425)/2,000,000 copies]  480,000 copies = 2024: [($8,700 − $425)/2,000,000 copies]  400,000 copies =

$1,655 / year $3,480 / year $2,088 / year

$1,986 $1,655

Book value: a. Straight-line method: 2023: $8,700 − $1,655 = $7,045 2024: $7,045 − $1,655 = $5,390 b. Double-declining-balance method: 2023: $8,700 − $3,480 = $5,220 2024: $5,220 − $2,088 = $3,132 c. Units-of-production method: 2023: $8,700 − $1,986 = $6,714 2024: $6,714 − $1,655 = $5,059

If Berkshire Corporation had decided to use the straight-line method of depreciation instead of the double-declining-balance method of depreciation, Berkshire would have reported $2,258 higher income over the 2 years. This amount is computed as the difference between the 2023 and 2024 depreciation expense under the double-declining-balance method ($3,480 + $2,088) and the straight-line method ($1,655 + $1,655). Because less depreciation expense would have been recorded, Berkshire would have also reported a $2,258 higher book value of its operating assets.

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E 7-42 1.

2023 depreciation expense: a. Straight-line method: ($173,400 − $15,000)/8 years b. Double-declining-balance method: $173,400  (1/8  2) c. Units-of-production method: [($173,400 − $15,000)/4,500,000 copies]  675,000 copies Book value at end of 2023: a. Straight-line method: 2023: $173,400 − $19,800 b. Double-declining-balance method: 2023: $173,400 − $43,350 c. Units-of-production method: 2023: $173,400 − $23,760

$19,800 /year

$43,350

$23,760

$153,600

$130,050

$149,640

$4,200 /year

= =

$9,000 $7,200

$4,200

$3,640

= =

$40,800 $36,600

= =

$36,000 $28,800

= =

$40,800 $37,160

E 7-43 1.

Depreciation expense: a. Straight-line method: ($45,000 − $3,000)/10 years b. Double-declining-balance method: 2023: $45,000  (1/10  2) 2024: ($45,000 − $9,000)  (1/10  2) c. Units-of-production method: 2023: [($45,000 − $3,000)/150,000 miles]  15,000 miles 2024: [($45,000 − $3,000)/150,000 miles]  13,000 miles Book value: a. Straight-line method: 2023: $45,000 − $4,200 2024: $40,800 − $4,200 b. Double-declining-balance method: 2023: $45,000 − $9,000 2024: $36,000 − $7,200 c. Units-of-production method: 2023: $45,000 − $4,200 2024: $40,800 − $3,640

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E 7-43 (Continued) 3.

If the useful life were estimated at 8 years or 100,000 miles and the residual value were estimated at $1,000, depreciation expense would be: a. Depreciation expense: i. Straight-line method: ($45,000 − $1,000)/8 years = $5,500 /year ii. Double-declining-balance method: 2023: $45,000  (1/8  2) = $11,250.00 2024: ($45,000 − $11,250)  (1/8  2) = $8,437.50 iii. Units-of-production method: 2023: [($45,000 − $1,000)/100,000 miles]  15,000 miles = $6,600 2024: [($45,000 − $1,000)/100,000 miles]  13,000 miles = $5,720 b. The effect on book value would be as follows: i. Straight-line method: 2023: $45,000 − $5,500 = $39,500 2024: $39,500 − $5,500 = $34,000 ii. Double-declining-balance method: 2023: $45,000 − $11,250 = $33,750.00 2024: $33,750 − $8,437.50 = $25,312.50 iii. Units-of-production method: 2023: $45,000 − $6,600 = $38,400 2024: $38,400 − $5,720 = $32,680

Note that decreasing estimates of useful life or residual value have the effect of increasing depreciation expense and reducing the book value of the asset. Therefore, users of financial statements should pay close attention to the estimates used by management.

E 7-44 The original cost of the equipment can be found by using the formula for straight-line depreciation and solving for the original cost of equipment as an unknown variable as follows: (Original Cost − Residual Value)/Useful Life = Depreciation Expense (Original Cost − $5,000)/5 years = $44,000 Original Cost = ($44,000  5 years) + $5,000 Original Cost = $225,000

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E 7-45 1.

Straight-line method: End of Year

Depreciation Expense

Accumulated Depreciation

1 2 3

$77,200* 77,200* 77,200*

$ 77,200 154,400 231,600

Book Value $450,000 372,800 295,600 218,400

* ($450,000 − $64,000)/5 years = $77,200

Double-declining-balance method: End of Year

Depreciation Expense

Accumulated Depreciation

1 2 3

$180,000* 108,000** 64,800**

$180,000 288,000 352,800

Book Value $450,000 270,000 162,000 97,200

* ($450,000 − $0)  2/5 = $180,000 ** ($450,000 − $180,000)  2/5 = $108,000 *** ($450,000 − $288,000)  2/5 = $64,800

In the first and second years, the straight-line method produces the smallest depreciation expense, and, therefore, the largest net income. In the third year, the double-declining-balance method produces the smallest depreciation expense and, therefore, the largest net income.

If the controller is selecting a depreciation method for financial statement purposes, then the controller should consider the pattern of service potential decline over the asset’s life and select the depreciation method that most closely approximates that pattern. Selecting a depreciation method that best captures the declining service potential of the asset results in a better matching of expenses with revenues. Some might say that the controller may choose a depreciation method that results in the highest income for the current period since executive compensation is often tied to the performance, or net income, of a company. Similarly, selecting the depreciation method that results in the highest income might also serve to appease or deceive stockholders who demand higher income. If the controller is selecting a depreciation method for purposes of computing taxable income, then the controller is probably interested in selecting the method that provides the fastest depreciation of the asset in order to minimize the taxes paid by the company. The faster the depreciation, the more delay in the payment of income taxes. Finally, the controller may select the method that is the easiest to apply.

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E 7-46 Element of Cost New pump motor Repacking of bearings (performed monthly) New impeller Painting of pump housing (performed annually) Replacement of pump foundation New wiring (needed every 5 years) Installation labor, motor Installation labor, impeller Installation labor, wiring Paint labor (performed annually) Placement of fence around pump

Classification and Explanation Capitalized; it extends the life of the water pump and benefits future periods. Expensed; it benefits mainly the current month. Capitalized; it extends the life of the water pump. Expensed; it benefits only the current year. Capitalized; it benefits future periods and should be depreciated over the expected useful life of the foundation. Capitalized; it will benefit the next 5 years and should be depreciated over that interval of time. Capitalized; it extends the life of the water pump. Capitalized; it extends the life of the water pump. Capitalized; it extends the life of the water pump. Expensed; painting only benefits the current year. Capitalized; it benefits future periods and should be depreciated over the expected life of the fence.

E 7-47 1.

a. b. c. d. e.

Capital expenditure Capital expenditure Revenue expenditure Capital expenditure Revenue expenditure

If management had misclassified expenditures (a), (b), and (d) as revenue expenditures, initially assets would be lower by $34,000 ($4,000 + $20,000 + $10,000), stockholders’ equity would be lower by $34,000, expenses would be higher by $34,000, and income before taxes would be lower by $34,000. Additionally, future depreciation would be understated because the amounts were expensed immediately instead of being capitalized and amortized. If management had misclassified expenditures (c) and (e) as capital expenditures, initially assets would have be higher by $500 ($200 + $300), stockholders’ equity would be higher by $500, expenses would be lower by $500, and income before taxes would be higher by $500. Additionally, future depreciation would be overstated because the amounts were capitalized and depreciated instead of being expensed immediately.

E 7-48 Step 1.

Obtain the book value of the asset at the date of the revision in depreciation. Book value at January 1, 2023: $250,000 − $96,000 = $154,000

Step 2.

Compute depreciation expense using the revised amounts for book value, useful life, and residual value. Depreciation expense for 2023: ($154,000 − $14,000)/16 years = $8,750

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E 7-49 1.

First, depreciation must be calculated for 2021 and 2022: Depreciation expense = ($125,000 − $12,000)/5 years = $22,600 /year Book value at 1/1/2023 = $125,000 − ($22,600  2) = $79,800 Second, depreciation needs to be revised based on the book value at January 1, 2023, and management’s new estimates: Depreciation expense = ($79,800 − $3,600)/6 remaining years = $12,700 /year

The revision in depreciation will not affect prior years’ financial statements because all revisions in estimates are accounted for in current and future periods only. In the current income statement, Blizzards-R-Us will record $12,700 of depreciation instead of the $22,600 of depreciation that was originally estimated. This reduction in depreciation due to the change in estimates of useful life and residual value would reduce expense and increase income.

E 7-50 1.

Journal Date Jan.

Account and Explanation Equipment Cash

Debit 225,000

Depreciation expense calculation: Book value of machine (after addition): Acquisition cost ............................................................................ Less: Accumulated depreciation .................................................... Book value (before addition) ......................................................... Add: Cost of addition .................................................................... Revised book value ....................................................................... Depreciation expense = ($495,000 − $120,000)/6 years remaining = $62,500 / year Journal Date Account and Explanation Debit Dec. 31 Depreciation Expense 62,500 Accumulated Depreciation = =

Credit 225,000

$750,000 480,000 $270,000 225,000 $495,000

Credit 62,500

$495,000 (revised book value) − $62,500 $432,500

Book value, 12/31

If Roanoke had expensed the addition instead of capitalizing it, the entire amount of the addition would have been expensed immediately, and, therefore, income would have been significantly understated in the year of the addition (while expenses were overstated). However, in the future, there would be no additional depreciation expense related to the addition, so income would be higher in the next 5 years of the asset’s life.

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E 7-51 1.

($120,000 − $10,000)/8 years = $13,750/year 4 years  $13,750 = $55,000 accumulated depreciation at the end of 2022

Book value of device before modification: $120,000 − $55,000 = $65,000 Book value of device after modification: $65,000 + $35,000 = $100,000

($100,000 − $4,000)/6 years = $16,000 yearly depreciation expense after modification.

The bank president’s assertion is incorrect. He is focused only on the additional depreciation expense of $2,250 ($16,000 − $13,750) and is failing to consider the business that depends on the modifications to the encryption device. The after-modification depreciation expense is higher because the device will now allow the bank to provide greater services and create more revenue each year. The additional depreciation expense represents the allocation of the cost of an asset that is providing future economic benefit to the bank. Without the device, the bank had estimated that it would have lost $50,000 per year due to processing delays. Comparing the yearly increase in depreciation of $2,250 to the potential lost revenue of $50,000, it appears the modification was a good idea that led to higher income for the bank relative to if the modification had not been made.

E 7-52 Yearly depreciation expense Accumulated depreciation Book value = $23,400 − $13,600 1.

($23,400 − $3,000)/3 years 2 years  $6,800/year $9,800

= =

$6,800 $13,600

Journal entries: Date a.

= = =

Journal Account and Explanation Cash Accumulated Depreciation Equipment

Debit 9,800 13,600

Credit

23,400

Cash Accumulated Depreciation Loss on Disposal of Property, Plant, and Equipment Equipment

7,500 13,600

Cash Accumulated Depreciation Gain on Disposal of Property, Plant, and Equipment Equipment

11,500 13,600

2,300 23,400

1,700 23,400

The gain (or loss) on disposal would be shown on a multiple-step income statement in the “Other revenues and expenses” section. Gains are additions to income and losses are subtractions from income.

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E 7-53 1.

Depreciation expense = $82,000 /year [($880,000 − $60,000)/10 years] Journal Account and Explanation

Date 2023 Dec. 2.

Depreciation Expense Accumulated Depreciation

Debit

Credit

82,000 82,000

Accumulated depreciation at 12/31/2023 = 6 years  $82,000/year = $492,000

Journal Date Dec.

Account and Explanation 31

Cash Accumulated Depreciation Loss on Disposal of Property, Plant, and Equipment* Machine

Debit 225,000 492,000

Credit

163,000 880,000

* Loss on disposal of property, plant, and equipment = Proceeds from sale of $225,000 − book value of the asset sold of $388,000 ($880,000 − $492,000) = ($163,000).

Loss on disposal of property, plant, and equipment would be shown in the “Other Expenses and Losses” section of the income statement and would reduce income before taxes by $163,000. This reduction of income would also cause stockholders’ equity (on the balance sheet) to be reduced by $163,000. The disposal of the machine would cause a decrease in the property, plant, and equipment (on the balance sheet) of $388,000 (the book value of the machine). In addition, the receipt of cash would cause current assets to increase by $225,000.

E 7-54 1.

Depreciation expense of $83,660 can be determined by examining the accumulated depreciation T-account: Accumulated Depreciation 224,350 50,320 x 257,690

Disposal Depreciation Expense: × ×

Jan. 1 Depreciation expense Dec. 31

$224,350 + × − $50,320 = $257,690 = $257,690 + $50,320 − $224,350 = $83,660

The journal entry to record depreciation expense would be: Date Dec.

Journal Account and Explanation Depreciation Expense Accumulated Depreciation

Debit 83,660

Credit 83,660

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E 7-54 (Continued) 2.

To record the disposal of the equipment, the cost of the equipment being disposed of must be determined by examining the equipment T-account: Equipment 745,120 148,735 x 831,410

Jan. 1 Capital expenditures Dec. 31 Cost of equipment disposed of: × ×

= =

Cost of equipment disposed of

$745,120 + $148,735 − × = $831,410 $745,120 + $148,735 − $831,410 $62,445

The journal entry to record disposal of the equipment would be as follows: Journal Account and Explanation

Date Dec.

Cash Accumulated Depreciation Equipment Gain on Disposal of Property, Plant, and Equipment*

* Gain on Disposal of Property, Plant, and Equipment

Debit 14,150 50,320

Credit

62,445 2,025

= Cash Received − Book Value of Equipment = $14,150 − ($62,445 − $50,320) = $2,025

E 7-55 Net Sales Average Fixed Assets $1,025,000 = ($489,000 + $505,000)/2 = 2.06

2023 Fixed Asset Turnover =

Average Age of Fixed Assets =

Fixed asset turnover and asset age were near the industry averages, and Tabor appeared competitive in terms of efficiency of use of assets in 2018 and 2019. The jump in efficiency in 2020 was a result of Tabor not buying any new equipment; however, the age of assets started getting out of line with the industry. The jump in efficiency was clearly temporary, as the aging assets soon translated to less efficiency in the use of assets. With older assets, Tabor was not able to generate the sales necessary to remain competitive in the industry. Old assets for a technology company in a competitive environment is a recipe for disaster. Tabor’s decision to curtail capital expenditures might have helped with the cash flow issues in the short term, but it severely damaged the company’s long-run competitive position.

Accumulated Depreciation Depreciation Expense $543,000 = $126,000 = 4.31 years

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E 7-56 1.

Journal Date Jan.

Account and Explanation 2

June

Sept.

Patent Cash

Debit 175,000

Credit 175,000

Patent Cash

90,000

Trademark Cash

4,000

90,000

4,000

Research & Development Expense Cash

478,200 478,200

2. Date Dec.

Journal Account and Explanation Amortization Expense* Patent

Debit 33,125

Credit 33125

* ($175,000 + $90,000)/8 years = $33,125 Note: No journal entry for amortization on trademarks is required.

Patent: Trademark:

$231,875 $4,000

($175,000 + $90,000 − $33,125)

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E 7-57 Westfield Semiconductors Classified Balance Sheet (partial) December 31 Property, plant, and equipment: Land ............................................................................................. Building ........................................................................................ Less: Accumulated depreciationa ................................................... Building, net ............................................................................ Machine ....................................................................................... Less: Accumulated depreciationb ................................................... Machine, net ................................................................................ Truck ................................................................................................... Less: Accumulated depreciationc .......................................................... Truck, net ..................................................................................... Total property, plant, and equipment ............................................ Intangible assets: Patent, net of amortizationd… .......................................................

$104,300 $430,000 (160,000) 270,000 $285,000 (110,000) 175,000 $21,000 (7,920) 13,080 $562,380 $56,000

($430,000 − $30,000)/25 years = $16,000/year  10 years = $160,000 ($285,000 − $10,000)/5 years = $55,000/year  2 years = $110,000 c [($21,000 − $3,000)/100,000 miles]  44,000 miles = $7,920 d $80,000/10 years = $8,000/year  3 years = $24,000 $80,000 − $24,000 = $56,000 a

E 7-58 1. Date Jan.

Journal Account and Explanation Franchise Cash Organizational Costs Cash

Debit 225,000

Credit 225,000

15,000 15,000

2. Date Dec.

Journal Account and Explanation Amortization Expense* Franchise

Debit 22,500

Credit 22,500

* $225,000/10 years = $22,500 Note: Organization costs are not amortized.

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E 7-59 First, the rate of depletion is calculated as $0.11/barrel as follows: ($1,850,000 + $10,000,000 − $20,000)/108,000,000 barrels = $0.11/barrel Next, the rate of depletion is multiplied by the barrels extracted: Depletion: $0.11  15,000,000 barrels = $1,650,000

E 7-60 1.

Depletion rate = ($185,000 + $435,000 − $11,150)/55,000 tons = $11.07 / ton

Depletion = $11.07  8,500 tons = $94,095 Date Dec.

Journal Account and Explanation Inventory Accumulated Depletion

Debit 94,095

Credit 94,095

E 7-61 1.

Depletion per tree: Cost of land ($800/acre  5,000 acres) ...................................... Residual value ($107/acre  5,000 acres) .................................. Cost to be depleted .................................................................. Depletion rate = $3,465,000/1,650,000 trees = $2.10/ tree

$4,000,000 535,000 $3,465,000

Depletion = $2.10/tree  180,000 trees = $378,000 Date Dec.

Journal Account and Explanation Inventory Accumulated Depletion

Debit 378,000

Credit 378,000

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E 7-62 1.

$75,000/10 years 7 years  $7,500/year Book value, 1/1/2023

Step 1. Existence Does a loss exist?

Step 2. Measurement Impairment Loss

= $7,500 yearly depreciation expense = $52,500 accumulated depreciation = $75,000 − $52,500 = $22,500 = Book Value − Future Cash Flows = $22,500 − $12,000 = $10,500 = Book Value− Fair Value = $22,500 − $10,000 = $12,500

Journal Date Jan.

Account and Explanation Loss from Impairment

Debit 12,500

Equipment

Credit 12,500

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 7: Operating Aseets

PROBLEM SET A P 7-63A Olympic Acquisitions Inc. Balance Sheet December 31 Assets Current assets: Cash ..................................................................... Accounts receivable .............................................. Supplies................................................................ Total current assets.......................................... Property, plant, and equipment: Land ..................................................................... Buildings…… ......................................................... Less: Accumulated depreciation ............................ Buildings, net ................................................... Equipment ............................................................ Less: Accumulated depreciation ............................ Equipment, net ................................................ Truck .................................................................... Less: Accumulated depreciation ............................ Truck, net ............................................................. Total property, plant, and equipment.................... Intangible assets: Franchise ............................................................. Goodwill.............................................................. Total intangible assets..................................... Natural resources........................................................ Total assets.................................................................

$5,400 16,200 25,800 $47,400 $42,350 $155,900 (112,000) 43,900 $278,650 (153,000) 125,650 $ 31,100 (16,300) 14,800 226,700 $49,600 313,500 363,100 94,600 $731,800

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable.................................................. Wages payable ..................................................... Interest payable.................................................... Income taxes payable ........................................... Total current liabilities ..................................... Long-term liabilities: Notes payable ...................................................... Total liabilities ................................................. Stockholders’ equity: Common stock ...................................................... Retained earnings ................................................. Total stockholders’ equity ................................ Total liabilities and stockholders’ equity… ....................

$4,250 6,850 7,125 12,125 $30,350 185,550 $215,900 $304,500 211,400

515,900 $731,800

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P 7-64A 1.

The acquisition cost is computed as follows: Purchase price ..................................................... Transportation .................................................... Shipping insurance............................................... Plumbing… .......................................................... Electrical.............................................................. Water .................................................................. Soap .................................................................... Acquisition cost ...................................................

$41,700 975 200 2,150 1,125 20 10 $46,180

The replacement cost of the motor ($640) is not part of the acquisition cost of the car-washing machine because it was not a cost to prepare the asset for use (e.g., it was not normally necessary to incur this cost because the motor would not have normally been broken). It is recorded as an expense. Interest cost is not included as part of the cost of the machine because interest is a financing decision, not part of the decision to acquire the asset. Interest is reported as an expense on the income statement.

P 7-65A 1.

a. b.

Straight-line method: ($190,000 − $12,000)/8 Double-declining-balance method: Year 1 depreciation = $190,000  (1/8  2) Year 2 depreciation = ($190,000 − $47,500)  (1/8  2)

= $22,250 /year = $47,500 = $35,625

Year 1 depreciation for the units-of-production method is: [($190,000 − $12,000)/50,000,000 items]  6,100,000 items Year 2 depreciation for the units-of-production method is: [($190,000 − $12,000)/50,000,000 items]  5,600,000 items

Year 1 Year 2

Straight-Line Method $167,750b 145,500e

Book Valuesa Double-DecliningBalance Method $142,500c 106,875f

= $21,716 = $19,936

Units-of-Production Method $168,284d 148,348g

Note: Book value is computed as cost of $190,000 minus accumulated depreciation. The amounts for depreciation expense (and, therefore, accumulated depreciation) are obtained from Parts (1) and (2) of the problem.

$190,000 − $22,250 = $167,750

$190,000 − $47,500 = $142,500

$190,000 − $21,716 = $168,284

$167,750 − $22,250 = $145,500

$142,500 − $35,625 = $106,875

$168,284 − $19,936 = $148,348

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P 7-65A (Continued) 4.

Management should consider how the asset will be used in operations and select the depreciation method that best matches the decline in service potential of the asset. If the asset is expected to be used evenly over its useful life, the straight-line method would be appropriate. On the other hand, if management believes the asset’s service potential is greater in the early years of its life, and the asset will generate more revenue during this period, a declining balance method would be more appropriate. Selecting among depreciation methods based on this criteria would achieve the best matching of expenses with revenues. However, management is free to choose among methods and may use other criteria. For example, management may select the method that is easiest to apply (the straight-line method) or would produce the highest amount of current income.

P 7-66A 1.

Straight-Line-Depreciation Schedule End of Year

Depreciation Expense

Accumulated Depreciation

1* 2 3 4

$23,500 23,500 23,500 23,500

$23,500 47,000 70,500 94,000

Book Value $94,000 70,500 47,000 23,500 0

* ($94,000 − $0)/4 = $23,500

Double-Declining-Balance Depreciation Schedule End of Year

Depreciation Expense

Accumulated Depreciation

1 2 3 4

$47,000a 23,500b 11,750c 11,750d

$47,000 70,500 82,250 94,000

Book Value $94,000 47,000 23,500 11,750 0

$94,000  (1/4  2) = $47,000 ($94,000 − $47,000)  (1/4  2) = $23,500 c ($94,000 − $70,500)  (1/4  2) = $11,750 d Depreciation expense in the last year is the amount that reduces book value to residual value. a

To select the depreciation method, management should question how the service potential of the asset is expected to decline. If the service potential is expected to decline evenly over the asset’s life, straight-line method would achieve a good matching of expenses with revenues. On the other hand, if a different pattern of decline in service potential is expected, management should choose the method that best matches this decline in service potential.

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P 7-67A 1.

One year’s straight-line depreciation expense before the renovation is: ($12,400 − $900)/5 = $2,300

Original cost ................................................................................. Less: Accumulated depreciation ($2,300  3 years) ........................ Book value (before renovation) .................................................... Add capital expenditures: New heating equipment........................................................... Pressure cooking capability ........................................................... Book value (immediately after renovation) ...................................

$12,400 (6,900) $5,500 8,200 4,100 $17,800

Depreciation expense (after renovation): ($17,800 − $1,500)/10 = $1,630/year

P 7-68A 1.

Clermont needs to consider many factors when deciding whether or not to make this repair. Some factors that need to be considered are as follows: • Amount of revenue that can be expected from providing the ferry service • Expenses required to provide the ferry service • Cash outflows necessary to have the repairs made Note that the Coast Guard will not allow the ferry to continue service if the repair is not made. This means no revenue will be received by Clermont if the repair is not made. However, if the amount of revenue is sufficiently larger than the expenses, Clermont may find the cash outlay beneficial even though the costs cannot be recovered by increasing its revenues.

The repairs should be capitalized because they are going to increase the useful life of the ferry boat, which provides Clermont a benefit in current and future periods (the ability to use the ferry to produce revenue). Capitalizing the repairs will allow the cost to be evenly allocated over the new life of the asset instead of being recognized as expense in the year of installation.

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P 7-69A 1. Journal Account and Explanation

Date Oct.

Cash

Credit

Land

55,000

Gain on Disposal of Property, Plant, and Equipment

545,000

Cash Accumulated Depreciation Gain on Disposal of Property, Plant, and Equipment Buildings

225,000 155,000

Cash

120,000 133,000

Accumulated Depreciation Loss on Disposal of Property, Plant, and Equipment Furniture 2.

Debit 600,000

30,000 350,000

32,500 285,500

The disposal of the land would increase assets by $545,000 ($600,000 increase in Cash minus $55,000 decrease in Land) and would increase income and stockholders’ equity by $545,000 (the amount of the gain). The disposal of the building would increase assets by $30,000 ($225,000 increase in cash minus $195,000 decrease in property, plant, and equipment) and increase income and stockholders’ equity by $30,000 (the amount of the gain). The disposal of the furniture would decrease assets by $32,500 ($120,000 increase in cash minus $152,500 decrease in property, plant, and equipment) and decrease income and stockholders’ equity by $32,500 (the amount of the loss).

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P 7-70A 1. Date

Journal Account and Explanation Natural Resources Land Equipment

Debit 1,125,000 78,000 62,000

Goodwill Cash 2.

Credit

85,000 1,350,000

Depletion for 11,000 barrels = ($1,125,000/55,000 barrels)  11,000 barrels = $225,000

3. Date

Journal Account and Explanation Inventory Accumulated Depletion

Debit 225,000

Credit 225,000

Once the oil is sold (assuming it is all sold), the following entry is needed: Date

Journal Account and Explanation Cost of Goods Sold Inventory

Debit 225,000

Credit 225,000

The goodwill is not amortized. Goodwill is an intangible asset with an indefinite life. It is, however, reviewed for impairment at least once a year.

The oil is a natural resource, while the land and the equipment are tangible items of property, plant, and equipment. The oil must be accounted for separately because it is depleted (instead of depreciated like many items of property, plant, and equipment). Land, while an item of property, plant, and equipment, is not depreciated because it is not consumed in the operations of the company. The equipment is consumed in the operations of the company. Therefore, the equipment must be accounted for separately and depreciated. The amount of the depreciation of the equipment is reported as a part of operating expenses. If these assets were not separately capitalized, the assets could not be appropriately accounted for (e.g., depreciated over the period the asset provides benefits).

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P 7-71A One year’s patent amortization prior to the lawsuit was: $1,780,000/10 years = $178,000 Journal 1.

Date 2023 Dec.

2024 Jan.

Jan.

Account and Explanation 31

Debit

Amortization Expense Patent

178,000

Patent Cash

50,000

Cash Gain on Settlement of Lawsuit

250,000

Legal Expense Cash

50,000

Loss from Impairment* Patent

534,000

Credit

178,000

50,000

250,000

50,000

534,000

* Previous amortization = ($1,780,000/10 years)  7 years = $1,246,000 $1,780,000 cost − $1,246,000 amortization = $534,000

If the expenditure of $50,000 to successfully defend the patent were expensed instead of capitalized, current period expenses would be higher by $50,000. In addition, assets, net income, and retained earnings would all be lower by $50,000. GAAP requires the successful defense of a patent to be capitalized.

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PROBLEM SET B P 7-63B Athens Inc. Balance Sheet December 31 Assets Current assets: Cash .................................................................... Accounts receivable ............................................. Prepaid insurance ................................................ Total current assets......................................... Property, plant, and equipment: Land .................................................................... Buildings .............................................................. Less: Accumulated depreciation ............................ Buildings, net................................................... Equipment ............................................................ Less: Accumulated depreciation ............................ Equipment, net ................................................ Total property, plant, and equipment ........... Intangible assets: Patent ................................................................. Goodwill............................................................... Total intangible assets ................................... Natural resources......................................................... Total assets..................................................................

$ 3,325 27,975 8,350 $ 39,650 $ 21,150 $ 305,520 (101,950) 203,570 $ 126,310 (47,875) 78,435 303,155 $ 9,970 42,400 52,370 134,800 $529,975

Liabilities and Stockholders’ Equity Current liabilities: Accounts payable................................................... Unearned revenue ................................................. Interest payable..................................................... Income taxes payable ............................................ Total current liabilities ....................................... Long-term liabilities: Notes payable ........................................................ Total liabilities ................................................... Stockholders’ equity: Common stock ........................................................ Retained earnings ................................................... Total stockholders’ equity .................................. Total liabilities and stockholders’ equity .........................

$ 7,775 9,825 3,625 17,150 $ 38,375 170,000 $208,375 $125,000 196,600

321,600 $529,975

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P 7-64B 1.

The acquisition cost is computed as follows: Tractor ......................................................................................... $64,200 Shipping costs............................................................................... 925 Shipping insurance........................................................................ 180 Calibration.................................................................................... 75 Acquisition cost ........................................................................... $65,380 Interest cost is not included as part of the cost of the tractor because interest is a financing decision not part of the decision to acquire the asset. Interest is reported as an expense on the income statement.

P 7-65B 1.

a. b.

Straight-line method: ($65,200 − $8,200)/ 10 Double-declining-balance method: Year 1 depreciation = $65,200  (1/10  2) Year 2 depreciation = ($65,200 − $13,040)  (1/10  2)

= $5,700 /year = $13,040 = $10,432

Year 1 depreciation for the units-of-production method is: [($65,200 − $8,200)/1,500,000 items]  120,000 items

= $4,560

Year 2 depreciation for the units-of-production method is: [($65,200 − $8,200)/1,500,000 items]  135,000 items

= $5,130

Year 1 Year 2

Book Valuesa Double-DecliningStraight-Line Method Balance Method $59,500b $52,160c 53,800e 41,728f

Units-of-Production Method $60,640d 55,510g

Note: Book value is computed as cost of $65,200 minus accumulated depreciation. The amounts for depreciation expense (and, therefore, accumulated depreciation) are obtained from parts (1) and (2) of the problem. b $65,200 − $5,700 = $59,500 c $65,200 − $13,040 = $52,160 d $65,200 − $4,560 = $60,640 e $59,500 − $5,700 = $53,800 f $52,160 − $10,432 = $41,728 g $60,640 − $5,130 = $55,510

Management should consider how the asset will be used in operations and select the depreciation method that best matches the decline in service potential of the asset. If the asset is expected to be used evenly over its useful life, the straight-line method would be appropriate. On the other hand, if management believes the asset’s service potential is greater in the early years of its life and the asset will generate more revenue during this period, a declining balance method would be more appropriate. Selecting among depreciation methods based on this criteria would achieve the best matching of expenses with revenues. However, management is free to choose among methods and may use other criteria. For example, management may select the method that is easiest to apply (the straight-line method) or would produce the highest amount of current income.

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P 7-66B 1.

Straight-Line Depreciation Schedule End of Year

Depreciation Expense

Accumulated Depreciation

1* 2 3 4 5

$ 27,000 27,000 27,000 27,000 27,000

$ 27,000 54,000 81,000 108,000 135,000

Book Value $135,000 108,000 81,000 54,000 27,000 0

* ($135,000 − $0)/5 = $27,000

Double-Declining-Balance Depreciation Schedule End of Year

Accumulated Depreciation

Depreciation Expense

1 2 3 4 5

$54,000a 32,400b 19,440c 11,664d 17,496e

$54,000 86,400 105,840 117,504 135,000

Book Value $135,000 81,000 48,600 29,160 17,496 0

$135,000  (1/5  2) = $54,000 ($135,000 − $54,000)  (1/5  2) = $32,400 c ($135,000 − $86,400)  (1/5  2) = $19,440 d ($135,000 − $105,840)  (1/5  2) = $11,664 e Depreciation expense in the last year is the amount that reduces book value to residual value. a

P 7-67B 1.

One year’s straight-line depreciation expense before the renovation is: ($27,500 − $500)/8 = $3,375

Original cost ..................................................................................... Less: Accumulated depreciation ($3,375  2 years) ............................ Book value (before renovation) ........................................................ Add capital expenditures: Refrigerated display capability ................................................. Book value (immediately after renovation) .......................................

$27,500 (6,750) $20,750 18,785 $39,535

Depreciation expense (after renovation): ($39,535 − $1,000)/12 = $3,211*/year

*Rounded

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P 7-68B 1.

Ferinni needs to consider many factors when considering the remodeling decision. The fact that Ferinni cannot raise its rates to cover this remodel is definitely a factor to consider, but in the long run, the remodeling should result in an increase in revenues because of the increased customer traffic. Ferinni needs to make sure it has enough current cash flow to cover the large expenditure required for the rearrangement of the offices and the remodeling of the building.

The cost of the remodeling should be capitalized because it will benefit Ferinni over many future years (not just the current year). Therefore, this expenditure will be expensed in future periods as the remodeling contributes to the generation of revenue. Even though the rates cannot be increased, the remodel will lead to increased future economic benefits (increased revenue due to increased traffic), which meets the definition of an asset.

P 7-69B 1. Date

Journal Account and Explanation Accumulated Depreciation Loss on Disposal of Property, Plant, and Equipment Miscellaneous Expense

Debit 4,800

Credit

1,400 500 6,200

Equipment (pump)

500

Cash Cash

2,450

Accumulated Depreciation

17,500

Truck

18,600

Gain on Disposal of Property, Plant, and Equipment

1,350

Accumulated Depreciation Loss on Disposal of Property, Plant, and Equipment

3,850 350 4,200

Furniture Accumulated Depreciation

4,000

Loss on Disposal of Property, Plant, and Equipment

2,800

Equipment (testing apparatus)

6,800

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P 7-69B (Continued) 2.

The disposal of the pump (equipment) would decrease assets by $1,900 ($1,400 decrease in property, plant, and equipment plus $500 decrease in cash) and would decrease income and stockholders’ equity by $1,900 (loss of $1,400 plus the expense of $500). The disposal of the truck would increase assets by $1,350 ($2,450 increase in cash minus $1,100 decrease in property, plant, and equipment) and increase income and stockholders’ equity by $1,350 (the amount of the gain). The disposal of the furniture would decrease assets by $350 and decrease income and stockholders’ equity by $350 (the amount of the loss). The disposal of the chemical testing apparatus (equipment) would decrease assets by $2,800 and decrease income and stockholders’ equity by $2,800 (the amount of the loss).

P 7-70B 1. Date Jan. 1

Journal Account and Explanation Land Natural Resources Goodwill Cash

Debit 1,500,000 155,250,000 1,250,000

Credit

158,000,000

Depletion for 2,500,000 cubic feet: = ($155,250,000/105,000,000 cubic feet)  2,500,000 cubic feet = $3,696,429

3. Date Dec. 31

Journal Account and Explanation Inventory Accumulated Depletion

Debit 3,696,429

Credit 3,696,429

Once the natural gas is sold (assuming it is all sold), the following entry is needed: Date Dec. 31

Journal Account and Explanation Cost of Goods Sold Inventory

Debit 3,696,429

Credit 3,696,429

The goodwill is not amortized. Goodwill is an intangible asset with an indefinite life. It is, however, reviewed for impairment at least once a year.

The natural gas reserves are a natural resource, while the land is a tangible item of property, plant, and equipment. The natural gas reserves must be accounted for separately since they are subject to depletion. Land, while an item of property, plant, and equipment, is not depreciated because it is not consumed in the operations of the business. If these assets were not separately capitalized, the assets’ costs would not be properly allocated as expense over the period when the assets are providing a benefit.

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P 7-71B 1. Date Jan. 2.

Journal Account and Explanation Copyright Cash

Debit 825,000

Credit 825,000

$825,000/5 years = $165,000/year Date Dec.

Journal Account and Explanation Amortization Expense Copyright

Debit 165,000

Credit 165,000

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CASES Case 7-72 1.

Undoubtedly, the controller believes that the large national supplier delivers more computer for the money than can a number of small suppliers. The orders placed by Mr. Sage probably cost the company in terms of cash and, possibly, quality. More fundamentally, however, Mr. Sage’s behavior is deceitful and unethical. Mr. Sage is quite likely to repeat this pattern of behavior, and next time the costs may be even larger. Mr. Sage’s behavior may go undiscovered until after he advances to another position and perhaps another company. But it is quite likely that the controller will learn of it, and the consequences of discovery are severe. If discovered, Mr. Sage will probably lose his job. Leaving under such circumstances will damage Mr. Sage’s reputation when future employers learn of the reasons for his dismissal. (Even if the details are not a matter of formal record or are kept confidential, such matters are, in reality, difficult to keep secret.)

A computerized test for similar purchase orders would probably signal Mr. Sage’s scheme. However, internal control procedures are never completely effective by themselves. Companies must also rely on the good judgment and ethical behavior of their managers and employees.

Case 7-73 1.

Straight-line depreciation may be perfectly appropriate for this equipment, but given the intention to replace it in 8 to 10 years, the 12-year average life is too long. One is inclined to suspect that the controller and the management group as a whole are attempting to improve North Spruce’s net income by understating depreciation during the 6-year trial period. In the short run, both their jobs and their compensation are influenced by the level of net income. Some people have argued that the frequent movement of managers from one position or company to another encourages such shortsighted behavior.

If the depreciation decision is challenged by internal auditors, external auditors, or others in the company, the confidence of Great Basin executives in the North Spruce management group (particularly in its controller) will be damaged in a way that impairs the long-term prospects for North Spruce and restricts individual opportunities for advancement. If the depreciation decision goes unchallenged and the company realizes its potential, the direct consequences of the decision may be difficult to identify. However, the controller engaged in highly questionable accounting—a fact known to at least the immediate management group— giving the controller a reputation that will be difficult to live with in later years. If the depreciation decision goes unchallenged but North Spruce fails to meet expectations during the 6-year trial period, the losses will be unexpectedly large when North Spruce is sold or when the equipment is replaced. These losses will further damage the reputation of management and its controller.

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Case 7-74 1.

Depreciation expense, engineering estimates: ($550,000 − $90,000)/10 years Depreciation expense, production estimates: ($550,000 − $0)/8 years

= $46,000 per year = $68,750 per year

Ignoring taxes, an expense reduces net income by its full amount. The decrease in net income, based on the engineering estimates, is $46,000. The decrease in net income, based on the production estimates, is $68,750. Therefore, in general, higher estimates of expected life or residual value will result in lower depreciation expense and higher income.

Management prefers larger income for financial reporting and, therefore, would probably estimate depreciation to be as small as possible by using high residual values and long expected lives (the engineering estimates here). For the income tax return, management wants as small an income as possible, so they would use low residual values and short expected lives to produce as large a depreciation expense as possible (the production estimates here). A larger depreciation expense for tax purposes will result in a lower taxable income, lower taxes, and more cash than a smaller depreciation expense.

Case 7-75 1.

Verizon generally uses the straight-line method of depreciation. The typical useful lives of the operating assets are: Buildings and equipment 7–45 years Central office and other network equipment 3–50 years Cable, poles, and conduit 7–50 years Leasehold improvements 5–20 years Furniture, vehicles, and other equipment 3–20 years

The cost of property, plant, and equipment at December 31 is $265,734,000,000. The major components include: central office and network equipment; buildings and equipment; furniture, vehicles, and other equipment; leasehold improvements; cable, poles and conduit; land; and work in progress.

The amount of accumulated depreciation in Cost; property, plant, and equipment related to this plant, and equipment is $173,819,000,000.

The amount of depreciation and amortization expense for the last 3 years is: 2019: $16,682,000,000 2018: $17,403,000,000 2017: $16,954,000,000 The amount of capital expenditures in the last 3 years is: 2019: $17,939,000,000 2018: $16,658,000,000 2017: $17,247,000,000

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Case 7-75 (Continued) c.

The amount of disposed equipment is not disclosed in the financial statements, but it can be estimated as the beginning balance of property, plant, and equipment plus capital expenditures minus the ending balance of property, plant, and equipment as follows: $252,835 million + $17,939 million − $265,734 million = $5,040 million

Yes. Depreciation expense has been consistent with the amount of capital expenditures. An increase is expenditures is followed by a increase in depreciation in the subsequent year, while decreases in expenditures are followed by decreases in depreciation.

The change in accumulated depreciation for the current year is $10,270,000,000 ($173,819,000,000 − $163,549,000,000). This change is explained, in part, by the depreciation expense for the current year of $14,371,000,000 ($16,682,000,000 depreciation and amortization minus $2,311,000,000 amortization from Note 4). The additional differences can be explained by the sales of assets and the removal of the associated accumulated depreciation.

Verizon expects a stable amount of capital expenditures in future years. See more information in the Management Discussion and Analysis section.

Verizon tests for goodwill impairment every year in accordance with GAAP. Also, it is Verizon’s policy not to amortize the wireless licenses. Because the wireless licenses have been renewed with no problems every 10 years as they have expired, they are treated as intangible assets with indefinite lives. Verizon also has some intangibles that are subject to amortization each year, including customer lists and nonnetwork, internal-use software.

Verizon has many different types of intangible assets, including wireless licenses, goodwill, and other intangible assets. The largest of these by far are wireless licenses of $95,059,000,000 that provide Verizon’s wireless operations with the exclusive right to utilize the designated radio frequency spectrum to provide cellular communication services.

Case 7-76 1.

Kroger depreciation method: straight-line method Sprouts depreciation method: straight-line method

Kroger's typical useful lives: 10−40 years for buildings and land improvements, 3–9 years for store equipment, shorter of the lease term (4–25 years) or the the useful life for leasehold improvements, 3–15 years for food production plant and distribution center equipment, and 3–5 years for information technology assets. Sprouts' typical useful lives: 3–5 years for computer hardware and software, 7–20 years for furniture, fixture and equipment, up to 15 years for leasehold improvements, and 40 years for buildings.

The useful lives the companies use will affect the financial statements because one of the factors in calculating depreciation expense (on the income statement) is the useful life of each asset. Also, the useful lives used will affect the amount of accumulated depreciation on the balance sheet. Companies with shorter useful lives will recognize a greater percentage of their fixed assets as depreciation expense every year, resulting in lower net income. This will also lower the book value of property, plant, and equipment due to the increased amount recorded as accumulated depreciation.

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Case 7-76 (Continued) 2.

Depreciation and amortization expense:

Kroger

For the Year Ending Feb. 1, 2020 $2,649,000,000

For the Year Ending Feb. 2, 2019 $2,465,000,000

For the Year Ending Feb. 3 2018 $2,436,000,000

Sprouts

For the Year Ending Dec. 29, 2019 120,491,000

For the Year Ending Dec. 30, 2018 108,045,000

For the Year Ending Dec. 31, 2017 94,194,000

For the Year Ending Feb. 1, 2020 $3,128,000,000

For the Year Ending Feb. 2, 2019 $2,967,000,000

For the Year Ending Feb. 3 2018 $2,809,000,000

For the Year Ending Dec. 29, 2019

For the Year Ending Dec. 30, 2018

For the Year Ending Dec. 31, 2017

Capital expenditures:

Kroger

Sprouts c.

Kroger reported sales of property, plant, and equipment of $273,000,000, $85,000,000, and $138,000,000 over each of the last 3 years, respectively. Sprouts reported dispositions of property, plant, and equipment of $0, $1,000, and $30,000 over each of the last 3 years, respectively. $144,000, and $71,000 in 2016, 2015, and 2014, respectively. For both companies, the increasing amount of depreciation and amortization expense over the past 3 years is consistent with the pattern of purchases exceeding the disposition of operating assets in each year.

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Case 7-76 (Continued) 3.

Kroger Sprouts

Fixed Assets Turnover

Average Age of Fixed Asset

5.62 a 7.47 b

9.05 years c 4.80 years d

Note: The amounts are calculated as follows:

Fixed Asset Turnover =

Average Age of Fixed Assets =

Net Sales Average Fixed Assets Accumulated Depreciation Depreciation Expense

$122,286,000,000/[($21,635,000,000 + $21,871,000,000)/2] = 5.62 $5,634,835,000/[($766,429,000 + $741,508,000)/2] = 7.47 c $23,976,000,000/$2,649,000,000 = 9.05 d $577,817,000/$120,491,000 = 4.80 b

For every dollar in fixed assets, Sprouts is generating sales of 7.47, and Kroger is generating sales of 5.62. Thus, Sprouts appears to be more efficiently using its fixed assets than Kroger. In addition, Sprouts’ fixed assets are, on average, 4.80 years old, while Kroger’s assets are, on average, 9.05 years old.

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Annual Report Problem 1. Land

$8,390 million

Buildings

$18,432 million

Equipment

$13,666 million

Other PP&E

$4,372 million

Accumulated depreciation and amortization

$22,090 million

Net property, plant and equipment

$22,770 million

Sales

$110,225 million

2. Land

$9,229 million

Buildings

$20,275 million

Equipment

$15,033 million

Other PP&E

$4,809 million

Accumulated depreciation and amortization

$24,299 million

Net property, plant and equipment

$22,770 million

Sales

$112,430 million

3. a. Straight-line b. $2,505 million c. 5-45 years d. 4.70 e. 9.70 f.

2.23

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Case 7-77 1. and 2. Journal Account and Explanation

Date Jan.

Building Cash Notes Payable

Debit 390,000

Credit 10,000 380,000

Trademark Cash

25,000

Building Cash

21,530

Building Cash

45,720

Equipment Cash

12,350

25,000

21,530

45,720

12,350

Depreciation expense on building: [($390,000 + $21,530 + $45,720) − $35,000]/30 years = $14,075 per year × 11/12 months = $12,902 Depreciation expense on equipment: Declining Balance Rate = Depreciation Expense =

1/5 × 2 = 2/5 = 40% $12,350 × 0.4 × 11/12 months = $4,528*

* Rounded

Date Dec.

Journal Account and Explanation Depreciation Expense Accumulated Depreciation Depreciation Expense Accumulated Depreciation

Debit 12,902

Credit 12,902

4,528 4,528

Amortization would not be recorded on the trademark. A trademark is an intangible asset with an indefinite life, and, therefore, it is not amortized but will be tested annually for impairment.

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Making the Connection

INTEGRATIVE EXERCISE (CHAPTERS 4–7) Integrating Asset Accounting 1.

All highly liquid investments with maturities of 3 months or less at the date of purchase are classified as cash and cash equivalents.

Apple maintained, in all material respects, effective internal control over financial reporting as of September 28, 2019. The effectiveness of these controls were evaluated using criteria established in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO criteria”).

3. Sales Average Accounts Receivable* $260,174 2019 = ($23,186 + $22,926)  2 = 11.28

Accounts Receivable Turnover =

$265,595 ($17,874 + $23,186)  2 = 12.94

2018 =

Apple’s accounts receivable turnover is over 37% better than the industry average. Apple is managing its accounts receivable very efficiently. 4.

Cost of Goods Sold Average Inventory $161,782 2019 = ($3,956 + $4,106)  2 = 40.13

Inventory Turnover =

$163,756 ($4,855 + $3,956)  2 = 37.17

2018 =

Apple’s inventory turnover is approximately 98% better than the industry average. Apple is managing its inventory very efficiently.

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Apple’s accounts receivable turnover decreased by 12.8% from 2018 to 2019. Its inventory turnover, on the other hand, improved by 8.0% over the same period.

2019: 365 Accounts Receivable Turnover 365 = 11.28 = 32.35 days

Days’ Sales in Receivables =

365 Inventory Turnover 365 = 40.13 = 9.09 days

Days’ Sales in Inventory =

365 365 + Accounts Receivable Turnover Inventory Turnover = 32.35 + 9.09

Operating Cycle =

= 33.81days 2018 365 Accounts Receivable Turnover 365 = 12.94 = 28.21days

Days’ Sales in Receivables =

365 Inventory Turnover 365 = 37.17 = 9.82 days

Days’ Sales in Inventory =

365 365 + Accounts Receivable Turnover Inventory Turnover = 28.21 + 9.82

Operating Cycle =

= 38.03days

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Interest Expense Interest Expense

(Average Receivables + Average Inventory)  Change in = Operating Cycle  Interest Rate (Average Accounts Receivable + Average Inventory)  = (Change in Operating Cycle/365)  0.10  $23,186 + $22,926 $3,956 + $4,106  = +  2 2    [(38.03 days − 33.81 days) ÷ 365]  0.10 = ($23,056 + $4,031)  (-4.22 days ÷ 365)  0.10 = $27,087  −4.22 days ÷ 365  0.10 = $7,792,151 =

Gross Profit Sales $98,392 = $260,174 = 37.82 %

Gross Profit Ratio =

Income from Operations Sales $63,930 = $260,174 = 24.57 %

Operating Margin Ratio =

Net Income Sales $55,256 = $260,174 = 21.24 %

Net Profit Margin Ratio =

Apple was much more profitable than the industry average as it was approximately 37%, 212%, and 346% above the average for gross profit margin, operating margin, and net profit margin, respectively. 9.

Apple uses the straight-line method. The useful life of internally used software is from 3 to 5 years. This useful life appears reasonable.

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CURRENT AND CONTINGENT LIABILITIES

DISCUSSION QUESTIONS 1

Liabilities are probable future sacrifices of economic benefits. These sacrifices arise from the present obligations of an entity to transfer assets or provide services to another entity in the future as a result of past transactions or events.

In theory, a liability should not include the amount of future interest to be paid. For example, a $200 payable due in 45 days is not really a $200 liability today because theoretically a portion of that $200 payment made 45 days in the future will represent interest for the 45 days. However, in liabilities that will be retired within 3 months (e.g., standard Accounts Payable), the time value of money is ignored because it is deemed immaterial. In these cases, the liability is recorded at the amount to be paid in the future.

Most liabilities are recognized when goods or services are received or money is borrowed.

Current liabilities are obligations that require the firm to pay cash or another current asset, create a new current liability, or provide goods or services within the longer of 1 year or one operating cycle. Some common examples of current liabilities include unearned sales revenue, accounts payable, short-term notes payable, current portion of long-term debt, accrued liabilities, and other payables.

Common ways of ordering current liabilities on the balance sheet include the following: (1) (2) (3)

From largest to smallest In the order in which they will be paid (order of liquidity) In alphabetical order

An account payable arises when a business purchases goods or services on credit. Unlike an account payable, a note payable typically arises when a business borrows money or purchases goods or services from a company that requires a formal agreement or contract. This formal agreement or contract is what distinguishes the note payable from an account payable. Additionally, notes payable typically bear interest, while accounts payable generally have no interest.

An account payable is typically created through purchasing goods or services on credit.

Accrued liabilities represent the completed portion of activities in process at the end of the period. They are recognized through adjusting entries. Some common examples include wages payable, taxes payable, property taxes payable, and interest payable.

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A note payable is typically created by borrowing money from a bank or purchasing goods or services from a company that requires a formal agreement or contract.

10. Interest is typically ignored when creating an account payable because the payable is usually due within 30–60 days. The amount of interest that would be associated with the payable is minimal and is ignored as immaterial. 11. Interest expense is computed by multiplying the principal amount of the loan times the annual interest rate times the period of time (usually expressed as a fraction of a year). 12. The current portion of long-term debt is the amount of long-term debt principal that is due within the next year. At the end of each accounting period, the long-term debt that is due during the next year is reclassified as a current liability. In some cases, long-term debt that is due within the next year will be paid with the proceeds of a new long-term debt issue, creating a new long-term, not current, liability. When such refinancing is expected, the maturing obligation is not transferred to current liabilities but remains classified as long-term debt. 13. Payroll taxes paid by employees through a deduction from their gross pay include federal, state, and possibly city or county income taxes, as well as Social Security and Medicare. Payroll taxes paid by employers include Social Security, Medicare, and federal and state unemployment taxes. Social Security and Medicare together are called FICA. Employers match the FICA amount for each employee. 14. Both unearned revenues and customer deposits arise when the entity receives resources from customers in advance of the performance of services or the delivery of goods. Since the customer has “performed” by paying ahead of time, the seller has incurred a liability either to produce the goods or services or refund the customer’s advance payment. 15. A contingent liability is an obligation whose amount, timing, or recipient depends on future events. For example, a firm may be contingently liable for damages under a lawsuit that has yet to be decided by the courts. When the courts reach a decision, the liability will be known but until then it is contingent on that decision. 16. A contingency is recognized as a liability when it is both (1) probable and (2) reasonably estimable. 17. The matching concept requires that all of the expenses associated with a revenue be recorded in the period in which the related revenue is recorded. One of the expenses associated with the sale of merchandise is the warranty cost that is expected to be incurred during the warranty period. To the extent that warranty costs have not been incurred when the period ends, a liability must be recorded to permit proper matching. 18. The current ratio is an appropriate measure of short-term liquidity if all of the current assets are easily converted into cash. This means that accounts receivable are likely to

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be collected and any inventory is likely to be sold. The quick ratio and the cash ratio exclude inventory because it may be harder to liquidate. The quick ratio is appropriate when accounts receivable are highly likely to be collected. In some cases, accounts receivable are not liquid, and in these cases, the cash ratio provides a more appropriate measure of short-term liquidity. 19. The current, quick, and cash ratios involve all or parts of current assets divided by current liabilities. The current ratio includes all current assets, including inventory, divided by current liabilities. The quick ratio includes cash, marketable securities, and accounts receivable in the numerator and current liabilities in the denominator. The cash ratio includes only cash and marketable securities divided by current liabilities. The cash ratio provides the most conservative measure of short-term liquidity, because it includes only highly liquid assets in the numerator. 20. Operating cash flow looks at the ability of cash generated from operating activities to meet current obligations, whereas the current, quick, and cash ratios look at the status of the current liabilities as they stand at a particular point in time.

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MULTIPLE-CHOICE QUESTIONS 8-1. d 8-2. b 8-3. a

$200,000  0.10  3/12 = $5,000 Journal

Date Dec.

Account and Explanation 31

Interest Expense

Debit

Credit

5,000

Interest Payable

5,000

(Record accrual of interest expense) 8-4. a

Interest: $200,000  0.10 Interest Expense: 2023: $200,000  0.10  9/12 2024: $200,000  0.10  9/12

= $20,000 per year = $ 5,000 = $15,000 Journal

Date Oct.

Account and Explanation 1

Debit

Interest Expense

15,000

Interest Payable

5,000

Cash

Credit

20,000

(Record payment of note and interest) 8-5. d 8-6. a 8-7. d Journal Date

Account and Explanation Accounts Receivable

Debit

Credit

28,438

Sales Revenue*

26,250

Excise Taxes Payable (Federal)**

350

Sales Taxes Payable (State)***

1,838

(Record sale) * 350  $75 = $26,250 ** 350  $1 = $350 *** $26,250  0.07 = $1,838 (rounded)

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8-8.

8-9.

8-10.

8-11.

8-12.

8-13.

8-14.

8-15.

8-16.

8-17.

8-18.

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BRIEF EXERCISES BE 8-19 Journal 1.

Date June 18

July

Account and Explanation Inventory Accounts Payable (Record purchase of inventory on credit) Accounts Payable Cash (Record payment to supplier)

Debit 892,500

Credit 892,500

892,500 892,500

BE 8-20 Journal Date April 15

May

Nov.

Account and Explanation Inventory Accounts Payable (Record purchase of inventory on credit) Accounts Payable Notes Payable (Record issuance of note to cover unpaid account payable) Notes Payable Interest Expense* Cash (Record payment of note and interest)

Debit 1,340,000

Credit 1,340,000

1,340,000 1,340,000 1,340,000 80,400 1,420,400

* $1,340,000  0.12  6/12 = $80,400

BE 8-21 Journal Date Dec. 31

Account and Explanation Interest Expense ($385,000  0.07  4/12) Interest Payable (Record accrued interest expense)

Debit 8,983

Credit 8,983

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BE 8-22 Journal 1.

Date Jan. 1

Sept

Account and Explanation Cash Notes Payable (Record issuance of note payable) Notes Payable Interest Expense ($450,000  0.10  8/12) Cash (Record payment of interest and principal)

Debit 450,000

Credit 450,000

450,000 30,000 480,000

BE 8-23 Journal Date Dec. 31

Account and Explanation Interest Expense ($2,750,000  0.10  6/12) Interest Payable (Record accrued interest expense)

Debit 137,500

Credit 137,500

BE 8-24 Journal Date Dec. 31

Account and Explanation Interest Expense ($115,000  0.06  10/12) Interest Payable (Record accrued interest expense)

Debit 5,750

Credit 5,750

BE 8-25 Journal Date Dec. 31

Account and Explanation Property Taxes Expense* Property Taxes Payable (Record accrued property taxes)

Debit 5,500

Credit 5,500

* $11,000  6/12 = $5,500

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BE 8-26 Journal Date Dec. 31

Apr.

Account and Explanation Income Taxes Expense* Income Taxes Payable (Record accrued income taxes) Income Taxes Payable Cash (Record payment of income taxes)

Debit 140,000

Credit 140,000

140,000 140,000

*$400,000  0.35 = $140,000

BE 8-27 Journal Date Dec.

Account and Explanation 31

Debit

Wages Expense

Credit

4,000

(4 days  5 hours/day  $10/hours  20 employees) Wages Payable

4,000

(Record accrued wages expenses) BE 8-28 Journal Date Apr.

Account and Explanation 30

Wages Expense

Debit

Credit

12,600

(35 hrs. per week/5 days = 7 hrs./day) 3 days (Mon., Tue., and Wed.)  40 employees  7 hrs./day  $15/hour = $12,600 Wages Payable

12,600

(Record accrued wages expenses) May

Wages Expense

8,400

Wages Payable

12,600

Cash

21,000

(Record payment of wages)

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BE 8-29 The wages payable account would have 1 day of payroll accrued at $2,500 per day, totaling $2,500. BE 8-30 Journal Date Dec. 31

Jan.

Account and Explanation Wages Expense Wages Payable* (Record accrued wages) Wages Payable Wages Expense Cash (Record payment of wages)

Debit 10,500

Credit 10,500

10,500 24,500 35,000

*$35,000  (3 days/10 days) = $10,500

BE 8-31 Journal Date

Account and Explanation Accounts Receivable Excise Taxes Payable (Federal) Sales Taxes Payable (State) ($60,000  0.05) Sales Revenue (Record sale)

Debit 63,400

Credit 400 3,000 60,000

BE 8-32 Journal Date

Account and Explanation Accounts Receivable Sales Taxes Payable (State) [($50  980)  0.08] Sales Revenue ($50  980) (Record sale)

Debit 52,920.00

Credit 3,920.00 49,000.00

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BE 8-33 1.

Net pay recorded is $233,050.

Journal Date

Account and Explanation Wages Expense Federal Income Taxes Withholding Payable State Income Taxes Withholding Payable Social Security Taxes Payable (Employee) Medicare Taxes Payable (Employee) Charitable Contributions Payable Union Dues Payable Cash (Record wages and liabilities) Federal Unemployment Taxes Expense [($300,000 − $30,000)  0.02] Social Security Taxes Expense Medicare Taxes Expense Federal Unemployment Taxes Payable Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employer) (Record employer payroll taxes)

Debit 300,000

Credit 30,000 8,000 18,600 4,350 3,000 3,000 233,050

5,400 18,600 4,350 5,400 18,600 4,350

BE 8-34 Journal Date

Account and Explanation Wages Expense Federal Income Taxes Withholding Payable Social Security Taxes Payable (Employer) ($25,000  0.062) Medicare Taxes Payable (Employer) ($25,000  0.0145) Cash ($25,000 − $2,400 − $1,550 − $362.50) (Record wages and liabilities) State Unemployment Taxes Expense Social Security Taxes Expense Medicare Taxes Expense State Unemployment Taxes Payable Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employer) (Record employer payroll taxes)

Debit 25,000.00

Credit 2,400.00 1,550.00 362.50 20,687.50

75.00 1,550.00 362.50

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BE 8-35 Journal Date

Account and Explanation Wages Expense Federal Income Taxes Withholding Payable Social Security Taxes Payable (Employer) ($86,000  0.062) Medicare Taxes Payable (Employer) ($90,000  0.0145) Cash ($90,000 − $1,100 − $5,332 − $1,305) (Record wages and liabilities)

Debit 90,000

Credit 1,100 5,332 1,305 82,263

BE 8-36 Journal

1. Date

Account and Explanation Cash Unearned Sales Revenue (Record sale)

Debit 720

Credit 720

Journal Date

Account and Explanation

Debit

Unearned Sales Revenue ($720/15) Sales Revenue (Record recognition of sales revenue)

Credit

48 48

BE 8-37 Journal

1. Date

Account and Explanation Cash Unearned Rent Revenue (Record prepayment of rent)

2. Date

Journal Account and Explanation Unearned Rent Revenue ($71,250/3) Rent Revenue (Record recognition of rent revenue)

Debit 71,250

Credit 71,250

Debit 23,750

Credit 23,750

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BE 8-38 Warranty coverage qualifies as a contingent loss for the company providing the warranty. That is, the company will incur a loss in the future if the products covered by the warranty are defective. Companies must record a liability and a corresponding expense if such contingent liabilities are probable and reasonably estimable. For most companies, the amount of warranty losses is probable and reasonably estimable based on past experience. BE 8-39 Journal Date

Account and Explanation Other Expense Lawsuit Payable (Record contingent liability)

Debit 3,000,000

Credit 3,000,000

BE 8-40 1.

450 TVs  $575  0.02 = $5,175 estimated warranty liability Journal

Date Dec. 31

Account and Explanation Warranty Expense Warranty Liability (Record warranty expense)

Debit 5,175

Credit 5,175

BE 8-41 The warranty expense for the bounce houses sold during the year should be $26,680 (46 balloons  $29,000  0.02). This amount is added to the $25,000 beginning balance in the warranty liability account. Throughout the year, the warranty account was debited for $23,000 of actual claims, leaving the ending balance in the warranty liability account to be $28,680.

Claims incurred

Warranty Liability 25,000 23,000 26,680 28,680

Beginning balance Warranty expense ($29,000  46 units  0.02) Ending balance

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BE 8-42

Current Ratio

= = = =

Quick Ratio

Cash Ratio

= = = = = = =

Current Assets/Current Liabilities ($400,000 + $800,000 + $950,000 + $115,000)/($575,000 + $180,000) $2,265,000/$755,000 3.00 Short-Term (Cash + Marketable Securities + Accounts Receivable) /Current Liabilities ($400,000 + $115,000 + $800,000)/$755,000 $1,315,000/$755,000 1.74 (Cash + Marketable Securities)/Current Liabilities ($400,000 + $115,000)/$755,000 $515,000/$755,000 0.68

JRL’s current ratio appears adequate. However, it really depends on how liquid JRL’s inventory and accounts receivable are. If the inventory is slow moving or difficult to sell (e.g., large ticket items in a recession), then the quick ratio may be a better indicator of liquidity. The quick ratio is well below 2 but still appears adequate for JRL to meet its short-term obligations if the accounts receivable are collectible. If, on the other hand, accounts receivable may be difficult to collect, the cash ratio is best. If this were the case, then JRL has serious liquidity issues and there should be great concern regarding its ability to meet short-term obligations. BE 8-43 1.

Current Ratio

= = =

Quick Ratio

Cash Ratio

= = = = = = =

Current Assets/Current Liabilities $11,450,000/$4,975,000 2.30 Short-Term (Cash + Marketable Securities + Accounts Receivable) /Current Liabilities ($2,725,000 + $1,725,000 + $3,050,000)/$4,975,000 $7,500,000/$4,975,000 1.51 (Cash + Marketable Securities)/Current Liabilities ($2,725,000 + $1,725,000)/$4,975,000 $4,450,000/$4,975,000 0.89

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BE 8-43 (Continued) 4.

SJM’s current ratio appears adequate. However, it really depends on how liquid SJM’s inventory and accounts receivable are. If the inventory is slow moving or difficult to sell (e.g., large ticket items in a recession), then the quick ratio may be a better indicator of liquidity. The quick ratio is well below 2 but still appears adequate for SJM to meet its short-term obligations if the accounts receivable are collectible. If, on the other hand, accounts receivable may be difficult to collect, the cash ratio is best. If this were the case, then SJM has serious liquidity issues, and there should be great concern regarding its ability to meet short-term obligations.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

EXERCISES E 8-44 Journal Date Dec. 31

Account and Explanation Wages Expense* Wages Payable (Record accrued wages)

Debit 2,500

Credit 2,500

*$5,000  3/6 = $2,500

E 8-45 Journal Date a.

Account and Explanation Purchases Accounts Payable (Record purchase of inventory on account) Wages Expense Federal Income Taxes Withholding Payable Social Security Taxes Payable (Employee) Medicare Taxes Payable (Employee) Wages Payable (Record wages and liabilities) Income Taxes Expense Income Taxes Payable (Record accrued income taxes) Accounts Receivable Sales Taxes Payable (State) Sales Revenue (Record sale) Social Security Taxes Expense Medicare Taxes Expense Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employer) (Record employer payroll taxes) Cash Notes Payable (Record issuance of note)

Debit 50,000

Credit 50,000

22,000 2,200 1,364 320 18,116 37,350 37,350 2,160 90 2,070 1,364 320 1,364 320 20,000

20,000

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

E 8-46 Journal Date a.

Account and Explanation Purchases Accounts Payable (Record purchase of inventory on account) Wages Expense Federal Income Taxes Withholding Payable Medicare Taxes Payable (Employee) Wages Payable (Record wages and liabilities) Income Taxes Expense Income Taxes Payable (Record accrued income taxes) Accounts Receivable Sales Taxes Payable (State) Sales Revenue (Record sale) Medicare Taxes Expense Medicare Taxes Payable (Employer) (Record employer payroll taxes) Cash Notes Payable (Record issuance of note)

Debit 80,000

Credit 80,000

40,000 13,000 580 26,420 113,615 113,615 3,636 180 3,456 580 580 155,000 155,000

E 8-47 a. b. c. d.

A legally enforceable claim against the business to be paid in 3 months should be reported as a current liability. A guarantee given by a seller to a purchaser to repair or replace defective goods during the first 6 months following a sale should be reported as a warranty liability—a current liability. An amount payable to a bank in 10 years should be reported as a long-term notes payable. An amount to be paid next year on a long-term notes payable should be reported as a current liability.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

E 8-48 Journal a.

Date June

Account and Explanation Advertising Expense Accounts Payable (Record purchase of advertising) Supplies Expense Accounts Payable (Record purchase of supplies) Commissions Expense Commissions Payable (Record sales commission) Utilities Expense Accounts Payable (Record utilities expense) Repairs and Maintenance Expense Accounts Payable (Record vehicle repair)

Debit 1,950

Credit 1,950

475 475 2,000 2,000 4,200 4,200 970 970

E 8-49 Journal a.

Date Dec. 31

Account and Explanation a

Wages Expense Wages Payable (Record accrued wages) Income Taxes Expenseb Income Taxes Payable (Record accrued income taxes) Interest Expensec Interest Payable (Record accrued interest) Wages Expensed Wages Payable (Record accrued wages)

Debit 3,000

Credit 3,000

280,000 280,000 7,000 7,000 15,000 15,000

$5,000  3/5 = $3,000 $800,000  0.35 = $280,000 c $280,000  0.06  5/12 = $7,000 d ($800,000 − $650,000)  0.10 = $15,000 a

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

E 8-50 Journal a.

Date Dec. 31

Account and Explanation Wages Expense* Wages Payable (Record accrued wages) Interest Expense** Interest Payable (Record accrued interest) Income Taxes Expense*** Income Taxes Payable (Record accrued income taxes)

Debit 63,600

Credit 63,600

14,750 14,750 168,000 168,000

* $212,000  3/10 = $63,600 ** $295,000  0.10  6/12 = $14,750 *** $800,000  0.21 = $168,000

E 8-51 Journal Date

Account and Explanation Accounts Receivable Sales Taxes Payable (State)* Excise Taxes Payable (Federal)** Excise Taxes Payable (State)*** Sales Revenue (Record sale)

Debit 314,470

Credit 17,700 590 1,180 295,000

* $295,000  0.06 = $17,700 ** $295,000  0.002 = $590 *** $295,000  0.004 = $1,180

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E 8-52 1.

Journal Date Jan. 31

Account and Explanation Salaries Expense Wages Expense Cash* Social Security Taxes Payable (Employee)** Medicare Taxes Payable (Employee)*** Federal Income Taxes Withholding Payable (Record salaries, wages, and liabilities) Social Security Taxes Expense** Medicare Taxes Expense*** Federal Unemployment Taxes Expense State Unemployment Taxes Expense Social Security Taxes Payable (Employer)** Medicare Taxes Payable (Employer)*** Federal Unemployment Taxes Payable State Unemployment Taxes Payable (Record employer payroll taxes)

Debit 237,480.00 585,000.00

Credit

651,060.28 50,993.76 11,925.96 108,500.00 50,993.76 11,925.96 1,200.00 4,000.00 50,993.76 11,925.96 1,200.00 4,000.00

* $237,480 + $585,000 − $50,993.76 − $11,925.96 − $108,500 = $651,060.28 ** ($237,480 + $585,000)  0.062 = $50,993.76 *** ($237,480 + $585,000)  0.0145 = $11,925.96

The employees’ gross pay is $822,480 ($237,480 + $585,000). Blitzen pays additional taxes of $68,119.72 ($50,993.76 + $11,925.96 + $1,200.00 + $4,000.00). This is 8.28% of gross pay ($68,119.72/$822,480).

Net pay Total payroll expense ($822,480 + $68,119.72) Net pay as a percentage of total payroll expense

[$60,000  ($68,119.72/$822,480)] + $60,000 = $64,969.34

$651,060.28  890,599.72 73.10%

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

E 8-53 1.

Journal Date Dec. 1

Account and Explanation Cash* Unearned Sales Revenue (Record receipt of payment for services not yet performed)

Debit 1,600

Credit 1,600

*$400  4 months = $1,600

2. Date Dec. 31

Journal Account and Explanation Unearned Sales Revenue Sales Revenue* (Record recognition of revenue)

Debit 800

Credit 800

* $400  2 months = $800

Unearned sales revenue in the amount of $800 (see T-account below) would appear among Jennifer’s current liabilities. A prepaid asset of $800 would appear among Lola’s current assets. Unearned Sales Revenue 1,600 From part (2)

From part (1)

800 800

Ending balance

E 8-54 1. a 2. a 3. a 4. c 5. a 6. b 7. b 8. c 9. c 10. a

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E 8-55 1.

Mountain Bikes Expected claims = [625 units  (5/100)] = 31 units Expected cost = (31 units  $40) .................................................. Racing Bikes Expected claims = [150 units  (1/15)] = 10 units Expected cost = (10 units  $90) .................................................. Snowboards Expected claims = [400 units  (2/40)] = 20 units Expected cost = (20 units  $35) .................................................. Total expected cost ..........................................................................

$1,250

900

700 $2,850

Journal Date Dec.

Account and Explanation Warranty Expense Warranty Liability (Record warranty expense)

Debit 2,850

Credit 2,850

The warranty itself is an existing condition that involves uncertainty as to a possible loss that will be resolved in the future. As such, the warranty claims are contingent liabilities. Contingent liabilities must be recognized when they are (1) probable and (2) reasonably estimable. Kim's past experience suggests that warranty claims are probable and provides a basis for making a reasonable estimate.

E 8-56 1.

a. b. c. d.

Current ratio: Quick ratio: Cash ratio: Operating cash flow ratio:

$31,239* $20,782 ** $13,123 *** $33,145

/ / / /

$22,310 $22,310 $22,310 $22,310

= = = =

1.40 0.93 0.59 1.49

* $4,194 + $8,929 + $7,659 + $8,744 + $1,713 = $31,239 ** $4,194 + $8,929 + $7,659 = $20,782 *** $4,194 + $8,929 = $13,123

The current ratio appears to be weak because as a general rule of thumb, a current ratio over 2 is considered good. The more conservative quick and cash ratios are less than 1. However, because Intel has a relatively easy time selling its inventory quickly, the current ratio is probably the most relevant to Intel's short-term solvency. Further, the operating cash flow ratio of 1.49 indicates that the cash that the company is generating is sufficient to meet the current liabilities that the company owes.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

E 8-56 (Continued) 3.

The simplest way to raise the company's current ratio to 1.50 would be to use some of the almost $13,123.0 billion in cash and marketable securities to pay off some of the current liabilities. This will lower the current assets, but it will also lower the current liabilities by the same amount. And, because the current liabilities are less than the current assets, this reduction in current liabilities will represent a greater percentage reduction. To decide the amount of the payment, the following equation must be solved for x: 1.50 [($31,239 − x)/($22,310 − x)] = $31,239 − x = 1.50 ($22,310 − x) = $31,239 − x $33,465.0 − 1.50x $31,239 + 0.50x = $33,465.0 0.50x = $33,465.0 − $31,239 0.50x = $2,226.00 x = $4,452.00 That is, Intel must use $4,452 million of cash and/or marketable securities to pay down the current by the same amount to achieve a current ratio of 1.50 by fiscal year end.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

PROBLEM SET A P 8-57A 1.

Journal Date

Feb.

Mar.

Apr.

June

Aug.

Account and Explanation Supplies Accounts Payable (Record purchase of supplies on account) Accounts Payable Cash* (Record partial payment of supplier) Accounts Payable Notes Payable (Record issuance of note to cover unpaid portion of account payable) Cash Notes Payable (Record issuance of note) Inventory Accounts Payable (Record purchase of inventory on account) Accounts Payable Cash (Record payment of supplier) Cash Unearned Sales Revenue (Record receipt of deposit for services not yet performed)

Debit 160,000

Credit 160,000

40,000 40,000 120,000 120,000

300,000 300,000 78,000 78,000 78,000 78,000 22,000 22,000

* $160,000  0.25 = $40,000

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P 8-57A (Continued) Journal Date h.

Oct.

Dec.

Account and Explanation Social Security Taxes Payable (Employer)** Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employee)*** Medicare Taxes Payable (Employer) Federal Income Taxes Withholding Payable Cash (Record employer payroll taxes) Accounts Receivable Unearned Sales Revenue Service Revenue (Record recognition of revenue)

Debit 92,500 92,500 21,633 21,633 319,000

Credit

547,266 198,000 22,000 220,000

** $185,000  0.50 = $92,500 *** $43,266  0.50 = $21,633

Journal Date Dec.

Account and Explanation Interest Expense Interest Payable* (Record accrued interest)

Debit 25,000

Credit 25,000

* ($120,000  0.10  9/12) + ($300,000  0.08  8/12) = $25,000

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

P 8-58A 1.

Social Security: Medicare: Federal unemployment: State unemployment:

$615,000  0.062 $615,000  0.0145 $545,200  0.0075 $545,200  0.008

= = = =

$38,130.00 $ 8,917.50 $ 4,089.00 $ 4,361.60

Net pay = $615,000 − $110,105 − $38,130 − $8,917.50 = $457,847.50 Journal Date Dec. 31

Account and Explanation Wages Expense Federal Income Taxes Withholding Payable Social Security Taxes Payable (Employee) Medicare Taxes Payable (Employee) Cash (Record wages and liabilities) Federal Unemployment Taxes Expense* State Unemployment Taxes Expense** Social Security Taxes Expense Medicare Taxes Expense Federal Unemployment Taxes Payable State Unemployment Taxes Payable Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employer) (Record employer payroll taxes)

Debit 615,000.00

Credit 110,105.00 38,130.00 8,917.50 457,847.50

4,089.00 4,361.60 38,130.00 8,917.50 4,089.00 4,361.60 38,130.00 8,917.50

* $545,200.00  0.0075 = $4,089.00 ** $545,200.00  0.008 = $4,361.60

Pay ........................................................... Social Security........................................... Medicare .................................................. Fringe Benefits ..........................................

100.00% 6.20% 1.45% 25.00% 132.65%  $70,000 = Federal Unemployment: $12,000  0.0075 = State Unemployment: $12,000  0.008 =

$92,855.00 90.00 96.00 $93,041.00

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P 8-59A 1.

Journal Date 2023 Oct.

Account and Explanation 1

Cash Notes Payable (Record issuance of note)

Debit

Credit

600,000 600,000

Journal Date Dec.

Account and Explanation Interest Expense* Interest Payable (Record accrued interest)

Debit 12,000

Credit 12,000

* $600,000  0.08  3/12 = $12,000

Among the current liabilities: Short-term notes payable......................................................... Interest payable .......................................................................

$600,000 12,000

Journal Date 2024 May

Account and Explanation 1

Notes Payable Interest Payable Interest Expense* Cash (Record payment of note and interest)

Debit

Credit

600,000 12,000 16,000 628,000

* $600,000  0.08  4/12 = $16,000

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P 8-60A 1.

Journal Date 2024 Dec.

Account and Explanation 1

Inventory Accounts Payable (Record purchase of inventory on account

2. No journal entry necessary. 3. Date 2025 Mar.

Accounts Payable Notes Payable (Record issuance of note to cover unpaid account payable)

Credit

80,000 80,000

Journal Account and Explanation

Debit

Credit

80,000 80,000

Journal Date July

Account and Explanation Notes Payable Interest Expense* Cash (Record payment of note and interest)

Debit 80,000 1,600

Credit

81,600

* $80,000  0.06  4/12 = $1,600

P 8-61A 1.

Gas utility charges ........................................................................ State excise tax: Flat fee of $5.00 per customer a .................................................. 3% of total billing b ..................................................................... Total state excise tax .................................................................. Federal excise tax: Flat fee of $0.45 per customer c .................................................. 0.2% of total billing d .................................................................. Total federal excise tax ............................................................... Total bill .......................................................................................

$3,295,000 $180,000 98,850 278,850 $16,200 6,590 22,790 3,596,640

$5.00  36,000 customers = $180,000 $3,295,000  0.03 = $98,850 c $0.45  36,000 customers = $16,200 d $3,295,000  0.002 = $6,590 a

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P 8-61A (Continued) 2.

Journal Date

Account and Explanation Accounts Receivable Sales Revenue Excise Taxes Payable (State) Excise Taxes Payable (Federal) (Record sale)

Debit 3,596,640

Credit 3,295,000 278,850 22,790

Journal Date

Account and Explanation Cash Accounts Receivable (Record collection of receivables)

Debit 3,596,640

Credit 3,596,640

Journal Date

Account and Explanation Excise Taxes Payable (State) Cash (Record payment)

Debit 278,850

Credit 278,850

P 8-62A 1.

Journal Date Nov

Account and Explanation 20

Cash* Unearned Sales Revenue (Record receipt of deposit for merchandise not yet delivered)

Debit 187,500

Credit 187,500

* 750 units  $250 = $187,500

Current Liability: Unearned Sales Revenue .......................................................... Noncurrent Liability: Unearned Sales Revenue ..........................................................

$50,000 $137,500

The portion of customer deposits pertaining to next year’s deliveries ($50,000 = 200 units  $250) should be classified as a current liability on the balance sheet at the end of 2024; the remainder ($137,500) should be classified as a noncurrent liability.

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P 8-62A (Continued) 2.

Journal Date 2025

Account and Explanation Unearned Sales Revenue Cash* Sales Revenue** (Record recognition of revenue) Cost of Goods Sold*** Inventory (Record delivery of merchandise)

Debit

Credit

50,000 150,000 200,000 45,000 45,000

* (200 units  $1,000) − $50,000 = $150,000 ** 200 units  $1,000 = $200,000 *** 200 units  $225 = $45,000

$75,000 $62,500

The remaining balance in Unearned Sales Revenue is $137,500 (the original $187,500 minus the $50,000 recognized during 2025). Of this remaining amount, $75,000 (300 units  $250) pertains to next year’s deliveries and would be reported as a current liability on the balance sheet at the end of 2025, while the remainder, $62,500, would be classified as a long-term liability. 3.

Journal Date

Account and Explanation

Debit

Credit

2026 Unearned Sales Revenue a Cash b Sales Revenue c (Record recognition of revenue) Cost of Goods Sold d Inventory (Record delivery of merchandise)

75,000 225,000 300,000 67,500 67,500

300 units  $250 = $75,000 (300 units  $1,000) − $75,000 = $225,000 c 300 units  $1,000 = $300,000 d 300 units  $225 = $67,500 a

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P 8-63A 1.

Warranty expense for the year is the expected number of warranty claims times the expected cost of each claim. Expected number of warranty claims: 2,350 repairs  0.08 claims per repair = 188 Warranty expense: 188 expected claims  $240 per claim = $45,120

Journal Date

Account and Explanation Warranty Liability Cash (Record warranty expense)

Debit 32,700

Credit 32,700

The balance in Warranty Liability is: Warranty Liability 34,500 32,700 45,120 46,920

Claims paid

Balance, 1/1/X1 Warranty expense Balance, 12/31/X1

The balance increased because fewer claims were paid than were added to the liability from the liability through warranty expense. P 8-64A 1.

Current Assets Current Liabilities $67,959 2020 = $38,809 = 1.75

Current Ratio =

$39,690 $22,518 = 1.76

2019 =

(Cash + Marketable Securities + Accounts Receivable) Current Liabilities ($1,274 + $0 + $30,071) 2020 = $38,809 = 0.81

Quick Ratio =

($6,450 + $0 + $16,548) $22,518 = 1.02

2019 =

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P 8-64A (Continued) 3.

(Cash + Marketable Securities) Current Liabilities ($1,274 + $0) 2024 = $38,809 = 0.03

Cash Ratio =

($6,450 + $0) $22,518 = 0.29

2023 =

Cash Flow from Operating Activities Current Liabilities $12,829 2024 = $38,809 = 0.33

4. Operating Cash Flow =

$14,874 $22,518 = 0.66

2023 =

GER’s liquidity appears to hold constant when one looks only at the current ratio. However, under further scrutiny, it is apparent (using the quick ratio, cash ratio, and operating cash flow ratio) that this result is due to the significantly higher amounts of receivables and inventories in 2024 as compared to 2023. Because the receivables and inventories may not be easily converted to cash, the liquidity of GER may be worsening.

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PROBLEM SET B P 8-57B 1.

Journal Date

Jan.

Feb.

July

Aug.

Sept.

Oct.

Account and Explanation Inventory Accounts Payable (Record purchase of supplies on account) Accounts Payable Cash* (Record partial payment of supplier) Accounts Payable Notes Payable (Record issuance of note to cover unpaid portion of account payable) Cash Notes Payable (Record issuance of note) Inventory Accounts Payable (Record purchase of inventory on account) Accounts Payable Cash (Record payment of supplier) Cash Unearned Sales Revenue (Record receipt of deposit for services not yet performed)

Debit 25,000

Credit 25,000

10,000 10,000 15,000 15,000

300,000 300,000 150,000 150,000 150,000 150,000 40,000 40,000

* $25,000  0.40 = $10,000

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P 8-57B (Continued) Journal Date h.

Oct.

Dec.

Account and Explanation Social Security Taxes Payable (Employee)** Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employee)*** Medicare Taxes Payable (Employer) Federal Income Taxes Withholding Payable Cash (Record employer payroll taxes) Accounts Receivable Unearned Sales Revenue Service Revenue (Record recognition of revenue)

Debit 140,000 140,000 32,742 32,742 730,000

Credit

1,075,484 360,000 40,000 400,000

** $280,000  0.50 = $140,000 *** $65,484 = 0.50 = $32,742

Journal Date Dec.

Account and Explanation Interest Expense Interest Payable* (Record accrued interest)

Debit 12,250

Credit 12,250

* ($15,000  0.08  10/12) + ($300,000  0.09  5/12) = $12,250

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P 8-58B 1.

Social Security: $1,250,000  0.062 = $77,500 Medicare: $1,250,000  0.0145 = $18,125 State unemployment: $1,000,000  0.008 = $8,000 Federal unemployment: $1,000,000  0.005 = $5,000 Net pay = $1,250,000 − $180,600 − $77,500 − $18,125 = $973,775 Journal Date Mar.

Account and Explanation Wages Expense Federal Income Taxes Withholding Payable Social Security Taxes Payable (Employee) Medicare Taxes Payable (Employee) Cash (Record wages and liabilities) State Unemployment Taxes Expense* Federal Unemployment Taxes Expense** Social Security Taxes Expense Medicare Taxes Expense State Unemployment Taxes Payable Federal Unemployment Taxes Payable Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employer) (Record employer payroll taxes)

Debit 1,250,000

Credit 180,600 77,500 18,125 973,775

8,000 5,000 77,500 18,125 8,000 5,000 77,500 18,125

* $1,000,000  0.008 = $8,000 ** $1,000,000  0.005 = $5,000

Pay........................................................... Social Security .......................................... Medicare .................................................. Fringe Benefits..........................................

100.00% 6.20% 1.45% 28.00% 135.65%  $80,000 = State Unemployment: $7,000  0.008 = Federal Unemployment: $7,000  0.005 =

$108,520 56 35 $108,611

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P 8-59B 1.

Journal Date 2024 Sept.

Account and Explanation 1

Cash

Debit 425,000

Notes Payable (Record issuance of note) 2.

Credit

425,000

Journal Date Dec.

Account and Explanation Interest Expense* Interest Payable (Record accrued interest)

Debit 8,500

Credit 8,500

* $425,000  0.08  3/12 = $8,500

$425,000 8,500

Journal Date 2025 Apr.

Account and Explanation 30

Notes Payable Interest Payable Interest Expense* Cash (Record payment of note and interest)

Debit

Credit

425,000 8,500 8,500 442,000

* $425,000  0.08  3/12 = $8,500

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P 8-60B 1.

Journal Date 2020 Nov.

2. 3.

Account and Explanation 1

Inventory Accounts Payable (Record purchase of inventory on account)

Debit

Credit

770,000 770,000

No journal entry necessary. Journal Date 2021 Feb.

Account and Explanation 1

Accounts Payable Notes Payable (Record issuance of note to cover unpaid account payable)

Debit

Credit

770,000 770,000

Journal Date 2021 Sept.

Account and Explanation 1

Notes Payable Interest Expense* Cash (Record payment of note and interest)

Debit

Credit

770,000 53,900 823,900

* $770,000  0.12  7/12 = $53,900

P 8-61B 1

Electricity charges......................................................................... State excise tax: Flat fee of $3.50 per customer a ................................................ 2% of total billing b ................................................................... Total state excise tax................................................................

$393,000.00 $10,500.00 7,860.00 18,360.00

Federal excise tax: Flat fee of $0.50 per customer c ................................................ 0.15% of total billing d .............................................................. Total federal excise tax ............................................................ Total bill .......................................................................................

$1,500.00 589.50 2,089.50 $413,449.50

$3.50  3,000 customers = $10,500.00 $393,000  0.02 = $7,860.00 c $0.50  3,000 customers = $1,500.00 d $393,000  0.0015 = $589.50 a

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P 8-61B (Continued) 2.

Journal Date

Account and Explanation Accounts Receivable Sales Revenue Excise Taxes Payable (State) Excise Taxes Payable (Federal) (Record sale)

Debit 413,449.50

Credit 393,000.00 18,360.00 2,089.50

Journal Date

Account and Explanation Cash Accounts Receivable (Record collection of receivables)

Debit 413,449.50

Credit 413,449.50

Journal Date

Account and Explanation Excise Taxes Payable (State) Cash (Record payment)

Debit 18,360.00

Credit 18,360.00

P 8-62B 1.

Journal Date Dec.

Account and Explanation Cash* Unearned Sales Revenue (Record receipt of deposit for merchandise not yet delivered)

Debit 120,000

Credit 120,000

* 800 units  $150 = $120,000

$26,250 $93,750

The portion of customer deposits pertaining to next year’s deliveries ($26,250 = 175 units  $150) should be classified as a current liability on the balance sheet at the end of 2019; the remainder ($93,750) should be classified as a noncurrent liability.

P 8-62B (Continued)

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

Journal Date 2024

Account and Explanation Unearned Sales Revenue Cash* Sales Revenue** (Record recognition of revenue) Cost of Goods Sold*** Inventory (Record delivery of merchandise)

Debit 26,250 140,000

Credit

166,250 74,375 74,375

* (175 units  $950) − $26,250 = $140,000 ** 175 units  $950 = $166,250 *** 175 units  $425 = $74,375

$48,750 $45,000

The remaining balance in Unearned Sales Revenue is $93,750 (the original $120,000 minus the $26,250 recognized during 2024). Of this remaining amount, $48,750 (325 units  $150) pertains to next year’s deliveries and would be reported as a current liability on the balance sheet at the end of 2024, while $45,000 would be classified as a long-term liability. 3.

Journal Date

Account and Explanation

Debit

Credit

2025 Unearned Sales Revenue a Cashb Sales Revenuec (Record recognition of revenue) Cost of Goods Soldd Inventory (Record delivery of merchandise)

48,750 260,000 308,750 138,125 138,125

325 units  $150 = $48,750 (325 units  $950) − $48,750 = $260,000 c 325 units  $950 = $308,750 d 325 units  $425 = $138,125 a

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

P 8-63B 1.

Warranty expense for the year is the expected number of warranty claims times the expected cost of each claim. Expected number of warranty claims: 4,500 repairs  0.09 claims per repair = 405 Warranty expense: 405 expected claims  $250 per claim = $101,250

Journal Date

Account and Explanation Warranty Liability Cash (Record warranty expense)

Debit 110,000

Credit 110,000

The December 31 balance in Warranty Liability is:

Warranty Liability 25,000 Balance, Jan. 1 Claims paid 110,000 101,250 Warranty expense 16,250 Balance, Dec. 1 The balance decreased because more claims were paid than were added to the liability through warranty expense. P 8-64B 1.

Current Assets Current Liabilities $135,918 2023 = $77,618 = 1.75

Current Ratio =

$79,380 $45,036 = 1.76

2022 =

(Cash + Marketable Securities + Accounts Receivable) Current Liabilities ($2,548 + $0 + $60,142) 2023 = $77,618 = 0.81

Quick Ratio =

($12,900 + $0 + $33,096) $45,036 = 1.02

2022 =

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

P 8-64B (Continued) 3.

(Cash + Marketable Securities) Current Liabilities ($2,548 + $0) 2023 = $77,618 = 0.03

Cash Ratio =

($12,900 + $0) $45,036 = 0.29

2022 =

Cash Flow from Operating Activities Current Liabilities $25,658 2023 = $77,618 = 0.33

4. Operating Cash Flow =

$29,748 $45,036 = 0.66

2022 =

Chicago Water Slide’s liquidity appears to hold constant when one looks only at the current ratio. However, under further scrutiny, it is apparent (using the quick ratio, cash ratio, and operating cash flow ratio) that the improvement in liquidity is only due to the significantly higher amounts of receivables and inventories in 2023 as compared to 2022. Because the receivables and inventories may not be easily converted to cash, the liquidity of Chicago Water Slide may be worsening.

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CASES Case 8-65 1.

To the extent that the warranty liability is current (and it will be current for any warranty work estimated to be performed in the next year), current liabilities will be lowered. The current ratio is calculated as: Current Assets Current Liabilities This means that lowering the warranty liability will increase the current ratio.

Jim should tell his boss that ethically they are to provide the best estimate of the warranty liability they can. This means that the estimate should reflect the company’s “true” obligation as accurately as possible, and the estimate should be made without bias. Doing as the boss suggests would make the financial statements potentially misleading to investors and creditors such as the bank.

Jim’s first course of action is to try to reason with his boss. If this fails, he should raise the issue to his boss’s boss. Ultimately, if Jim is unable to resolve this issue in an ethical way within the department, he will have to consider other options. As a publicly traded company, Jim should have a hotline available to him that he can call to ask about any concerns surrounding the accounting change that his boss asked him to make. This hotline will be monitored by upper management and the board of directors. If he decides to “blow the whistle” on his boss’s request, he will have whistleblower protection to ensure that retaliation is not taken against him.

Case 8-66 1.

Journal Date Jan.

Account and Explanation Cash Notes Payable (Record issuance of note)

Debit 35,000

Credit 35,000

The loan increased current assets and current liabilities by the same amount; therefore, it did not change the excess of current assets over current liabilities. Journal Date

Account and Explanation Inventory Cash (Record purchase of inventory)

Debit 35,000

Credit 35,000

The inventory purchase increased and decreased current assets by the same amount; therefore, it did not change either the amount of current assets or the excess of current assets over current liabilities. 3.

Rocky Mountain could borrow another $23,000 ($58,000 − $35,000 = $23,000 excess) under the restriction, provided that use of the proceeds in conjunction with other transactions during January do not violate the restriction. Although investment in inventory does not affect the excess of current assets over current liabilities, investing in equipment reduces the excess of current assets over current liabilities and, therefore, might violate the restriction.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

Case 8-67 1.

At September 1, 2019, Costco had current liabilities of $23,237 (in millions).

$1,699 (in millions)

Costco appears to be a defendant in a number of lawsuits over the course of time. While they do not discuss every lawsuit, they do discuss a few. It is unclear how much, if any, Costco has recognized as a contingent liability. They do state that, “the Company establishes an accrual for legal proceedings if and when those matters reach a stage where they present loss contingencies that are both probable and reasonably estimable.” However, they also say, “the Company does not believe that any pending claim, proceeding or litigation, either alone or in the aggregate, will have a material adverse effect on the Company’s financial position, results of operations or cash flows…” Current Assets Current Ratio = Current Liabilities $20,289 2015 = $19,926 = 1.02

$23,485 $23,237 = 1.01

2016 =

Costco's current ratio is weak because it is well below conventional standards of at least 2. This raises fear that Costco may not be able to generate sufficient cash to meet its current obligations. Further, Costco's trend is very flat.

Cash + Marketable Securities + Accounts Receivable

(restricted cash is omitted, see note above) Current Liabilities $6,055 + $1,204 + $1,669 2018 = $19,926 = 0.45

Quick Ratio =

$8,384 + $1,060 + $1,535 $23,237 = 0.47

2019 =

Cash + Marketable Securities (restricted cash is omitted, see note above) Current Liabilities $6,055 + $1,204 2018 = $19,926 = 0.87

Cash Ratio =

$8,384 + $1,060 $23,237 = 0.41

2019 =

473

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

Case 8-67 (Continued) 7.

The quick and cash ratios further reinforce that Costco has potential short-term liquidity problems. To be fair to Costco, its inventories are relatively easy to turn into cash. As such, the current ratio is the most appropriate short-term liquidity ratio. However, as shown in answers 4 and 5, the current ratio is potentially weak.

Operating Cash Flow Ratio =

Cash Flows from Operating Activities Current Liabilities $5,774 2018 = $19,926 = 0.29 $6,356 $23,237 = 0.27

2019 =

The operating cash flow ratio indicates that Costco is unable to meet its current obligations with cash generated from operating activities.

Case 8-68 1.

2. 3.

The principal contingencies are (1) insurance (they are self-insured against workmen’s compensation claims in most states), (2) litigation (various claims and lawsuits arising in the normal course of business), and (3) assignments (contingently liable for leases that have been assigned to other parties in connection with closing and selling stores). With respect to litigation, Kroger states, “…it has made provisions where it is reasonably possible to estimate and when an adverse outcome is probable.” However, Kroger also says, “Management currently believes that the aggregate range of loss for the Company’s exposure is not material to the Company.” Sprouts (Note 11): $22,806 (in thousands) Current Assets Current Ratio = Current Liabilities Kroger:

$10,890 $14,243 = 0.76

2019 =

$10,803 $14,274 = 0.76

2018 =

Sprouts: $2,722,983 $416,812 = 6.53

2019 =

$1,675,614 $310,000 = 5.41

2018 =

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

Case 8-68 (Continued) 4.

Sprouts’ current ratio is clearly superior to Kroger’s. This suggests that Kroger’s short-term liquidity risk is higher than that of Sprouts’. Further, while Sprouts’ current ratio improved by 20.7% from 2018 to 2019, Krogers’s current ratio did not change. Kroger’s current ratio being less than 1.0 indicates that it will need to obtain cash from someplace other than current assets to pay off their current liabilities. This will entail some combination of (1) generating cash through operations or (2) obtaining additional financing or, if things get really bad, (3) selling off noncurrent assets.

Quick Ratio =

Cash + Marketable Securities + Accounts Receivable Current Liabilities

Kroger: $1,578 + $0 + $1,706 $14,243 = 0.23

2019 =

$1,610 + $0 + $1,589 $14,274 = 0.22

2018 =

Sprouts: $85,314 + $0 + $15,713 $416,812 = 0.24

2019 =

$1,588 + $0 + $40,564 $366,070 = 0.14

2018 =

Cash Radio =

Cash + Marketable Securities Current Liabilities

Kroger: $1,578 + $0 $14,243 = 0.11

2019 =

$1,610 + $0 $14,274 = 0.11

2018 =

Sprouts: $85,314 + $0 $416,812 = 0.20

2019 =

$1,588 + $0 $310,000 = 0.01

2018 =

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 8: Current and Contingent Liabilities

Case 8-68 (Continued) 6.

Both companies have quick and current ratios that are substantially below 1.0. For Sprouts, with a current ratio of 5.41 and 6.53 in 2018 and 2019, respectively, this means they will need to sell their inventory to meet their current obligations. In the grocery industry selling inventory would appear to be relatively assured. However, Kroger, with a current ratio of 0.76 in both years, will need to generate additional cash through operations or additional financing.

Operating Cash Flow Ratio =

Cash Flows from Operating Activities Current Liabilities

Kroger: $4,664 $14,243 = 0.33

2019 =

$4,164 $14,274 = 0.29

2018 =

Sprouts: $355,210 $416,812 = 0.85

2019 =

$294,379 $310,000 = 0.95

2018 =

Sprouts’ operating cash flow ratio is clearly better than Kroger’s. However, Kroger’s did trend up slightly in 2019, while Sprouts’ deteriorated by a little over 10%. Further, neither company is generating sufficient cash flows from operations to cover their current liabilities.

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Annual Report Problem: 1

Cash Short-term investments Accounts receivable Inventory Other current assets Accounts payable Other current liabilities Cash flows from operating activities

(amounts in millions) 2,133 2,106 14,531 1,040 7,787 10,588 13,723

Cash Short-term investments Accounts receivable Inventory Other current assets Accounts payable Other current liabilities Cash flows from operating activities

2,303.64 2,274.48 15,693.48 1,123.20 8,721.44 11,117.40 13,585.77

3 4 5 6 7

Current ratio Quick ratio Cash ratio Operating cash flow ratio Contingencies?

1.08 0.23 0.12 0.68 No

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Case 8-69 1.

Journal Date

Feb.

Account and Explanation 28 Inventory Accounts Payable (Record purchase of inventory) 1 Equipment Notes Payable (Record issue of note for equipment purchase) 28 Interest Expense* Interest Payable (Record accrued interest) 28 Cash Unearned Sales Revenue Sales Taxes Payable (State) (Record unearned revenue and sales taxes) 28 Wages Expense Social Security Taxes Payable (Employee) Medicare Taxes Payable (Employee) Federal Income Taxes Withholding Payable Cash (Record wages and related liabilities) 28 Social Security Taxes Expense Medicare Taxes Expense Federal Unemployment Taxes Expense State Unemployment Taxes Expense Social Security Taxes Payable (Employer) Medicare Taxes Payable (Employer) Federal Unemployment Taxes Payable State Unemployment Taxes Payable (Record employer payroll taxes)

Debit 5,325

Credit 5,325

8,000 8,000 67 67 3,745 3,500 245 2,000 124 29 375 1,472 124 29 16 108 124 29 16 108

* $8,000  0.10  1/12 = $67

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Case 8-69 (Continued) 2.

The current ratio for Front Row Entertainment before the additional information is 1.52* ($67,760/$44,615). The current ratio after the additional information is 1.20** ($75,358/$62,557).

$12,480 + $3,900 + $20,380 + $31,000 $8,640 + $375 + $1,200 + $26,100 + $8,300 $67,760 = $44,615 = 1.52

*Current Ratio Before =

**Current Ratio After =

$67,760 + $5,325 + $3,745 − $1,472 $44,615 + $5,325 + $8,000 + $67 + $3,745 + $124 + $29 + $375 + $124 + $29 + $16 + $108

$75,358 $62,557 = 1.20

Because a judgment against Front Row Entertainment was determined to be “remote,” no journal entry or disclosure in the notes to the financial statements is required.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

LONG-TERM LIABILITIES

DISCUSSION QUESTIONS 1.

Long-term debt generally refers to obligations that extend beyond 1 year. Long-term notes, bonds, and capital leases are examples of long-term debt.

When a company borrows money from a bank, it typically signs a formal agreement or contract called a “note.” Frequently, notes are also issued in exchange for a noncash asset such as equipment. Larger corporations typically elect to issue bonds instead of notes. A bond is a type of note that requires the issuing entity to pay the face value of the bond to the holder when it matures and usually to pay interest periodically at a specified rate. A bond issue essentially breaks down a large debt into smaller chunks because the total amount borrowed is too large for a single lender. Accounting treatment for bonds and notes is conceptually identical.

The face value (also known as par value or principal) of a bond represents the amount paid to a bondholder at the maturity date (generally stated in denominations of $1,000). It is the nominal value or dollar value of a security stated by the issuer and the amount of principal paid back to the lender at maturity.

The maturity date of a bond is a specified date in the future when the issuer repays the purchaser the face value of the bond.

The stated or coupon rate of a bond is the rate of interest paid on the face (or par) value. The borrower pays this interest to the creditor each period until maturity.

The yield rate is the market interest rate demanded by creditors. It often differs from the stated rate. The stated rate is the interest rate used to calculate interest payments. If the stated rate is less than the yield (or market) rate, the bond will be sold at a discount (less than face value). If the stated rate is greater than the yield rate, the bond will be sold for a premium (more than face value).

A secured bond provides collateral (e.g., real estate or another asset) for the lender. If the borrower fails to make payments on the debt, the lender can “repossess” the collateral. Debt that does not have this pledged collateral is called an unsecured (or debenture) bond.

If a bond is callable, it means that the borrower has the option to pay off the debt prior to maturity. This option is often exercised if (1) the interest rate being paid on the debt is much greater than the current market rate. (2) the borrower has the means to pay back the creditor.

A convertible bond gives the lender the option to convert the bond into other securities, typically shares of common stock. This “conversion” will usually take place if the value of the common stock is greater than the interest and principal payments supplied by the debt instrument.

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10. Junk bonds are unsecured and very risky (typically due to the borrower’s poor credit quality), and, therefore, pay a high rate of interest to compensate the lender for the added risk of the borrower being unable to meet interest payments and/or repay the principal. 11. Total interest on long-term debt equals the excess of the amount paid to the lender over the amount borrowed throughout the entire life of the bond. 12. New issues of long-term debt are sold directly to institutions such as insurance companies or pension funds or to the public through underwriters. When debt securities are sold directly to lenders, the company gives information about its profitability, financial position, cash flows, and future plans to potential lenders and negotiates directly with them regarding the terms of the borrowing. When debt securities are sold through underwriters, the underwriters negotiate with businesses for the right to sell the debt securities to individual investors and financial institutions. Underwriters examine the provisions of the debt security and the credit standing of the borrower to determine either the fee they will charge or the price they will offer the borrower for the debt securities. The underwriters make their profits either by charging the borrower a fee or by selling the debt securities for more than was paid to the borrower. 13. If the stated rate is less than the yield (or market) rate, the bond is sold at a discount (less than face value). If the stated rate is greater than the yield rate, the bond is sold for a premium (more than face value). 14. Premium on long-term debt is presented on the balance sheet as an addition to the face (or par) amount of the debt. The sum of the premium and the face amount is the carrying amount of the liability. Discount on long-term debt is a contra-liability item and is presented with the face amount of the debt on the balance sheet. Subtracting the discount from the face amount produces the carrying amount of the long-term debt. The following excerpt from a balance sheet illustrates the presentation: Long-term debt Bonds payable: Bonds payable Add: Premium on bonds payable

$xxxx xxxx $xxxx

or Bonds payable Less: Discount on bonds payable

$xxxx (xxxx)

$xxxx 15. Premiums and discounts serve to adjust the stated interest rate to the market rate. If a bond is sold for a premium, it is sold for an amount greater than the face value of the long-term debt security to balance out the fact that the stated interest rate on the bond is higher than the market rate. A bond is sold at a discount (less than face value) to balance out the fact that the stated interest rate on the bond is lower than the

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market rate. If bonds are issued at a discount, the interest expense will be higher than the interest payment. If bonds are issued at a premium, the interest expense will be lower than the interest payment. 16. When using the straight-line method to amortize premiums and discounts, the initial discount or premium is divided by the number of interest payments made over the life of the bond to determine the amount to amortize each period. Using the straight-line method, the amortization will be the same each period. When using the effective interest rate method to amortize a premium or discount, the per-period amount of the amortized premium or discount is equal to the difference between the current carrying value of the bond multiplied by the market rate of interest and the predetermined cash payment (Face Value  Stated Rate). Using the effective interest method, the amortization will vary each period. 17. Since zero-coupon bonds have a 0% interest rate, they are sold at a relatively large discount with the full face value being repaid at the maturity date. This large discount will be amortized over the life of the bond, and it can be thought of as interest that is paid in full at maturity. 18. Under the effective interest rate method, interest payments are calculated by multiplying the face value of the bond by the stated interest rate multiplied by time (in years). The interest expense, however, is calculated by multiplying the carrying value by the yield rate multiplied by the time (in years). 19. A firm can “leverage” its capital structure by using capital supplied by creditors in the hope of producing more income than is needed to cover the interest on the related liability, which is fixed by the lending agreement. When the resultant income is sufficiently high, the leverage is advantageous, and operating income in excess of the interest accrues to the stockholders. However, if income is not sufficiently high, the leverage is disadvantageous, and the excess of the (guaranteed) interest over the related income is borne by the stockholders. 20. Recent rule changes require all leases with a lease term of 1 year or longer to recognize an asset and a liability at the time the lease is signed. Leases with a lease term of under 1 year do not require an asset or a liability to be recognized at the time the lease is signed. 21. Under the old lease accounting rules, many leases with a lease term of 1 year or longer were able to be structured in a way that no asset or liability needed to be recognized at the time the lease was signed. 22. The bond issue price is determined by adding the present value (of annuity) of the interest payments and the present value (single amount) of the principal payments.

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MULTIPLE-CHOICE QUESTIONS 9-1. 9-2. 9-3.

c b a

9-4. 9-5. 9-6. 9-7. 9-8. 9-9. 9-10. 9-11. 9-12. 9-13. 9-14. 9-15.

c c d d b b c a d b d b

101.25 = 101.25% of face value = 1.0125  $1,000 = $1,012.50

$100,000  0.06 = $6,000/year  10 = $60,000 $40,000  0.08 = $3,200/year  6/12 = $1,600

Interest payments = $100,000  0.06 = $6,000 First period interest expense = $107,732  0.05 = $5,387 First period premium amortization = $6,000 − $5,387 = $613

9-16. c 9-17. b

Total Liabilities Total Equity $5,000 + $1,500 + $2,300 = $6,000 = 1.47

9-18. a.

Debt to Equity =

9-19. c.

Long-Term Debt to Equity =

9-20. d.

Debt to Total Assets =

9-21.

Long-Term Debt Total Equity $100,000 − $75,000 = $200,000 − $100,000 = 0.25

Total Liabilities Total Assets $100,000 = $200,000 = 0.50

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

BRIEF EXERCISES BE 9-22 a.

Bonds payable ............................................................................ Less: Discount on bonds payable................................................. Bonds payable, net .....................................................................

$1,600,000 60,000

Bonds payable………………………………….. ........................................ Add: Premium on bonds payable ................................................ Bonds payable, net .....................................................................

$2,400,000 75,000

$1,540,000

$2,475,000

BE 9-23 Date a.

Journal Account and Explanation Cash Bonds Payable Cash ($8,000,000  1.03) Premium on Bonds Payable Bonds Payable Cash ($8,000,000  0.96) Discount on Bonds Payable Bonds Payable

Debit 8,000,000

Credit 8,000,000

8,240,000 240,000 8,000,000 7,680,000 320,000 8,000,000

BE 9-24 Date a. b.

Journal Account and Explanation Cash Bonds Payable Cash ($4,100,000  1.01) Premium on Bonds Payable Bonds Payable Cash ($4,100,000  0.96) Discount on Bonds Payable Bonds Payable

Debit 4,100,000

Credit 4,100,000

4,141,000 41,000 4,100,000 3,936,000 164,000

4,100,000

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BE 9-25 Journal Account and Explanation

Date 1.

Cash Discount on Bonds Payable Bonds Payable

Debit 194,620 5,380

Credit

200,000

The stated rate (the rate on the face of the bonds) is less than the yield rate (the rate of interest demanded by investors). We know this because the bonds were issued at a discount.

BE 9-26 Date June

Journal Account and Explanation 30 Interest Expense* Cash

Debit 120,000

Credit 120,000

*$4,000,000  0.06  6/12

BE 9-27 Date 2020 Dec.

Journal Account and Explanation 31 Interest Expense Discount on Bonds Payable* Cash**

Debit

Credit

3,050,000 600,000 2,450,000

* $30,000/5 years **$35,000,000  0.07 = $2,450,000

BE 9-28

a b

Period At issue

Cash Paymenta (Credit) —

Interest Expenseb (Debit) —

Discount on Bonds Payablec (Credit) —

Discount on Bonds Payable Balance $3,000,000

Carrying Valued $32,000,000

12/31/20

$2,450,000

$3,050,000

$600,000

2,400,000

32,600,000

12/31/21

2,450,000

3,050,000

600,000

1,800,000

33,200,000

12/31/22

2,450,000

3,050,000

600,000

1,200,000

33,800,000

12/31/23

2,450,000

3,050,000

600,000

6,000,000

34,400,000

12/31/24

2,450,000

3,050,000

600,000

35,000,000

Cash Payment = $35,000,000  0.07  12/12 Interest Expense = Cash Payment + Discount on Bonds Payable

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

c d

Discount on Bonds Payable = $3,000,000/5 periods Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance

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BE 9-29 Date Dec.

Journal Account and Explanation 31 Interest Expense* Premium on Bonds Payable** Cash

Debit 5,460,000 140,000

Credit

5,600,000

* ($80,000,000  0.07) − ($840,000/6) **($80,840,000 − $80,000,000)/6

BE 9-30

Period At issue 12/31/24 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29

Cash Paymenta (Credit) — $5,600,000 5,600,000 5,600,000 5,600,000 5,600,000 5,600,000

Interest Expenseb (Debit) — $5,460,000 5,460,000 5,460,000 5,460,000 5,460,000 5,460,000

Premium on Bonds Payablec (Credit) — $140,000 140,000 140,000 140,000 140,000 140,000

Premium on Bonds Payable Balance $840,000 700,000 560,000 420,000 280,000 140,000 0

Carrying Valued $80,840,000 80,700,000 80,560,000 80,420,000 80,280,000 80,140,000 80,000,000

Cash Payment = $80,000,000  0.07  12/12 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = $840,000/6 years d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

BE 9-31

Period At issue 06/30/25 12/31/25 06/30/26 12/31/26

Cash Paymenta (Credit) — $34,000 34,000 34,000 34,000

Interest Expenseb (Debit) — $39,100 39,355 39,623 39,904

Discount on Bonds Payablec (Credit) — $5,100 5,355 5,623 5,904

Discount on Bonds Payable Balance $68,000 62,900 57,545 51,922 46,018

Carrying Valued $782,000 787,100 792,455 798,078 803,982

Cash Payment = $850,000  0.08  6/12 Interest Expense = Carrying Value  0.10  6/12 c Change in Discount Balance = Interest Expense − Cash Payment d Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance a

487

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

BE 9-32 Date 2025 Dec.

Journal Account and Explanation

Debit

31 Interest Expense* Discount on Bonds Payable Cash

Credit

39,355 5,355 34,000

*Interest expense comes from the Interest Expense column in the table in BE 9-53.

Date 2026 Dec.

Journal Account and Explanation

Debit

31 Interest Expense* Discount on Bonds Payable Cash

Credit

39,904 5,904 34,000

*Interest expense comes from the Interest Expense column in the table in BE 9-53.

BE 9-33

Period At issue 12/31/24 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 12/31/30

Cash Paymenta (Credit) — $25,000 25,000 25,000 25,000 25,000 25,000 25,000

Interest Expenseb (Debit) — $28,325 28,525 28,736 28,960 29,198 29,450 29,718 e

Discount on Bonds Payablec (Credit) — $3,325 3,525 3,736 3,960 4,198 4,450 4,718

Discount on Bonds Payable Balance $27,912 24,587 21,062 17,326 13,366 9,168 4,718 0

Carrying Valued 472,088 475,413 478,938 482,674 486,634 490,832 495,282 500,000

Cash Payment = $500,000  0.05  12/12 Interest Expense = Carrying Value  0.06  12/12 c Change in Discount Balance = Interest Expense − Cash Payment d Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance e Difference due to rounding a

488

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

BE 9-34 Date 2026 Dec.

2027 Dec.

Journal Account and Explanation

Debit

31 Interest Expense Discount on Bonds Payable Cash

28,736

31 Interest Expense Discount on Bonds Payable Cash

28,960

Credit

3,736 25,000

3,960 25,000

BE 9-35

Period At issue 12/31/24 12/31/25 12/31/26 12/31/27 12/31/28 12/31/29 12/31/30

Cash Paymenta (Credit) — $13,200 13,200 13,200 13,200 13,200 13,200 13,200

Interest Expenseb (Debit) — $12,584 12,523 12,455 12,380 12,298 12,208 12,110 e

Premium on Bonds Payablec (Debit) — $616 677 745 820 902 992 1,090

Premium on Bonds Payable Balance $5,842 5,226 4,549 3,804 2,984 2,082 1,090 0

Carrying Valued $125,842 125,226 124,549 123,804 122,984 122,082 121,090 120,000

Cash Payment = $120,000  0.11  12/12 Interest Expense = Carrying Value  0.10  12/12 c Premium on Bonds Payable = Cash Payment − Interest Expense d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance e Difference due to rounding a

BE 9-36 Date 2025 Dec.

2026 Dec.

Journal Account and Explanation

Debit

31 Interest Expense Premium on Bonds Payable Cash

12,523 677

31 Interest Expense Premium on Bonds Payable Cash

12,455 745

Credit

13,200

489

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

BE 9-37 After-Tax Interest Rate = (1 − Tax Rate)  Interest Rate = (1 − 0.21)  0.09 = 7.11%

BE 9-38 1.

Interest net of income taxes: $2,500,000  0.08  (1 − 0.35) = $130,000

Crackle incurred interest expense of $200,000 ($2,500,000  0.08). However, since interest expenses are tax deductible, Crackle Company can decrease its taxes by $70,000 ($200,000 − $130,000). These savings increase Crackle Company’s financial leverage. The money it needs to borrow is now substantially less.

BE 9-39 Total Liabilities Total Equity ($80,000 + $155,000 + $25,000) = $120,000 = 2.17

Debt to Equity =

BE 9-40 Total Liabilities Total Equity $2,210,000 = ($3,700,000 − $2,210,000) = 1.48

Debt to Equity =

BE 9-41 Total Liabilities Total Assets $2,900,000 = $4,300,000 = 0.67

Debt to Total Assets =

Long-Term Debt Total Equity $500,000 = ($4,300,000 − $2,900,000) = 0.36

Long-Term Debt to Total Equity =

490

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

BE 9-42 PV of interest payments: ($3,000,000  0.06  6/12)  (PV of an annuity, 10 periods, 4%) $90,000  13.59033 =

$1,223,130

PV of principal payments: $3,000,000  (PV of a single sum 10 periods, 4%) $3,000,000  0.45639 = Issue price of bonds

1,369,170 $2,592,300

BE 9-43 PV of interest payments: ($3,500,000  0.08  6/12)  (PV of an annuity, 20 periods, 3%) $140,000  14.87747 =

$2,082,846

PV of principal payments: $3,500,000  (PV of a single sum, 10 periods, 3%) $3,500,000  0.55368 = Issue price of bonds

1,937,880 $4,020,726

491

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

EXERCISES E 9-44 Journal Account and Explanation

Date 1.

Cash Bonds Payable (Record issuance of bonds at par) Cash Premium on Bonds Payable Bonds Payable (Record issuance of bonds at premium) Cash Discount on Bonds Payable Bonds Payable (Record issuance of bonds at discount)

Debit 1,500,000

Credit 1,500,000

1,519,000 19,000 1,500,000 1,468,000 32,000 1,500,000

The yield is highest when the bonds sell at a discount. We know this because as the yield increases relative to the stated rate, the price at which the bonds are issued decreases.

E 9-45 1. 2. 3. 4. 5.

750 bonds  ($1,000 + $30 per bond) 750 bonds  ($1,000 − $10 per bond) 750 bonds  ($1,000 per bond  0.92) 750 bonds  ($1,000 per bond  1.03) 750 bonds  $975 per bond

= $772,500 = $742,500 = $690,000 = $772,500 = $731,250 Journal Account and Explanation

Date

Cash Discount on Bonds Payable Bonds Payable (Record issuance of bonds at discount) 6.

750 bonds  $1,015 per bond Date

Debit 731,250 18,750

Credit

750,000

$761,250

Journal Account and Explanation Cash Premium on Bonds Payable Bonds Payable (Record issuance of bonds at premium)

Debit 761,250

Credit 11,250 750,000

492

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-46 Date 2024 Jan.

2024 Dec.

2025 Dec.

Journal Account and Explanation

Debit

1 Cash Bonds Payable (Record issuance of bonds at discount)

420,000

31 Interest Expense* Cash (Record interest expense)

33,600

31 Bonds Payable Cash (Record repayment of bond principal)

420,000

Credit

420,000

33,600

420,000

* $420,000  0.08 = $33,600

Interest expense would be lower by the amount of the premium amortization.

E 9-47 1.

Yearly interest allocation: $2,544/2 years

2. Date 2024 Jan.

2024 Dec.

2025 Dec.

$1,272

Journal Account and Explanation

Debit

1 Cash Discount on Notes Payable Notes Payable (Record issuance of note at discount)

10,000 2,544

31 Interest Expense Discount on Notes Payable (Record interest expense)

1,272

31 Interest Expense Notes Payable Discount on Notes Payable Cash (Record interest expense and repayment of note principal)

1,272 12,544

Credit

12,544

1,272

1,272 12,544

493

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-48 Date 2024 Jan.

Journal Account and Explanation 1 Cash Premium on Bonds Payable Bonds Payable (Record issuance of bonds at premium)

Debit

Credit

1,887,000 87,000 1,800,000

Semiannual interest payment: $1,800,000  0.08  6/12 = $72,000 Date 2024 June

Journal Account and Explanation 30 Interest Expense Premium on Bonds Payable* Cash (Record interest expense)

Debit

Credit

69,100 2,900 72,000

* $87,000/30 periods = $2,900

Interest expense for 2024: $69,100  2 = $138,200

The yield would decrease because the risk of interest rate fluctuation would be transferred from the lenders to Swiss. That is, because the lenders are no longer bearing the risk of interest rate fluctuation, they are willing to accept a lower return.

Swiss should consider its ability to handle the risk of higher interest payments should interest rates rise with a variable rate.

E 9-49 Journal Account and Explanation

Date

Debit

Credit

1. Jan.

1 Cash Discount on Bonds Payable Bonds Payable (Record issuance of bonds at discount)

335,000 50,000 385,000

Cash payment: $385,000  0.12  6/12 =

$23,100

Discount: ($385,000 − $335,000)/30 periods =

$ 1,667

Interest expense: $23,100 + $1,667 =

$24,767

494

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-49 (Continued) 3. Date 20X1 June

Journal Account and Explanation

Debit

30 Interest Expense Discount on Bonds Payable Cash (Record interest expense)

$24,767  2 =

Credit

24,767 1,667 23,100

$49,534

E 9-50 1. 2. 3.

($3,000,000  0.09) = $270,000 ($3,000,000  0.09) − $12,000 = $258,000 ($3,000,000  0.09) + $33,000 = $303,000

Interest expense: Interest expense: Interest expense:

E 9-51 1.

The annual interest payments are $24,000 (semiannual payments of $12,000) and the principal is $200,000 ($192,000 carrying value + $8,000 discount). Therefore, the stated rate is: $24,000 = 12% $200,000

Interest expense:

$12,000 + $800

$12,800

Discount amortization: $12,800 − $12,000 =

$800

The liability balance on June 30, 2025: $193,600 + $800 = $194,400

E 9-52

Date 2024 Jan.

Journal Account and Explanation 1 Cash

Debit 420,000

Bonds Payable Premium on Bonds Payable (Record issuance of bonds at premium) 2.

2024 June

30 Interest Expense Premium on Bonds Payable Cash (Record interest expense)

Credit

400,000 20,000

12,000 2,000

14,000

495

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-52 (Continued)

2025 interest expense: $12,000  2 = $24,000

Reported among long-term liabilities at December 31, 2027: Bonds payable: 7% Bonds, due 2028............................................................... Add: Unamortized premium on bonds payable .......................

$400,000 4,000

$404,000

E 9-53 Date 2025 Jan.

2025 June

Journal Account and Explanation

Debit

1 Cash Discount on Bonds Payable Bonds Payable (Record issuance of bonds at discount)

285,000 15,000

30 Interest Expense Discount on Bonds Payable Cash (Record interest expense)

15,000

Credit

300,000

1,500 13,500

2027 interest expense: $15,000  2 = $30,000

The bonds would be reported as follows on Panamint’s December 31, 2028 balance sheet: Bonds payable: 9.0% Bonds, due 2029 ......................................................... Less: Discount on bonds payable .........................................

$300,000 (3,000)

$297,000

496

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-54 1. Period At issue 06/30/24 12/31/24 06/30/25 12/31/25 06/30/26 12/31/26 06/30/27 12/31/27

Cash Paymenta (Credit) — $35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000

Interest Expenseb (Debit) — $30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000

Premium on Bonds Payablec (Debit) — $5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000

Premium on Bonds Payable Balance $40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0

Carrying Valued $1,040,000 1,035,000 1,030,000 1,025,000 1,020,000 1,015,000 1,010,000 1,005,000 1,000,000

Cash Payment = $1,000,000  0.07  6/12 = $35,000 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = ($1,040,000 − $1,000,000)/8 periods = $5,000 d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

2. Date 2025 Dec.

Journal Account and Explanation 31 Interest Expense Premium on Bonds Payable Cash (Record interest expense)

Debit

Credit

30,000 5,000 35,000

The bonds payable will appear as a liability on the company’s balance sheet on December 31, 2025, in the amount of $1,020,000. Bonds payable .............................................................................. Add: Premium on bonds payable................................................... Bonds payable, net .......................................................................

$1,000,000 20,000

$1,020,000

497

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-55 Date 2024 Jan.

2024 Dec.

2025 Dec.

Journal Account and Explanation

Debit

1 Cash Discount on Bonds Payable Bonds Payable (Record issuance of bonds at discount)

90,000 12,400

31 Interest Expense* Discount on Bonds Payable (Record interest expense)

6,200

31 Interest Expense* Discount on Bonds Payable (Record interest expense) 31 Bonds Payable Cash (Record repayment of bond principal)

6,200

Credit

102,400

6,200

6,200 102,400 102,400

* $12,400/2 = $6,200

E 9-56

Date 2024 Jan.

Journal Account and Explanation 1 Cash Discount on Notes Payable Notes Payable (Record issuance of bonds at discount)

Debit

Credit

200,000 46,660 246,660

The entry for both years will be as follows: Date Dec.

Journal Account and Explanation 31 Interest Expense* Discount on Notes Payable (Record interest expense)

Debit 11,665

Credit 11,665

* $46,660/4 = $11,665

498

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-56 (Continued) 3. Date 2027 Dec.

Journal Account and Explanation 31 Interest Expense* Discount on Notes Payable (Record interest expense) 31 Notes Payable Cash (Record repayment of bond principal)

Debit

Credit

11,665 11,665 246,660 246,660

* $46,660/4 = $11,665

E 9-57 1. Date 2024 Jan.

Journal Account and Explanation 1 Cash Discount on Notes Payable Notes Payable (Record issuance of notes at discount)

Debit

Credit

822,186 77,814 900,000

Semiannual interest payments: $900,000  0.07  6/12 = $31,500

3. Period At issue 06/30/24 12/31/24 07/01/25 12/31/25

Cash Paymenta (Credit) — $31,500 31,500 31,500 31,500

Interest Expenseb (Debit) — $32,887 32,943 33,001 33,061

Discount on Notes Payablec (Cebit) — $1,387 1,443 1,501 1,561

Discount on Notes Payable Balance Carrying Valued $77,814 $822,186 76,427 823,573 74,984 825,016 73,483 826,517 71,922 828,078

Cash Payment = $900,000  0.07  6/12 = $31,500 Interest Expense = Carrying Value  0.08  6/12 c Discount on Notes Payable = Interest Expense − Cash Payment d Carrying Value = Previous Carrying Value + Change in Discount on Notes Payable Balance a

499

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-57 (Continued) 4. Date 2024 June

Journal Account and Explanation 30 Interest Expense Cash Discount on Notes Payable (Record interest expense)

Debit

Credit

32,887 31,500 1,387

Interest expense for 2021: $33,001 + $33,061 = $66,062

E 9-58 1. Date 2023 Jan.

Journal Account and Explanation 1 Cash Premium on Bonds Payable Bonds Payable (Record issuance of bonds at premium)

Interest payments: $315,000  0.11 = $34,650

Cash Paymenta (Credit) — $34,650 34,650

Period At issue 12/31/23 12/31/24

Interest Expenseb (Debit) — $30,011 29,594

Debit

Credit

333,456 18,456 315,000

Premium on Premium on c Bonds Payable Bonds Payable (Debit) Balance Carrying Valued — $18,456 $333,456 $4,639 13,817 328,817 5,056 3,865 153,865

Cash Payment = $315,000  0.11  12/12 = $34,650 Interest Expense = Carrying Value  0.09  12/12 c Premium on Bonds Payable = Cash Payment − Interest Expense d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

4. Date 2023 Dec.

Journal Account and Explanation 31 Interest Expense Premium on Bonds Payable Cash (Record interest expense)

Debit

Credit

30,011 4,639 34,650

Interest expense for 2023: $30,011 Interest expense for 2024: $29,594

500

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-59 1.

Stated interest rate: $18,000*/$200,000 = 9%

* The annual cash interest payment is $18,000.

Effective annual interest rate: ($9,290/$197,660)  2 = 9.4% (or 4.7% per 6 months)

3. Period 12/31/2023 06/30/2024 12/31/2024

Cash Paymenta (Credit) $9,000 9,000 9,000

Interest Expenseb (Debit) $9,277 9,290 9,304

Discount on Discount on Bonds Payablec Bonds Payable (Debit) Balance Carrying Valued $277 $2,340 $197,660 290 2,050 197,950 304 1,746 198,254

Cash Payment = $200,000  0.09  6/12 = $9,000 Interest Expense = Carrying Value  0.094  6/12 c Discount on Bonds Payable = Interest Expense − Cash Payment d Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance a

The liability balance on December 31, 2024, is $198,254: Bonds payable: 9% Bonds, due 2024 .................................................................. Less: Discount on bonds payable................................................

$200,000 (1,746)

$198,254

E 9-60 1.

Stated interest rate: $18,000*/$200,000 = 9%

* The annual cash interest payment is $18,000.

Effective annual interest rate: ($8,465/$206,457)  2 = 8.2% (or 4.1% per 6 months)

3. Period At issue 06/30/24 12/31/24 06/30/25 12/31/25

Cash Paymenta (Credit) — $9,000 9,000 9,000 9,000

Interest Expenseb (Debit) — $8,465 8,443 8,420 8,396

Premium on Premium on Bonds Payablec Bonds Payable (Debit) Balance Carrying Valued — $6,457 $206,457 $535 5,922 205,922 557 5,365 205,365 580 4,785 204,785 604 4,181 204,181

Cash Payment = $200,000  0.09  6/12 = $9,000 Interest Expense = Carrying Value  0.082  6/12 c Premium on Bonds Payable = Cash Payment − Interest Expense d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

501

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-60 (Continued) 4.

The bonds will mature when the premium is fully amortized. The only way to be sure is to complete the amortization table. By doing that (see the following table) we find that the bonds will mature on December 31, 2028.

Period At issue 06/30/24 12/31/24 06/30/25 12/31/25 06/30/26 12/31/26 06/30/27 12/31/27 06/30/28 12/31/28

Cash Paymenta (Credit) — $9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000

Interest Expenseb (Debit) — $8,465 8,443 8,420 8,396 8,371 8,346 8,319 8,291 8,262 8,230e

Premium on Premium on Bonds Payablec Bonds Payable (Debit) Balance Carrying Valued — $6,457 $206,457 $535 5,922 205,922 557 5,365 205,365 580 4,785 204,785 604 4,181 204,181 629 3,552 203,552 654 2,898 202,898 681 2,217 202,217 709 1,508 201,508 738 770 200,770 770 0 200,000

E 9-61

Period At issue 1/31 2/28 3/31 4/30 5/31 6/30 7/31 8/31 9/30 10/31 11/30 12/31

Cash Payment (Credit) — $3,914.50 3,914.50 3,914.50 3,914.50 3,914.50 3,914.50 3,914.50 3,914.50 3,914.50 3,914.50 3,914.50 3,914.50

Interest Expensea (Debit) — $300.00 275.90 251.65 227.23 202.65 177.90 152.99 127.91 102.67 77.26 51.67 26.17d

Reduction of Note Payableb (Debit) — $3,614.50 3,638.60 3,662.85 3,687.27 3,711.85 3,736.60 3,761.51 3,786.59 3,811.83 3,837.24 3,862.83 3,888.33

Note Payable Balancec $45,000.00 41,385.50 37,746.90 34,084.05 30,396.78 26,684.93 22,948.33 19,186.82 15,400.23 11,588.40 7,751.16 3,888.33 0.00

Interest Expense = Carrying Value  0.08  1/12 Reduction of Note Payable = $3,914.50 − Interest Expense c Note Payable Balance = Previous Note Payable Balance − Reduction of Note Payable d Difference due to rounding a

502

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-62 Date Mar.

Apr.

Journal Account and Explanation 31 Interest Expense Note Payable Cash (Record monthly payment) 30 Interest Expense Note Payable Cash (Record monthly payment)

Debit 251.65 3,662.85

Credit

3,914.50 227.23 3,687.27 3,914.50

E 9-63 Interest expense: $250,000  0.12  1/12 = Principal repayment: $2,571.53 − $2,500.00 =

$2,500.00 $71.53

E 9-64 Date 2027 Dec.

Journal Account and Explanation 31 Interest Expense Discount on Bonds Payable* (Record interest expense)

Debit

Credit

87,500 87,500

* [$1,000,000  (1 − 0.65)]/4 years = $87,500

E 9-65 After-Tax Interest Rate

= = =

(1 − Tax Rate)  Interest (1 − 0.20)  0.06 4.8%

E 9-66 1.

Interest net of income taxes: $3,000,000  0.10  (1 − 0.21) = $237,000

Diamond incurred interest expense of $300,000 ($3,000,000  0.10). However, since interest expenses are tax deductible, Diamond Company can decrease its taxes by $63,000 ($300,000 − $237,000). These savings increase Diamond Company’s financial leverage. The money it needs to borrow is now substantially less.

503

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-67 1.

Total Liabilities Total Equity $8,972 = $29,803 = 0.301

Debt to Equity =

Debt to Total Assets =

Long-Term Debt to Equity =

Times Interest Earned (Accrual Basis) =

Total Liabilities Total Assets $8,972 = $38,775 = 0.231

Long-Term Debt Total Equity $4,400 = $29,803 = 0.148

Operating Income Interest Expense $1,223 = $398 = 3.073 Cash Flows from Operations +

Taxes Paid + Interest Paid Interest Payments $1,015 + $150 + $432 = $432 = 3.697

Times Interest Earned (Cash Basis) =

The liabilities the company holds are only about 30.1% of the size of the company’s equity. The value of the stockholders’ equity is more than triple that of the company’s debt. The company’s liabilities are also low in comparison to its assets. Additionally, the company has much less longterm debt than equity. Lastly, its operating income would be able to cover its debt obligations more than three-fold.

504

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

E 9-68 a.

PV of interest payments: = ($500,000  0.08  6/12)  (PV of an annuity, 30 periods, 3%) = $20,000  19.60044 = $392,009 PV of principal payments: = $500,000  (PV of a single amount, 30 periods, 3%) = $500,000  0.41199 = $205,995 Issue price of bonds:

$392,009 + $205,995 = $598,004

PV of interest payments: = ($500,000  0.08  6/12)  (PV of an annuity, 30 periods, 5%) = $20,000  15.37245 = $307,449 PV of principal payments: = $500,000  (PV of a single amount, 30 periods, 3%) = $500,000  0.23138 = $115,690 Issue price of bonds:

$307,449 + $115,690 = $423,139

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

PROBLEM SET A P 9-69A Fridley Manufacturing Liabilities Section of the Balance Sheet December 31, 2024 Current liabilities: Accounts payable.......................................................................... Interest payable............................................................................ Income taxes payable ................................................................... Current portion of installment note* ............................................. Total current liabilities ............................................................. Long-term liabilities: Bonds payable: Bonds payable (8.7%, due in 2027) ........................................... Bonds payable (9.4%, due in 2031) ........................................... Less: Discount on bonds payable .............................................. Bonds payable (9.4%, due in 2031), net ............................. Notes payable: Notes payable (7.8%, due in 2029) ............................................ Add: Premium on notes payable............................................... Notes payable (7.8%, due in 2029), net.............................. Installment note payable (8%)* ................................................ Note payable (4%, due in 2030) ................................................ Less: Discount on note payable ................................................ Notes payable (4%, due in 2030), net ................................ Other long-term liabilities: Lease liability ........................................................................... Deferred tax liability ................................................................ Total liabilities .....................................................................................

$ 62,500 38,700 26,900 30,000 $158,100

50,000 $ 800,000 (12,600) 787,400 $400,000 6,100 406,100 90,000 $50,000 (18,100) 31,900 41,500 133,400 $1,698,400

* $120,000 installment note payable due in equal ($30,000) installments from 2025 through 2028. The $30,000 due in 2025 is current, and the $90,000 due from 2026–2028 is long-term.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-70A

Date 2023 June

2023 Dec.

2024 May

Journal Account and Explanation 1

Cash Notes Payable (Record issuance of note at par)

Debit

Credit

150,000 150,000

Interest Expense* Interest Payable (Record interest expense)

5,600

Interest Expense** Interest Payable Cash (Record interest expense and payment of interest)

4,000 5,600

5,600

9,600

* $150,000  0.064  7/12 = $5,600 ** $150,000  0.064  5/12 = $4,000

Current liabilities: Interest payable .......................................................................

$5,600

Long-term liabilities: Notes payable, 6.4%, due in 2026 .............................................

150,000

Date 2026 May

Journal Account and Explanation 31

Interest Expense* Interest Payable Cash (Record interest expense and payment of interest) Notes Payable Cash (Record repayment of note principal)

Debit

Credit

4,000 5,600 9,600

150,000 150,000

* $150,000  0.064  5/12 = $4,000

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-71A Cash Paymenta (Credit) — $9,000 9,000 9,000

Period At issue 12/31/25 12/31/26 12/31/27

Interest Expenseb (Debit) — $8,100 8,100 8,100

Premium on Bonds Payablec (Debit) — $900 900 900

Premium on Bonds Payable Balance $2,700 1,800 900 0

Carrying Valued $102,700 101,800 100,900 100,000

Cash Payment = $100,000  0.09  12/12 = $9,000 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = ($102,700 − $100,000)/3 periods = $900 d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

P 9-72A Journal Account and Explanation

Date 1.

2024 Jan.

2024 June

2024 Dec.

Debit

Cash Discount on Notes Payable Notes Payable (Record issuance of notes at discount)

792,800 7,200

Interest Expense Discount on Notes Payable* Cash** (Record interest expense)

39,360

Interest Expense Discount on Notes Payable* Cash (Record interest expense)

39,360

Credit

800,000

360 39,000

* $7,200/20 periods = $360 ** $800,000  0.0975  6/12 = $39,000

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-72A (Continued) 4.

At the end of the fifth year, one-half of the discount ($3,600) will have been amortized. Therefore, the carrying amount of the notes will be $796,400 ($800,000 − $3,600).

Beginning balance

Ending balance

Discount on Notes Payable 7,200 360 6 months’ amortization Year 1 360 6 months’ amortization Year 1 360 6 months’ amortization Year 2 360 6 months’ amortization Year 2 360 6 months’ amortization Year 3 360 6 months’ amortization Year 3 360 6 months’ amortization Year 4 360 6 months’ amortization Year 4 360 6 months’ amortization Year 5 360 6 months’ amortization Year 5 3,600

P 9-73A 1.

Amortization Table Cash Paymenta Period (Credit) At issue — 06/30/20 $33,250 12/31/20 33,250 06/30/21 33,250 12/31/21 33,250 06/30/22 33,250 12/31/22 33,250 06/30/23 33,250 12/31/23 33,250 06/30/24 33,250 12/31/24 33,250

Interest Expenseb (Debit) — $30,650 30,650 30,650 30,650 30,650 30,650 30,650 30,650 30,650 30,650

Premium on Bonds Payablec (Debit) — $2,600 2,600 2,600 2,600 2,600 2,600 2,600 2,600 2,600 2,600

Premium on Bonds Payable Balance $26,000 23,400 20,800 18,200 15,600 13,000 10,400 7,800 5,200 2,600 0

Carrying Valued $726,000 723,400 720,800 718,200 715,600 713,000 710,400 707,800 705,200 702,600 700,000

Cash Payment = $700,000  0.095  6/12 = $33,250 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = ($726,000 − $700,000)/10 periods = $2,600 d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-73A (Continued) 2. Date June

Dec.

Journal Account and Explanation 30 Interest Expense Premium on Bonds Payable Cash (Record interest expense) 31 Interest Expense Premium on Bonds Payable Cash (Record interest expense)

Debit 30,650 2,600

Credit

33,250 30,650 2,600 33,250

P 9-74A 1.

Amortization Table

Period At issue 06/30/20 12/31/20 06/30/21 12/31/21 06/30/22 12/31/22 06/30/23 12/31/23 06/30/24 12/31/24

Cash Paymenta (Credit) — $32,250 32,250 32,250 32,250 32,250 32,250 32,250 32,250 32,250 32,250

Interest Expenseb (Debit) — $36,105 36,105 36,105 36,105 36,105 36,105 36,105 36,105 36,105 36,105

Discount on Bonds Payablec (Credit) — $3,855 3,855 3,855 3,855 3,855 3,855 3,855 3,855 3,855 3,855

Discount on Bonds Payable Balance $38,550 34,695 30,840 26,985 23,130 19,275 15,420 11,565 7,710 3,855 0

Carrying Valued $711,450 715,305 719,160 723,015 726,870 730,725 734,580 738,435 742,290 746,145 750,000

Cash Payment = $750,000  0.086  6/12 = $32,250 Interest Expense = Cash Payment + Discount on Bonds Payable C Discount on Bonds Payable = ($750,000 − $711,450)/10 periods = $3,855 d Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance a

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-74A (Continued) 2. Date June

Dec.

Journal Account and Explanation 30 Interest Expense Discount on Bonds Payable Cash (Record interest expense) 31 Interest Expense Discount on Bonds Payable Cash (Record interest expense)

Debit 36,105

Credit 3,855 32,250

36,105 3,855 32,250

P 9-75A 1.

Amortization Table

Period At issue 06/30/24 12/31/25 06/30/26 12/31/27

Cash Paymenta (Credit) — $118,750 118,750 118,750 118,750

Interest Expenseb (Debit) — $112,500 112,500 112,500 112,500

Premium on Bonds Payable c (Debit) — $6,250 6,250 6,250 6,250

Premium on Bonds Payable Balance $125,000 118,750 112,500 106,250 100,000

Carrying Valued $5,125,000 5,118,750 5,112,500 5,106,250 5,100,000

Cash Payment = $5,000,000  0.0475  6/12 = $118,750 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = ($5,125,000 − $5,000,000)/20 periods = $6,250 d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

Yes. Girves is in effect buying the plant and using the county government to secure less expensive financing for the plant. Girves is assuming most of the risks of ownership.

Yes. Girves has accepted the liability to repay the principal and interest on these bonds. Certainly, a liability must be recorded if an asset is recorded, and vice versa.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-76A

Date 2024 Jan.

2024 Dec.

2025 Dec.

Journal Account and Explanation

Debit

1 Cash Discount on Notes Payable Notes Payable (Record issuance of notes at discount)

110,000 45,000

31 Interest Expense Discount on Notes Payable* (Record interest expense)

22,500

31 Interest Expense Discount on Notes Payable (Record interest expense)

22,500

31 Notes Payable Cash (Record repayment of note principal)

155,000

Credit

155,000

22,500

155,000

* $45,000/2 periods = $22,500

P 9-77A Amortization Table

Period At issue 12/31/25 12/31/26 12/31/27 12/31/28

Cash Payment (Credit) — $0 0 0 0

Interest Expensea (Debit) — $205,000 205,000 205,000 205,000

Discount on Bonds Payableb (Credit) — $205,000 205,000 205,000 205,000

Discount on Bonds Payable Balance $820,000 615,000 410,000 205,000 0

Carrying Valuec $2,180,000 2,385,000 2,590,000 2,795,000 3,000,000

Interest Expense = Cash Payment + Discount on Bonds Payable Discount on Bonds Payable = ($3,000,000 − $2,180,000)/4 periods = $205,000 c Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance b

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

PROBLEM SET B P 9-69B Craig Corporation Liabilities Section of the Balance Sheet December 31, 2023 Current liabilities: Accounts payable.......................................................................... Interest payable............................................................................ Income taxes payable ................................................................... Current portion of installment note* ............................................. Total current liabilities ............................................................. Long-term liabilities: Bonds payable: Bonds payable (8.3%, due in 2027) ........................................... Bonds payable (9.4%, due in 2028) ........................................... Less: Discount on bonds payable .............................................. Bonds payable (9.4%, due in 2028), net .................................... Notes payable: Notes payable (7.8%, due in 2032) ............................................ Add: Premium on notes payable............................................... Notes payable (7.8%, due in 2032), net ..................................... Installment note payable (9%)* ................................................ Note payable (3%, due in 2030) ................................................ Less: Discount on note payable ................................................ Note payable (3%, due in 2030), net ......................................... Other long-term liabilities: Lease liability .................................................................... Deferred tax liability ......................................................... Total liabilities .....................................................................................

$ 73,000 33,400 28,100 10,000 $144,500

60,000 $ 900,000 (11,900) 888,100 $350,000 5,000 355,000 100,000 $ 50,000 (20,200) 29,800 30,000 127,600 $462,100

* $110,000 installment note payable due in equal ($10,000 = $110,000 ÷ 11 years) installments from 2024 through 2034. The $10,000 due in 2024 is current, and the $100,000 due from 2025 to 2034 is long-term.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-70B

Date 2023 Feb.

Dec.

2024 Jan.

Journal Account and Explanation 1

Debit

Cash Notes Payable (Record issuance of notes at par) Interest Expense* Interest Payable (Record interest expense)

200,000

31 Interest Expense** Interest Payable Cash (Record interest expense and interest payment)

1,433 15,767

Credit

200,000 15,767 15,767

17,200

* $200,000  0.086  11/12 = $15,767 ** $200,000  0.086  1/12 = $1,433

Current liabilities: Interest payable .........................................................................

$15,767

Long-term liabilities: Notes payable, 8.6%, due in 2026 ...............................................

200,000

5. Date 2026 Jan.

Journal Account and Explanation 31 Interest Expense* Interest Payable Cash (Record interest expense and interest payment) 31 Notes Payable Cash (Record repayment of note principal)

Debit

Credit

1,433 15,767 17,200

200,000 200,000

* $200,000  0.086  1/12 = $1,433

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-71B

Period At issue 12/31/24 12/31/25 12/31/26

Cash Paymenta (Credit) — $32,000 32,000 32,000

Interest Expenseb (Debit) — $16,333 16,333 16,334

Premium on Bonds Payablec (Debit) — $15,667 15,667 15,666e

Premium on Bonds Payable Balance $47,000 31,333 15,666 0

Carrying Valued $447,000 431,333 415,666 400,000

Cash Payment = $400,000  0.08  12/12 = $32,000 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = ($447,000 − $400,000)/3 periods = $15,667 d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance e Difference due to rounding a

P 9-72B

Date 2024 Jan.

2024 June

Dec.

Journal Account and Explanation

Debit

1 Cash Discount on Notes Payable Notes Payable (Record issuance of notes at discount)

985,500 14,500

30 Interest Expense Discount on Notes Payable* Cash** (Record interest expense) 31 Interest Expense Discount on Notes Payable* Cash** (Record interest expense)

44,475

Credit

1,000,000

725 43,750 44,475 725 43,750

* $14,500/20 periods = $725 ** $1,000,000  0.0875  6/12 = $43,750

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-72B (Continued) 4.

At the end of the fifth year, one-half of the discount ($7,250) will have been amortized. Therefore, the carrying amount of the notes will be $992,750 ($1,000,000 − $7,250). Discount on Notes Payable

Beginning balance

Ending balance

14,500 725

6 months’ amortization Year 1

725

6 months’ amortization Year 1

725

6 months’ amortization Year 2

725

6 months’ amortization Year 2

725

6 months’ amortization Year 3

725

6 months’ amortization Year 3

725

6 months’ amortization Year 4

725

6 months’ amortization Year 4

725

6 months’ amortization Year 5

725

6 months’ amortization Year 5

7,250

P 9-73B 1.

Amortization Table

Period At issue 06/30/X1 12/31/X1 06/30/X2 12/31/X2 06/30/X3 12/31/X3 06/30/X4 12/31/X4 06/30/X5 12/31/X5

Cash Paymenta (Credit) — $46,750 46,750 46,750 46,750 46,750 46,750 46,750 46,750 46,750 46,750

Interest Expenseb (Debit) — $39,250 39,250 39,250 39,250 39,250 39,250 39,250 39,250 39,250 39,250

Premium on Bonds Payablec (Debit) — $7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500

Premium on Bonds Payable Balance $75,000 67,500 60,000 52,500 45,000 37,500 30,000 22,500 15,000 7,500 0

Carrying Valued $1,175,000 1,167,500 1,160,000 1,152,500 1,145,000 1,137,500 1,130,000 1,122,500 1,115,000 1,107,500 1,100,000

Cash Payment = $1,100,000  0.085  6/12 = $46,750 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = ($1,175,000 − $1,100,000)/10 periods = $7,500 d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-73B (Continued) 2. Date 20X1 June

Dec.

Journal Account and Explanation 30 Interest Expense Premium on Bonds Payable Cash (Record interest expense) 31 Interest Expense Premium on Bonds Payable Cash (Record interest expense)

Debit

Credit

39,250 7,500 46,750 39,250 7,500 46,750

P 9-74B 1.

Amortization Table

Period At issue 06/30/X1 12/31/X1 06/30/X2 12/31/X2 06/30/X3 12/31/X3 06/30/X4 12/31/X4 06/30/X5 12/31/X5

Cash Paymenta (Credit) — $31,200 31,200 31,200 31,200 31,200 31,200 31,200 31,200 31,200 31,200

Interest Expenseb (Debit) — $37,200 37,200 37,200 37,200 37,200 37,200 37,200 37,200 37,200 37,200

Discount on Bonds Payablec (Credit) — $6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000

Discount on Bonds Payable Balance $60,000 54,000 48,000 42,000 36,000 30,000 24,000 18,000 12,000 6,000 0

Carrying Valued $740,000 746,000 752,000 758,000 764,000 770,000 776,000 782,000 788,000 794,000 800,000

Cash Payment = $800,000  0.078  6/12 = $31,200 Interest Expense = Cash Payment + Discount on Bonds Payable c Discount on Bonds Payable = ($800,000 − $740,000)/10 periods = $6,000 d Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance a

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-74B (Continued) 2. Date 20X1 June

Dec.

Journal Account and Explanation 30 Interest Expense Discount on Bonds Payable Cash (Record interest expense) 31 Interest Expense Discount on Bonds Payable Cash (Record interest expense)

Debit

Credit

37,200 6,000 31,200 37,200 6,000 31,200

P 9-75B 1.

Amortization Table

Period At issue 06/30/24 12/31/24 06/30/25 12/31/25

Cash Paymenta (Credit) — $154,375 154,375 154,375 154,375

Interest Expenseb (Debit) — $131,875 131,875 131,875 131,875

Premium on Bonds Payablec (Debit) — $22,500 22,500 22,500 22,500

Premium on Bonds Payable Balance $450,000 427,500 405,000 382,500 360,000

Carrying Valued $6,950,000 6,927,500 6,905,000 6,882,500 6,860,000

Cash Payment = $6,500,000  0.0475  6/12 = $154,375 Interest Expense = Cash Payment − Premium on Bonds Payable c Premium on Bonds Payable = ($6,950,000 − $6,500,000)/20 periods = $22,500 d Carrying Value = Previous Carrying Value − Change in Premium on Bonds Payable Balance a

Yes. Cook is in effect buying the plant and using the county government to secure less expensive financing for the plant. Cook is assuming most of the risks of ownership.

Yes. Cook has accepted the liability to repay the principal and interest on these bonds. Certainly, a liability must be recorded if an asset is recorded, and vice versa.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

P 9-76B Date 2024 Jan.

2024 Dec.

2025 Dec.

Journal Account and Explanation

Debit

1 Cash Discount on Notes Payable Notes Payable (Record issuance of note at discount)

90,000 20,300

31 Interest Expense Discount on Notes Payable* (Record interest expense)

10,150

31 Interest Expense Discount on Notes Payable* (Record interest expense) 31 Notes Payable Cash (Record interest expense)

10,150

Credit

110,300

10,150

10,150 110,300 110,300

* $20,300/2 periods = $10,150

P 9-77B Amortization Table

Period At issue 12/31/24 12/31/25 12/31/26

Cash Payment (Credit) — $0 0 0

Interest Expensea (Debit) — $60,000 60,000 60,000

Discount on Bonds Payableb (Credit) — $60,000 60,000 60,000

Discount on Bonds Payable Balance $180,000 120,000 60,000 0

Carrying Valuec $2,500,000 2,560,000 2,620,000 2,680,000

Interest Expense = Cash Payment + Discount on Bonds Payable Discount on Bonds Payable = ($2,680,000 − $2,500,000)/3 periods = $60,000 c Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance b

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

CASES Case 9-78 There are many possible answers to this question. Although accounting rules permit such treatment, they would not properly reflect Diversified Industries’ financial position. Stockholders of the company would be misled by the financial statements. Since the collapse of Enron, in which the same accounting treatment was used to hide its deteriorating financial position, the Sarbanes–Oxley Act of 2002 has made it mandatory to disclose transactions such as these on the company’s financial statements.

Case 9-79 1.

If the standard is not implemented and Roswell proceeds with the acquisition, its total liabilities will rise to $19.5 million, raising its debt to equity ratio from 1.5:1 to 1.95:1, which is within the limit set by the note indenture covenant. If the standard is implemented, Roswell’s total liabilities will rise to $17 million ($15 million + $2 million), raising its debt to equity ratio from 1.5:1 to 1.7:1. Borrowing an additional $4.5 million to acquire Ashland would increase total liabilities to $21.5 million ($17 million + $4.5 million), raising the ratio to 2.15:1, which exceeds the upper limit imposed by the note indenture covenant. Thus, if adoption of the new standard is likely, Roswell may be forced to abandon its acquisition plans. Note indentures are very difficult and costly to change; however, if the acquisition really represents a highly profitable opportunity for Roswell, it may be able to find a way to renegotiate the note indenture if the new standard is implemented.

One possibility is that you do not agree with the proposed standard and plan to vote against it; in that case, you can discuss your plans with other board members to try to convince a sufficient number of them to vote against the proposal. If you support the proposed standard, however, you should hear Martha’s arguments and determine whether she convinces you to change your position. (Since you have probably spent several years thinking about the pros and cons of the proposed standard, you are not likely to change your mind at this point.) Your best course of action is simply to state your arguments for supporting the proposal. The strongest arguments are based on general concepts about the nature of liabilities. You might also question Martha to make sure that she has properly interpreted the proposed standard and properly estimated its impact on her company’s liabilities. Further, you might also offer advice about renegotiating the bond indenture. Finally, you might point out that the new standard has the strong support of the Securities and Exchange Commission and that the continuance of private sector accounting standard setting depends on the FASB’s being responsive to the oversight role of the SEC.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

Case 9-80 1.

If income from operations is $550,000 per year, then earnings per share (EPS) is calculated as follows under the alternative financing plans: Financing with notes:

[$550,000 − (0.08  $1,250,000)]  (1 − 0.30) 50,000 shares = $6.30

EPS =

Financing with stock:

[$550,000  (1 − 0.30) 75,000 shares = $5.13

EPS =

Earnings per share are higher when the expansion is financed with notes; therefore, Gearing should finance with notes. 2.

If income from operations is $275,000 per year, then earnings per share is calculated as follows under the alternative financing plans: Financing with notes:

[$275,000 − (0.08  $1,250,000)]  (1 − 0.30) 50,000 shares = $2.45

EPS =

Financing with stock: $275,000  (1 − 0.30) 75,000 shares = $2.57

EPS =

Earnings per share are lower when the expansion is financed with notes; therefore, Gearing should finance with stock.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

Case 9-80 (Continued) 3.

If income from operations is $300,000 per year, then earnings per share is calculated as follows under the alternative financing plans: Financing with notes:

[$300,000 − (0.08  $1,250,000)]  (1 − 0.30) 50,000 shares = $2.80

EPS =

Financing with stock: $300,000  (1 − 0.30) 75,000 shares = $2.80

EPS =

If income from operations is $300,000, earnings per share are the same whether the expansion is financed with notes or with stock. Gearing should finance with notes for incomes above $300,000 and with stock for incomes below $300,000. Since income is above $300,000 only 40% of the time, financing with stock is the preferred option. 4.

A possible first step in the analysis would be to calculate the level of operating income at which the present level of debt financing ceases to be advantageous. This is the level of operating income at which earnings per share for the present financing arrangements equal earnings per share for a feasible reduction in debt financing. Of course, such calculations are based on speculation about the feasibility of debt reduction, possibilities for stock offerings, and assumptions about future tax rates. The financial statements contain some information that would be useful in forming the required speculations and estimates, but information about present and future capital markets and the firm’s access to those markets would also be required.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

Case 9-81 Net Income Average Common Shares Outstanding $770,000 = 300,000 shares = $2.57

1. EPS =

2. Income from operations .................. Less: Interest expense ..................... Income before taxes ........................ Less: Income taxes expense (30%) ............................ Net income ..................................... Earnings per share ...........................

As Reported $1,200,000 (100,000) $1,100,000

Changes Due to Expansion $350,000 (153,000)* $197,000

(330,000) $770,000

With Expansion $1,550,000 (253,000) $1,297,000 (389,100) $907,900 $3.03**

* $1,800,000  0.085 = $153,000 ** Earnings per Share = Net Income/Average Common Shares Outstanding = $907,900/300,000 shares = $3.03 (rounded)

Yes, this use of debt (or leverage) would be advantageous because it will substantially increase EPS. Of course, there is risk that projections are too optimistic, so part of the decision depends on the level of confidence Cook Corporation has in its projections. 3. Income from operations .................. Less: Interest expense ..................... Income before taxes ........................ Less: Income taxes expense (30%) ............................ Net income ..................................... Earnings per share ...........................

As Reported $1,200,000 (100,000) $1,100,000

Changes Due to Expansion $ 150,000 (153,000)* $ (3,000)

(330,000) $770,000

With Expansion $1,350,000 (253,000) $1,097,000 (329,100) $767,900 $2.56**

* $1,800,000  0.085 = $153,000 ** Earnings per Share = Net Income/Average Common Shares Outstanding = $767,900/300,000 shares = $2.56 (rounded)

No, this would not be advantageous because it does not increase EPS. Recognize that, although EPS doesn’t really go down, the added risk of the uncertainty of being able to obtain the projected numbers makes the project unattractive.

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Case 9-81 (Continued) 4. With equity financing: Income from operations .................. Less: Interest expense ..................... Income before taxes ........................ Less: Income taxes expense (30%) ............................ Net income ..................................... Earnings per share ...........................

As Reported $1,200,000 (100,000) $1,100,000

Changes Due to Expansion $ 200,000 0 $ 200,000

(330,000) $770,000

With Expansion $1,400,000 (100,000) $1,300,000 (390,000) $910,000 $2.28*

* Earnings per Share = Net Income/Average Common Shares Outstanding = $910,000/400,000 shares = $2.28 (rounded)

With debt financing:

Income from operations .................. Less: Interest expense ..................... Income before taxes ........................ Less: Income taxes expense (30%) ............................ Net income ..................................... Earnings per share ...........................

As Reported $1,200,000 (100,000) $1,100,000

Changes Due to Expansion $200,000 (153,000)* $ 47,000

With Expansion $1,400,000 (253,000) $1,147,000

(330,000)

(344,100)

$770,000

$ 802,900 $2.68**

* $1,800,000  0.085 = $153,000 ** Earnings per Share = Net Income/Average Common Shares Outstanding = $802,900/300,000 shares = $2.68 (rounded)

Cook would prefer to finance with debt because it results in a higher EPS. This is true even though the debt financing is riskier because it requires the interest be paid no matter how well (or poorly) things go. Further, Cook is likely to undertake the expansion project using debt because EPS is significantly higher ($2.68) than if the project is not undertaken ($2.57).

Case 9-82 Note: All numbers in millions other than percentages. 1.

Total liabilities and stockholders’ equity ....................................... Less: Total stockholders' equity .................................................... Total liabilities ..............................................................................

$25,051 703 $24,348

Long-term debt ............................................................................ Current portion of long-term debt ................................................. Total long-term debt .....................................................................

$9,963 977 $10,940

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Case 9-82 (Continued) 3.

The long-term debt footnote is #9: a. December 1, 2028 (4.800%) b. Near the end of the footnote, it provides the amounts maturing each of the next 5 years (this is a required disclosure) as follows: 2020 ................................................................................... 977 2021 ................................................................................... 1,164 2022 ................................................................................... 1,657 2023 ................................................................................... 694 2024 ................................................................................... 3,783 Total next 5 years ................................................................ $ 8,275 Thereafter, there is $2,665 that will mature. c.

From narrative in footnote 9: The credit agreement was increase to $4.5 billion in 2019. The interest rate is LIBOR plus a spread based on Marriott's public debt rating. The agreement expires on June 28, 2024.

$24,348 = 34.63 $703 $1,800 Times interest earned (accrual basis): = = 4.57 $394 Debt to equity: =

Marriott's debt to equity ratio indicates that they are heavily financed by debt. While this is not unusual in an industry that is heavily dependent on real estate, it would be prudent to compare Marriott's ratios to industry average. However, the times interest earned ratio suggests that Marriott's operations are easily able to cover its interest expense.

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Case 9-83 1.

Kroger’s “Debt Obligation” footnote (Note #6) states that its Senior Notes have interest rates ranging from 1.50% to 8%, so 8% is the highest. Sprouts "Long-Term Debt and Finance Lease Liabilities" footnote (Note #13) states that Sprouts can borrow up to $700.0 million on its Credit Agreement.

Times Interest Earned =

Operating Income Interest Expense

Kroger: $2,251 $603 = 3.73

2019 =

$2,614 $620 = 4.22

2018 =

Sprouts: $217,360 $21,192 = 10.26

2019 =

$222,911 $27,435 = 8.13

2018 =

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

Case 9-83 (Continued) 3.

Kroger: If long-term debt is calculated as formal debt (long-term debt and current portion of long-term debt): Long-Term Debt Total Equity $12,111 2019 = $8,573 = 1.41

Long-Term Debt to Equity =

$12,072 $7,835 = 1.54

2018 =

If it is considered to be all long term liabilities: $22,440 $8,573 = 2.62

2019 =

$16,009 $7,835 = 2.04

2018 =

Sprouts: If long-term debt is calculated as formal debt (long-term debt and current portion of long-term debt): Long-Term Debt Total Equity $549,419 2019 = $581,952 = 0.94

Long-Term Debt to Equity =

$453,000 $589,196 = 0.77

2018 =

If it is considered to be all long-term liabilities: $1,724,219 $581,952 = 2.96

2019 =

$776,418 $589,196 = 1.32

2018 =

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 9: Long-Term Liabilities

Case 9-83 (Continued) 4.

Debt to Equity =

Total Liabilities Total Equity

Kroger: $36,683 $8,573 = 4.28

2019 =

$30,283 $7,835 = 3.87

2018 =

Sprouts: $2,141,031 $581,952 = 3.68

2019 =

$1,086,418 $589,196 = 1.84

2018 =

Long-Term Debt Total Assets If long-term debt is formal debt: Kroger: $12,111 $45,256 = 0.27

2019 =

$12,072 $38,118 = 0.32

2018 =

Sprouts: $549,419 $2,722,983 = 0.20

2019 =

$453,000 $1,675,614 = 0.27

2018 =

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Case 9-83 (Continued) If long-term debt is all long-term liabilities: Kroger: $22,440 $45,256 = 0.50

2019 =

$16,009 $38,118 = 0.42

2018 =

Sprouts: $1,724,219 $2,722,983 = 0.63

2019 =

$776,418 $1,675,614 = 0.46

2018 =

Debt to Total Assets =

Total Liabilities Total Assets

Kroger: $36,683 $45,256 = 0.81

2019 =

$30,283 $38,118 = 0.79

2018 =

Sprouts: $2,141,031 $2,722,983 = 0.79

2019 =

$1,086,418 $1,675,614 = 0.65

2018 =

Kroger has a greater proportion of long-term debt than Sprouts. However, both companies are easily able to cover their interest expense/payments through operations. You could reference industry averages to see how the companies fare with their liabilities as a percentage of equity and total assets, but there are no obvious long-term solvency issues.

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Annual Report Problem: (amounts in millions) 51,236 54,352 28,670 7,307 15,843 1,201

Total assets Total liabilities Long-term debt Other long-term liabilities Operating income Interest expense

Total assets Total liabilities Long-term debt Operating income Interest expense

Lease payments

$ 955

Debt to equity

15.10

Debt to total assets

1.07

Long-term debt to equity

8.04

Times interest earned

12.91

Make interest payments?

Yes

53,797.80 57,613.12 30,676.90 16,593.00 1,285.07

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Case 9-106 1. Date 2024 July

Journal Account and Explanation 1 Cash Discount on Bonds Payable Bonds Payable (Record issuance of bonds at discount)

Debit

Credit

1,378,300 121,700 1,500,000

Period At issue 12/31/24 06/30/25 12/31/25

Cash Paymenta (Credit) — $45,000 45,000 45,000

Interest Expenseb (Debit) — $57,170 57,170 57,170

Discount on Bonds Payablec (Credit) — $12,170 12,170 12,170

Discount on Bonds Payable Balance $121,700 109,530 97,360 85,190

Carrying Valued $1,378,300 1,390,470 1,402,640 1,414,810

Cash Payment = $1,500,000  0.06  6/12 = $45,000 Interest Expense = Cash Payment + Discount on Bonds Payable c Discount on Bonds Payable = ($1,500,000 − $1,378,300)/10 periods = $12,170 d Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance a

b. Date 2024 Dec.

Journal Account and Explanation 31 Interest Expense Cash Discount on Bonds Payable (Record interest payment)

Debit

Credit

57,170 45,000 12,170

Long-term liabilities: Bonds payable ....................................................................... $1,500,000 Less: Discount on bonds payable ............................................ (109,530) Bonds payable (net) ..................................................................... $1,390,470

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3. a.

Period At issue 12/31/24 06/30/25 12/31/25

Cash Paymenta (Credit) — $45,000 45,000 45,000

Interest Expenseb (Debit) — $55,132 55,537 55,959

Discount on Bonds Payablec (Credit) — $10,132 10,537 10,959

Discount on Bonds Payable Balance $121,700 111,568 101,031 90,072

Carrying Valued $1,378,300 1,388,432 1,398,969 1,409,928

Cash Payment = $1,500,000  0.06  6/12 = $45,000 Interest Expense = Carrying Value  0.08  6/12 c Discount on Bonds Payable = $55,132 − $45,000 d Carrying Value = Previous Carrying Value + Change in Discount on Bonds Payable Balance a

b. Date 2024 Dec.

Journal Account and Explanation 31 Interest Expense Cash Discount on Bonds Payable (Record interest payment)

Long-term liabilities: Bonds payable ....................................................................... Less: Discount on bonds payable ............................................ Bonds payable (net) ...................................................................

Debit

Credit

55,132 45,000 10,132

$1,500,000 (111,568) $1,388,432

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 10: Stockholders’ Equity

STOCKHOLDERS’ EQUITY

DISCUSSION QUESTIONS 1.

Stockholders’ equity, which is also called equity, represents the owners’ claims against the assets of a corporation after all liabilities have been deducted. There are various elements of equity, and the stockholders’ equity section of the balance sheet clearly classifies these elements according to their source: (1) Capital stock—split between preferred and common stock and the associated additional paid-in capital (2) Retained earnings or deficit (3) Accumulated other comprehensive income (4) Treasury stock

A share of stock represents part ownership of the company.

Corporations issue stock to raise cash (or capital) in a way that eases the transfer of ownership and limits the liability of owners.

A privately held corporation is one whose stock is held by a relatively small group of private individuals, whereas a publicly held corporation is one whose stock is owned and purchasable by the general public.

Authorized shares are the maximum number of shares the corporation may issue in each class of stock. This number is included in the corporate charter.

Corporations can buy back their own stock. When a corporation purchases its own previously issued stock, it is called treasury stock. These shares are no longer outstanding. Therefore, the number of shares outstanding is the number of issued shares actually in the hands of stockholders. When firms reacquire their own stock, the reacquired shares are not considered to be outstanding.

Common stockholders have four main benefits. Common stockholders typically have the right to: (1) vote in the election of the board of directors (2) share in the profits and dividends of the company (3) keep the same percentage of ownership if new stock is issued (preemptive right) (4) share in the assets in liquidation in proportion to their holdings. This is referred to as the “residual claim,” because common stockholders are only paid after all creditors and preferred stockholders are paid in full (which is very rare in liquidation).

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Preferred stock grants certain privileges, usually involving dividends, to its holders that are not granted to holders of common stock. Common stock confers voting rights. Dividends on common stock are usually more closely correlated with the success of the corporation than are preferred dividends. Other differences include dividend preferences, conversion privileges, liquidation preferences, call provisions, and denial of voting rights. The first three are usually advantages of preferred stockholders, while the last two are disadvantages.

Preferred dividends are conceptually similar to interest payments. Specifically, preferred dividends are a contractually defined amount (e.g., some percentage of par) and are typically paid each year. Further, both debt and preferred stock are paid off in full before common stockholders receive anything in liquidation. Additionally, neither preferred stock nor debt provides voting rights. Finally, the value of preferred stock, like the value of debt, is most closely tied to interest rate levels and the company’s overall credit worthiness.

10. Each form of equity offers a different advantage to the issuing corporation. For example, the conversion privilege normally allows the issuer to sell the convertible preferred stock with a lower dividend rate than would have been required for comparable stock without a conversion feature. Convertible preferred stock is frequently issued with a call option that entitles the issuing corporation to repurchase the shares should conditions in the marketplace change. Effective management of common and preferred stock requires careful attention to the interplay of conversion and call provisions, stock market values, and stockholder incentives. Consequently, virtually all corporations have authorized different forms of equity. 11. The cumulative dividend preference requires the eventual payment of all preferred dividends—both unpaid dividends from prior periods and any due in the current period—before any dividends are paid to common stockholders. For example, if no dividends are paid in the current year, then next year the cumulative feature will require preferred stockholders to receive 2 years of dividends before the common stockholders receive any. Preferred stock that does not have the cumulative feature does not have to pay preferred stockholders for years in which no dividends are paid. 12. While dividends on common stock are set by the corporation’s board of directors and are subject to change each year, dividends on preferred stock are usually established as one of the terms of the issue. Most preferred stock issues fix their dividend rate as a percentage of the par value. For example, an 8% preferred share with a $100 par value has an annual dividend of $8 share ($100 par  8%). Of course, both preferred and common dividends are subject to various per restrictions imposed by statute, by corporate charter, by the terms of preferred stock issues, and by contracts with bondholders and others. 13. In a stock issuance, the contributions of stockholders are usually divided between two equity accounts on the basis of the par value of the stock. The par value multiplied by the number of shares sold is recorded in an account that describes the type of stock—

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for example, Common Stock or Preferred Stock. When a corporation receives more than par value for newly issued stock, as it usually does (stock rarely sells for exactly its par value), the excess over par is recorded in an account called Additional Paid-In Capital. 14. Par value and stated value are measures of legal capital. Par value is the established minimum price for which each share must be issued but does not determine the economic value of the stock. If stock is issued without a par value, it may have a stated value per share to establish the legal capital. 15. Stock options allow cash-poor companies to compete for higher priced talent in the employee market. Also, stock options are believed to better align the incentives of the employee with those of the stockholders by tying the employee’s compensation to the stock price. 16. A stock warrant is the right granted by a corporation to purchase a specified number of shares of its common stock at a stated price and within a stated time period. Warrants are used when bonds or preferred stock are sold to make those instruments more attractive to investors. When additional shares of stock are sold to the public, warrants are often issued to existing stockholders to provide them the opportunity to maintain their existing percentage level of ownership. Warrants are also issued in the form of stock options to employees and executives as compensation. 17. Two common forms of dividend payouts are cash and additional shares of stock. Also, when the corporation is liquidating, stockholders get to share in proportion to their holdings or have a residual claim. 18. When a corporation purchases its own previously issued stock, the stock that it buys is called treasury stock. 19. Corporations purchase treasury stock for many reasons. Answers should include four of the following: (1) To buy out the ownership of one or more stockholders (2) To reduce the size of corporate operations (3) To reduce the number of outstanding shares of stock in an attempt to increase earnings per share and market value per share (4) To acquire shares to be transferred to employees under stock bonus, stock option, or stock purchase plans (5) To satisfy the terms of a business combination in which the corporation must give a quantity of shares of its stock as part of the acquisition of another business (6) To reduce vulnerability to an unfriendly takeover 20. The purchase of treasury stock is a temporary reduction of equity rather than the acquisition of an investment. Instead of requiring a debit to an investment account, the reacquisition of treasury stock requires a debit to a contra-equity account, Treasury Stock.

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21. The reselling of treasury stock never has an effect on the income statement (except for the earnings per-share calculation, which uses outstanding stock). 22. On the declaration date, the company records the dividend by a debit to Dividends Declared and a credit to Dividends Payable. There is no journal entry on the date of record. On the date of payment, the company records a debit to Dividends Payable and a credit to Cash. 23. When retained earnings have been reduced to zero, any additional dividends must come from paid-in capital. Such dividends are called liquidating dividends and must be charged against Capital Stock accounts—first additional paid-in capital, then par value. The payment of liquidating dividends usually accompanies the dissolution of the corporation and is regulated by various laws designed to protect the interests of creditors and other holders of nonresidual equity. Liquidating dividends are a return of paid-in capital. A cash dividend, on the other hand, transfers cash from the corporation to its stockholders. It does not get charged against Capital Stock accounts and does not occur when the company is in dissolution. 24. A cash dividend decreases stockholders' equity (ultimately through the Retained Earnings account). A stock dividend does not change stockholders' equity; instead, it transfers retained earnings into contributed capital accounts. 25. A stock dividend transfers shares of stock from the corporation to its stockholders. The stockholders receive additional shares of the corporation’s stock. A stock split, like a stock dividend, increases the number of outstanding shares without altering the proportionate ownership of a corporation. Unlike a stock dividend, however, a stock split involves a decrease in the per-share par value (or stated value), with no capitalization of retained earnings. In other words, a stock split is a stock issue that increases the number of outstanding shares of a corporation without changing the balances of its equity accounts. Therefore, no journal entry is required to record a stock split. 26. A stock split typically changes the number of authorized shares and always changes the numbers of issued and outstanding shares. It involves a decrease in the per-share par or stated value and an increase in the number of shares outstanding. However, stock splits do not change any equity account balances. 27. A current dividend preference provides that current dividends must be paid to preferred stockholders before any dividends are paid to common stockholders. A cumulative dividend preference requires the eventual payment of all preferred dividends—both dividends in arrears and current dividends—before any dividends are paid to common stockholders. A participating dividend preference provides that preferred stockholders receive, in addition to the stated dividend, a share of amounts available for distribution as dividends to other classes of stock. 28. Dividends do not become a liability of a corporation until they have been declared by the board of directors. Since preferred dividends in arrears have not been declared, they are not recorded as liabilities but are disclosed in a footnote to the financial statements.

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29. Retained earnings (or deficit) is the accumulated earnings (or losses) over the entire life of the corporation that have not been paid out in dividends to stockholders. 30. Under most corporate charters, the balance of a corporation’s retained earnings represents an upper limit on the entity’s ability to pay dividends. (Dividends cannot reduce retained earnings below zero.) A corporation’s capacity to pay dividends may be further restricted by agreements with lenders, by the corporation’s board of directors, and by various provisions of state law, as follows: (1) An agreement between the corporation and bondholders may require that retained earnings never fall below a specified level so long as the bonds are outstanding. (2) The firm’s board of directors may set aside a portion of retained earnings and declare it unavailable for the payment of dividends. Such an action may be used to communicate to stockholders changes in dividend policy made necessary by expansion programs or other decisions of the board. (3) State law may require that dividends not reduce retained earnings below the cost of treasury stock. 31. Prior period adjustments are corrections of errors in financial statements of prior periods and are presented as adjustments to beginning retained earnings. Adjustments arising from estimation errors or changes from one accounting principal to another are excluded from prior period adjustments. 32. Accumulated other comprehensive income is gains and losses from certain nonowner transactions that bypass the income statement and go directly to stockholders’ equity. Retained earnings are what is left of the earnings that flow through the income statement after payment to the owners. 33. The statement of changes in stockholders’ equity shows changes in each of the Capital Stock accounts, changes in the number of shares outstanding, and changes in retained earnings. 34. Stockholders want to understand: (1) how the value of their shares of stock will change (2) how the company will distribute any excess cash to stockholders. The results of these ratios are usually used in two ways. First, they are compared over time to evaluate trends. Second, the ratios can be compared to results from other companies in the industry.

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MULTIPLE-CHOICE QUESTIONS 10-1.

10-2.

10-3.

10-4.

10-5.

Total stock issued ($50,000/$0.25) Less: Treasury stock Total stock outstanding

10-6.

No gains or losses are recognized for treasury stock transactions.

10-7.

10-8.

200,000 shares (15,000) shares 185,000 shares

12,000 shares  $25/share = $300,000 increase to stockholders’ equity Cash Common Stock* Additional Paid-In Capital—Common Stock**

300,000 60,000 240,000

* 12,000 shares  $5 = $60,000 ** 12,000 shares  $20 = $240,000

10-9.

Prepaid rent* Common stock** Additional paid-in capital—common stock

$72,000 20,000 $52,000

* For newly organized or closely held corporations, the fair market value of the asset/service is usually more readily determinable than the fair market value of the stock ($3,000  24 months = $72,000). ** 20,000 shares  $1 = $20,000

10-10. c 10-11. c 10-12. a 10-13. b 10-14. b 10-15. d 10-16. d 10-17. c 10-18. c

$50 market price/2 = $25 per new share

10-19. d

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10-20. c

Preferred dividends:

In arrears: (100,000  $50)  6% = $300,000 Current Year: (100,000  $50)  6% = $300,000 $750,000 − $600,000 = $150,000 left over for dividends to common shareholders Beg. Retained Earnings

Net Income

−

Dividends

End. Retained Earnings

$100,000

−

$60,000

$500,000

10-21. c 10-22. a 10-23. a 10-24. d

$50,000/$250,000 = 0.2

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BRIEF EXERCISES BE 10-25 Preferred stock grants certain privileges, usually involving dividends, to its holders that are not granted to holders of common stock. Common stock confers voting rights. Dividends on common stock are usually more closely correlated with the success of the corporation than are preferred dividends. Other differences include (1) dividend preferences, (2) conversion privileges, (3) liquidation preferences, (4) call provisions, and (5) denial of voting rights. The first three are usually advantages of preferred stockholders, while the last two are usually advantages of common stockholders.

BE 10-26 Journal Account and Explanation

Date

Casha Preferred Stockb Additional Paid-In Capital—Preferred Stockc Common Stockd Additional Paid-In Capital—Common Stocke (Record sale of preferred and common stock)

Debit 2,092,100

Credit 51,000 39,100 1,040 2,000,960

(1,700 shares  $53) + (104,000 shares  $19.25) = $2,092,100 1,700 shares  $30 = $51,000 c 1,700 shares  ($53 − $30) = $39,100 d 104,000 shares  $0.01 = $1,040 e 104,000 shares  ($19.25 − $0.01) = $2,000,960 a

BE 10-27 Date Sept.

Journal Account and Explanation a

30 Cash Common Stockb Additional Paid-In Capital—Common Stockc (Record sale of common stock)

Debit 9,880,000

Credit 78,000 9,802,000

520,000 shares  $19.00 = $9,880,000 520,000 shares  $0.15 = $78,000 c 520,000 shares  ($19 − $0.15) = $9,802,000 a

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BE 10-28 Additional paid-in capital—common stock............................................ Selling price ......................................................................................... Less: Par .............................................................................................. Additional above par for each share ..................................................... Total Shares

= = =

$443,700 $14.00 1.25 $ 12.75

Additional Paid-In Capital / Additional Above Par for Each Share $443,700 / $12.75 34,800 shares

BE 10-29 Date Aug. Oct.

Nov.

Journal Account and Explanation 19 Treasury Stock (2,600  $7) Cash 31 Cash (400  $12) Treasury Stock (400  $7) Additional Paid-In Capital—Treasury Stock [400  ($12 − $7)] 17 Cash (2200  $5) Additional Paid-In Capital—Treasury Stock * Retained Earnings Treasury Stock (2200  $7)

Debit 18,200

Credit 18,200

4,800 2,800 2,000 11,000 2,000 2,400 15,400

Additional Paid-In Capital—Treasury Stock Nov. 17*

2,000

Oct. 31

Ending balance

2,000

* This account may be debited, but it cannot have a debit balance. As such, the maximum debit is the credit balance prior to the entry.

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BE 10-30 1. Date Jan. May

Nov.

Journal Account and Explanation 23 Treasury Stock (235,000  $18) Cash 19 Cash (111,500  $10) Retained Earnings [111,500  ($18 − $10)] Treasury Stock (111,500  $18) 1 Cash (75,000  $25) Treasury Stock (75,000  $18) Additional Paid-In Capital—Treasury Stock [75,000  ($25 − $18)]

Debit 4,230,000

Credit 4,230,000

1,115,000 892,000 2,007,000 1,875,000 1,350,000 525,000

The income statement is not affected by treasury stock transactions because the income statement is reserved for transactions with nonowners. On a more practical level, you can also observe that no income statement accounts were debited or credited in part 1.

BE 10-31 1.

Decrease total stockholders’ equity by $3,145,000 (185,000  $17).

The net income is not affected by treasury stock transactions because these are transactions with owners.

BE 10-32 Date

Journal Account and Explanation Treasury Stock (185,000  $17) Cash

Debit 3,145,000

Credit 3,145,000

BE 10-33 Date of Declaration—December 1: Date Dec.

Journal Account and Explanation 1 Dividends Declared (or Retained Earnings) (17,000*  $0.88) Dividends Payable

Debit 14,960

Credit

14,960

* Outstanding shares = Shares issued less outstanding treasury stock 22,000 − (9,000 − 4,000)

Date of Record—December 15: No entry is required.

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BE 10-33 (Continued) Date of Payment—December 20: Date Dec.

Journal Account and Explanation 20 Dividends Payable Cash

Debit 14,960

Journal Account and Explanation 31 Dividends Declared (or Retained Earnings) Dividends Payable

Debit 62,000

Credit 14,960

BE 10-34 Date Dec.

Credit 62,000

BE 10-35 1. Date

2. Date

Journal Account and Explanation Dividends Declared [(24,000*  5%)  $45] Common Stock [(24,000*  5%)  $4] Additional Paid-In Capital—Common Stock Journal Account and Explanation Dividends Declared [(24,000*  27%)  $4] Common Stock

Debit 54,000

Credit 4,800 49,200

Debit 25,920

Credit 25,920

*24,000= (42,000 issued – 18,000 treasury stock)

Total stockholders’ equity is unaffected by these transactions. The overall effect is to move some retained earnings into contributed capital.

BE 10-36 Year 2022 2023 2024 2025

Amount Available for Dividends

Dividends to Preferred

Dividends to Common

$21,000 23,000 26,000

$21,000 21,000 14,000

$ — 2,000 12,000

Remaining in Arrears $14,000 7,000 — —

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BE 10-37 Preferred stock = 6%  $5  20,000 shares  3 years = $18,000 Common stock = $75,000 − $18,000 = $57,000

BE 10-38 Beginning retained earnings, January 1................................................. Add: Net income ..................................................................................

$1,100,000 380,000 $1,480,000 28,500 $1,451,500

Deduct: Dividends (38,000  $0.75) ...................................................... Ending retained earnings, December 31 ................................................ Retained Earnings 1,100,000

Beginning balance

380,000

Net income

1,451,500

Ending balance

Dividends declared (38,000 shares  $0.75)

28,500

BE 10-39 Titanic Corporation Retained Earnings Statement For the year ending December 31, 20X1 Retained earnings, January 1, 20X1 ...................................................... Add: Prior period adjustment* ............................................................. Retained earnings as adjusted, January 1, 20X1 .................................... Add: Net income .................................................................................. Less: Dividends**................................................................................. Retained earnings, December 31, 20X1 .................................................

$1,100,000 59,250 $1,159,250 380,000 (28,500) $1,510,750

Retained Earnings

Dividends**

1,100,000

Beginning balance

59,250

Prior period adjustment

380,000

Net income

1,510,750

Ending balance

28,500

* Because depreciation was overstated by $75,000, Titanic must make a prior period adjustment. Because of the $75,000 overstatement of depreciation and the 21% tax rate, 20X1 net income was understated by 59,250 [$75,000  (1 − 0.21)]. ** 38,000 shares  $0.75 = $28,500

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BE 10-40 Dividends per Common Share Common Stock Price $1.50 = $25 = 6.00%

Dividend Yield =

Common Dividends Net Income (or Comprehensive Income) (16,000  $1.50) = $104,000 = 23.08%

Dividend Payout =

(Common Dividends + Common Stock Repurchase) Net Income (or Comprehensive Income) [(16,000  1.50) + $65, 000] = $104,000 = 85.58 %

Total Payout =

BE 10-41 (Net Income − Preferred Dividends) Average Common Stockholders’ Equity ($2,420,000 − $310,000) = $18,250,000 = 11.56%

Return on Common Equity =

Earnings per Share =

(Net Income − Preferred Dividends) Average Common SharesOutstanding

($2,420,000 − $310,000) 675,000 = $3.13

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EXERCISES E 10-42 The number of issued shares at December 31: 318,000 + 24,350 = 342,350 shares The number of outstanding shares at December 31: 318,000 + 24,350 − 4,500 − 8,200 = 329,650 shares

E 10-43 $225,000 = 45,000 shares $5

45,000 shares − 13,000 treasury stock = 32,000 shares outstanding

E 10-44 Common stock* ................................................................................... Preferred stock**................................................................................. Total capital stock .........................................................................

$1,125,000 125,000 $1,250,000

* 75,000 shares  $15 = $1,125,000 ** 5,000 shares  $25 = $125,000

E 10-45 Stahl Company Balance Sheet (Partial) December 31, 20X1 Stockholders’ equity: Preferred stock, 6% cumulative, $20 par, 80,000 shares authorized, 5,000 shares issued and outstanding ..................... Common stock, $2 par, 600,000 shares authorized, 75,000 shares issued and outstanding ...................................... Additional paid-in capital: Preferred stock ........................................................................ Common stock ......................................................................... Total Additional paid-in capital ..................................................... Total capital stock ......................................................................... Retained earnings ......................................................................... Total stockholders’ equity ........................................................

$100,000 150,000 $25,000 975,000

1,000,000 $1,250,000 500,000 $1,750,000

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E 10-46 Journal Account and Explanation

Date 1.

46,750 shares  $16 = $748,000

46,750 shares  ($48 − $16) = $1,496,000

46,750 shares  $9 = $420,750

46,750 shares  ($48 − $9) = $1,823,250

46,750 shares  $48 = $2,244,000

Debit 2,244,000

Credit 748,000 1,496,000

2,244,000 420,750 1,823,250 2,244,000 2,244,000

The different par value has no effect on total capital stock or total stockholders’ equity.

E 10-47 Date Mar.

Nov.

Journal Account and Explanation 22 Cash Common Stocka Additional Paid-In Capital—Common Stockb Preferred Stockc Additional Paid-In Capital—Preferred Stockd (Record sale of preferred and common stock) 9 Treasury Stock Cashe (Record purchase of treasury shares)

Debit 5,956,000

Credit 180,000 5,760,000 7,500 9,000

875,000 875,000

180,000 shares  $1.00 = $180,000 180,000 shares  ($33.00 − $1.00) = $5,760,000 c 1,500 shares  $5.00 = $7,500 d 1,500 shares  ($11.00 − $5.00) = $9,000 e 25,000 shares  $35.00 = $875,000 a

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E 10-48 Renee Corporation Balance Sheet (Partial) December 31 Stockholders’ equity: Preferred stock, $10 par, 0 shares authorized, 8,000 shares issued and outstanding ........................................ Common stock, $5 par, 750,000 shares authorized, 300,000 shares issued, and 250,000 shares Outstanding ............................................................................. Additional paid-in capital: Preferred stock ........................................................................ Common stock ......................................................................... Total additional paid-in capital ...................................................... Total capital stock ......................................................................... Retained earnings ......................................................................... Less: Treasury stock .................................................................... Total stockholders’ equity ........................................................

$80,000*

1,500,000** $50,000 2,250,000 2,300,000 $3,880,000 1,837,000 (1,200,000) $4,517,000

* Preferred stock = 8,000 shares  $10 = $80,000 ** Common stock = 300,000 shares  $5 = $1,500,000

E 10-49 Wildcat Drilling Balance Sheet (Partial) December 31 Stockholders’ equity: Preferred stock, $10 par ................................................................ Common stock, $1 par .................................................................. Additional paid-in capital: Preferred stock ........................................................................ Common stock ......................................................................... Total additional paid-in capital ...................................................... Total capital stock ......................................................................... Retained earnings ......................................................................... Accumulated other comprehensive income .............................. Treasury stock ......................................................................... Total stockholders’ equity ......................................................

$ 340,000 600,000 $400,000 3,100,000

3,500,000 $4,440,000 600,000 70,000 (382,000) $4,728,000

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E 10-50 1. 2. 3.

100,000 shares 550,000 shares $10.00 ($6,000,000/600,000)

Common stock ................................................... Additional paid-in capital—common .................. Number of issued shares .....................................

$1,200,000 $4,800,000 600,000

$16.00 ($800,000/ 50,000)

Treasury stock .................................................... Number of issued shares ..................................... Number of outstanding shares ............................ Number of treasury shares ..................................

$800,000 600,000 550,000 50,000

$0.80 ($0.80/$10)

Annual dividends ................................................ Preferred stock ................................................... Number of shares outstanding ............................ Par value ............................................................

8.00% $300,000 30,000 $10

E 10-51 Date Feb.

May

Nov.

Journal Account and Explanation Treasury Stocka Cash (Record purchase of treasury shares) Cashb Treasury Stockc Additional Paid-In Capital—Treasury Stock Stockd (Record reissue of treasury shares) Cashe Retained Earningsf Additional Paid-In Capital—Treasury Stockg Treasury Stockh (Record reissue of treasury shares)

Debit 409,200

Credit 409,200

192,500 170,500 22,000 169,400 47,300 22,000 238,700

13,200 shares  $31.00 = $409,200 5,500 shares  $35.00 = $192,500 c 5,500 shares  $31.00 = $170,500 d $192,500 − $170,500 = $22,000 e (13,200 shares − 5,500 shares)  $22.00 = $169,400 f Any amounts required as a debit to this journal entry beyond the balance in the Additional Paid-In Capital— Treasury Stock account have to come from Retained Earnings. g This account had a balance of $9,000 and therefore can only be reduced to a zero balance. h (13,200 shares − 5,500 shares)  $31.00 = $238,700 a

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E 10-52

Date Mar.

Sept.

Apr.

Oct.

Journal Account and Explanation Dividends Declared (or Retained Earnings)* Dividends Payable (Record liability for dividends) Dividends Declared (or Retained Earnings)** Dividends Payable (Record liability for dividends) Dividends Payable Cash (Record payment of dividends) Dividends Payable Cash (Record payment of dividends)

Debit 272,800

Credit

272,800 267,729 267,729 272,800 272,800 267,729 267,729

* 248,000 shares  $1.10 = $272,800 ** (248,000 shares − 4,610 shares)  $1.10 = $267,729

The number of shares outstanding decreased by 4,610 due to the purchase of treasury stock on July 2.

E 10-53 1.

Dividends in arrears preferred* .................................................... Current year preferred dividend** ................................................ Common dividend***................................................................... Total dividends declared and paid .................................................

$1,620,000 540,000 450,000 $2,610,000

* 150,000 shares  $30  0.12  3 years = $1,620,000 ** 150,000 shares  $30  0.12 = $540,000 *** 1,000,000 shares  $0.45 = $450,000

2. Date

Journal Account and Explanation Dividends Declared (or Retained Earnings) Dividends Payable (Record liability for dividends)

Debit 2,610,000

Credit

2,610,000

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E 10-54 Corporations distribute assets to stockholders through: (1) dividends (2) stock repurchases (i.e., purchasing treasury stock) Stock repurchases have tax advantages for shareholders over dividends. First, dividends are paid to all stockholders, thus creating tax consequences for everyone. Stock repurchases, on the other hand, only trigger tax consequences for those stockholders who elect to sell their stock back to the company. Thus, if a stockholder does not want to incur tax consequences in the current year, (s)he can elect not to sell shares back to the company. Second, historically, gains from selling stock have been taxed at lower rates than dividends. However, currently the tax rates for dividends and gains on stock repurchases are the same and it appears it will stay this way for the foreseeable future. Finally, dividends have the advantage of allowing the shareholder to receive assets from the corporation without reducing their ownership share.

E 10-55 Stock dividend = 0.15  183,700 outstanding shares = 27,555 shares Amount of dividend = $40  27,555 shares = $1,102,200

Date Aug.

Aug.

Journal Account and Explanation 22 Dividends Declared (or Retained Earnings) Common Stock* Additional Paid-In Capital—Common Stock** (Record small stock dividend) 22 Dividends Declared (or Retained Earnings)*** Common Stock (Record large stock dividend)

Debit 1,102,200

Credit 275,550 826,650

551,100 551,100

* 27,555 shares  $10 = $275,550 ** 27,555 shares  ($40 − $10) = $826,650 *** (183,700 shares  0.30)  $10 = $551,100

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E 10-56 1.

Increase in Capital Stock = Number of Shares in Small Stock Dividend Stock Price $270,000 = 15,000 shares $18 Number of Shares in Stock Dividend = Percent Stock Dividend Number of Shares Prior to Stock Dividend 15,000 shares = 10% 150,000 shares 2.

Decrease in Retained Earnings = Number of Shares in Large Stock Dividend Par Value $75,000 = 75,000 shares $1 Number of Shares in Stock Dividend = Percent Stock Dividend Number of Shares Prior to Stock Dividend 75,000 shares = 50% 150,000 shares

E 10-57 Authorized shares = 750,000  4 Issued shares = 400,000  4 Market value per share = $600/4 Par value = $3.00/4

= = = =

3,000,000* 1,600,000 $ 150 $ 0.75

* Although stockholders must amend the charter and the SEC must approve the amendment to increase the number of authorized shares, the number of authorized shares is typically adjusted for the split.

E 10-58 1. 2. 3.

$140,000 + $363,400 $140,000 + $363,400 $140,000 + $363,400 − $189,000*

= = =

$503,400 $503,400 $314,400

* 3,000 shares  $63 = $189,000

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E 10-59 1.

Annual preferred dividend = 45,000  0.08  $25 = $90,000 Date

2. Date

Journal Account and Explanation Dividends Declared (or Retained Earnings)* Dividends Payable (Record liability for dividends) Journal Account and Explanation Dividends Payable Cash (Record payment of dividends)

Debit 22,500

Credit 22,500

Debit 22,500

Credit 22,500

* $90,000/4 = $22,500

E 10-60 1.

Dividends in arrears preferred* .................................................... Current year preferred dividends** ............................................... Total dividends to preferred ..................................................... Total dividends ............................................................................. Less: Dividends to preferred .......................................................... Total dividends to common ......................................................

$180,000 90,000 $270,000 $360,000 (270,000) $90,000

Total dividends ............................................................................. Less: Dividends to preferred .......................................................... Total dividends to common ......................................................

$280,000 (270,000) $10,000

* 10,000 shares  $60  0.15  2 years = $180,000 ** 10,000 shares  $60  0.15 = $90,000

E 10-61 1. Preferred dividends Common dividends

Ending Retained Earnings = = =

Retained Earnings 650,000 70,000 55,000 340,000 865,000

Beginning balance

Net income Ending balance

Retained Earnings − Overstatement Amount $865,000 − $13,000 $852,000

E 10-62 Beg. Retained Earnings ($116,000) + Net Income − Dividends ($30,000*) = End. Retained Earnings ($173,000); Net Income = $87,000 * Dividends = 60,000 shares  $0.50 = $30,000 © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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E 10-63 Longfellow Clothing Balance Sheet (Partial) December 31, 20XX Stockholders’ equity: Common stock, $5 par, 30,000 issued and outstanding ............................................................................. Additional paid-in capital—common stock .................................... Total capital stock .................................................................... Retained earnings: Restricted retained earnings under agreements with bondholders..................................................................... Unrestricted retained earnings* ............................................... Total retained earnings ................................................................. Total stockholders’ equity ........................................................

$150,000 236,500 $386,500

$50,000 246,900 296,900 $683,400

* $226,700 + $92,000 − $21,800 − $50,000 = $246,900

E 10-64 1.

Payout ratios:

Dividends per Common Share Common Stock Price $0.90 = $55.00 = 1.64%

Dividend Yield =

Common Dividends Net Income (or Comprehensive Income) $765,000 = $15,485,000 = 4.94%

Dividend Payout =

Common Dividends + Common Stock Repurchase Net Income (or Comprehensive Income) $765,000 + $120,000 = $15,485,000 = 5.72%

Total Payout =

Stock Repurchase Payout = Total Payout − Dividend Payout* = (5.72% − 4.94%)** = 0.78% * Or Common Stock Repurchase/Net Income ** Or $120,000/$15,485,000

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E 10-64 (Continued) 2.

Profitability ratios:

Return on Common Equity =

Net Income − Preferred Dividends Average Common Stockholders’ Equity*

$15,485,000 − $238,800 ($23,136,000** + $20,184,000***)/2 $15,246,200 = $21,660,000 = 70.39%

2019 Return onCommon Equity =

Common Stockholders’ Equity ** 2019 Common Stockholders’ Equity *** 2018 Common Stockholders’ Equity

= Total Stockholders’ Equity − Preferred Stock = $28,435,000 − $5,299,000 = $23,136,000 = $25,483,000 − $5,299,000 = $20,184,000

Net Income − Preferred Dividends Average Common Shares Outstanding $69,385,000 − $1,444,000 = 850,000 = $17.94 per share

Earnings per Share =

E 10-65 1.

Dividends per Common Share Common Stock Price Dividends per Common Share 1% = $25 Dividends per Common Share = $25  0.01 Dividend Yield =

= $0.25

Common Dividends Net Income $0.25*  550,000 20% = Net Income 20%  Net Income = $137,500 Dividend Payout =

Net Income = $137,500/0.20 = $687,500 * From Solution 1 above

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E 10-66 1. i 2. c 3. e 4. j 5. g 6. a 7. k 8. b 9. f 10. l 11. h 12. d

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PROBLEM SET A P 10-67A Green Line Corporation Balance Sheet (Partial) December 31, 20XX Stockholders’ equity: Preferred stock, $25 par, 200,000 shares authorized 65,000 shares issued and outstanding ...................................... Common stock, $2 par, 1,500,000 shares authorized, 120,000 shares issued and 105,000 outstanding ....................... Additional paid-in capital: Preferred stock ........................................................................ Common stock ......................................................................... Total additional paid-in capital ................................................. Total capital stock ......................................................................... Retained earnings ......................................................................... Less: Treasury stock (15,000 shares, at cost) ............................. Total stockholders’ equity ...................................................

$1,625,000a 240,000b $455,000c 840,000d 1,295,000 $3,160,000 408,000e (165,000)f $3,403,000

65,000 shares  $25 = $1,625,000 120,000 shares  $2 = $240,000 c 65,000 shares  ($32 − $25) = $455,000 d 120,000 shares  ($9 − $2) = $840,000 e $460,000 − $52,000 = $408,000 f 15,000 shares  $11 = $165,000 a

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P 10-68A Journal Account and Explanation

Date a.

Cash Common Stocka Additional Paid-In Capital—Common Stockb (Record sale of common stock) Cashc Common Stockd Additional Paid-In Capital—Common Stocke (Record sale of common stock) Cashf Preferred Stockg Additional Paid-In Capital—Preferred Stockh (Record sale of preferred stock) Legal Expense Common Stocki Additional Paid-In Capital—Common Stockj (Record sale of common stock)

Debit 550,000

Credit 250,000 300,000

96,000 40,000 56,000 340,000 280,000 60,000 1,200 500 700

50,000 shares  $5 = $250,000 $550,000 − $250,000 = $300,000 c 8,000 shares  $12 = $96,000 d 8,000 shares  $5 = $40,000 e 8,000 shares  ($12 − $5) = $56,000 f 4,000 shares  $85 = $340,000 g 4,000 shares  $70 = $280,000 h 4,000 shares  ($85 − $70) = $60,000 i 100 shares  $5 = $500 j $1,200 − $500 = $700 a

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P 10-69A 1. a.

Date Jan.

Jan.

July

Aug.

Journal Account and Explanation Treasury Stocka Cash (Record purchase of treasury shares) Cashb Retained Earnings Treasury Stockc (Record reissue of treasury shares) Treasury Stockd Cash (Record purchase of treasury shares) Cashe Retained Earnings Treasury Stockf (Record reissue of treasury shares)

Debit 182,000

Credit 182,000

12,000 16,000 28,000 48,000 48,000 79,300 93,900 173,200

13,000 shares  $14 = $182,000 2,000 shares  $6 = $12,000 c 2,000 shares  $14 = $28,000 d 3,000 shares  $16 = $48,000 e 11,000 shares + 1,200  $6.50 = $79,300 f (11,000 shares  $14) + (1,200 shares  $16) = $173,200 a

The four transactions reduced equity by $138,700: Transaction a b c d Total

Effect on Equity $(182,000) (16,000) 28,000 (48,000) 173,200 (93,900) $(138,700)

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P 10-70A 1.

Journal Account and Explanation

Date a.

Cash

Common Stockb Additional Paid-In Capital—Common Stockc (Record sale of common stock) Cashd Preferred Stocke Additional Paid-In Capital—Preferred Stockf (Record sale of preferred stock) Retained Earnings (or Dividends) Cash (Record declaration and payment of dividends) Treasury Stockg Cash (Record purchase of treasury shares) Cashh Additional Paid-In Capital—Treasury Stock Treasury Stocki (Record reissue of treasury shares)

Debit 95,000

Credit 50,000 45,000

90,000 60,000 30,000 22,000 22,000 24,000 24,000 7,800 600 7,200

5,000 shares  $19 = $95,000 5,000 shares  $10 = $50,000 c 5,000 shares  ($19 − $10) = $45,000 d 1,200 shares  $75 = $90,000 e 1,200 shares  $50 = $60,000 f 1,200 shares  ($75 − $50) = $30,000 g 1,000 shares  $24 = $24,000 h 300 shares  $26 = $7,800 I 300 shares  $24 = $7,200 a

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P 10-70A (Continued) 2.

Haley Corporation Balance Sheet (Partial) December 31, 20XX

Stockholders’ equity: Preferred stock, 12%, $50 par ....................................................... Common stock, $850,000 par ........................................................ Additional paid-in capital: Preferred ................................................................................. Common .................................................................................. Treasury ................................................................................. Total additional paid-in capital ...................................................... Total capital stock ........................................................................ Retained earnings ......................................................................... Less: Treasury stock, at cost ..................................................... Total stockholders’ equity ...................................................

$60,000 850,000a $30,000 245,000b 600 275,600 $1,185,600 380,700c (16,800)d $1,549,500

$800,000 + $50,000 = $850,000 $200,000 + $45,000 = $245,000 c $279,000 + $123,700 − $22,000 = $380,700 d $24,000 − $7,200 = $16,800 b

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P 10-71A 1. a.

Date Mar.

Apr.

May

June

Aug.

Sept.

Journal Account and Explanation Dividends Declared (or Retained Earnings)a Dividends Payable (Record liability for dividends) Dividends Payable Cash (Record payment of dividends) Treasury Stockb Cash (Record purchase of treasury shares) Cash Common Stockc Additional Paid-In Capital—Common Stockd (Record reissue of treasury shares) Dividends Declared (or Retained Earnings) Dividends Payablee (Record liability for dividends) Dividends Payable Cash (Record payment of dividends)

Debit 112,500

Credit 112,500

112,500 112,500 144,000 144,000 34,500 7,500 27,000 165,825 165,825 165,825 165,825

375,000 shares  $0.30 = $112,500 8,000 shares  $18 = $144,000 c 1,500 shares  $5 = $7,500 d 1,500 shares  ($23 − $5) = $27,000 e (375,000 shares − 8,000 shares + 1,500 shares)  $0.45 = $165,825 a

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P 10-71A (Continued)

Date Oct.

Nov.

Dec.

Journal Account and Explanation 15 Dividends Declared (or Retained Earnings)f Common Stockg Additional Paid-In Capital—Common Stockh (Record small stock dividend) 10 Dividends Declared (or Retained Earnings)i Dividends Payable (Record liability for dividends) 10 Dividends Payable Cash (Record payment of dividends)

Debit 460,625

Credit 92,125 368,500

193,463 193,463 193,463 193,463

(5%  368,500 shares)  $25 = $460,625 (5%  368,500 shares)  $5 = $92,125 h (5%  $368,500 shares)  ($25 − $5) = $368,500 i $0.50  [368,500 shares + (5%  368,500 shares)] = $193,463 f

The total amount of dividends for the year was: $112,500 + $165,825 + $460,625 + $193,463 = $932,413

Effects on assets and stockholders’ equity of dividend transactions [(c) and (d) are not dividend transactions]: Transaction a b e f g h i Total effect

Effect on Assets

Effect on Stockholders’ Equity $(112,500)

$(112,500) (165,825) (165,825) no effect on either (193,463) (193,463) $(471,788)

$(471,788)

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P 10-72A 1.

Total assets would have been $572,000 ($587,000 − $15,000) and retained earnings would have been $202,000 ($217,000 − $15,000). Journal Date Account and Explanation Debit Credit Dec. 31 Dividends Declared (or Retained Earnings) 15,000 Cash 15,000 (Record declaration and payment of dividend)

If a 15% stock dividend is declared and paid, total assets are unchanged but retained earnings are decreased to $73,000 ($217,000 − $144,000). Date Dec.

Journal Account and Explanation 31 Dividends Declared (or Retained Earnings)* Common Stock** Additional Paid-In Capital—Common Stock*** (Record small stock dividend)

Debit 144,000

Credit 24,000 120,000

* (0.15  80,000 shares)  $12 = $144,000 ** (0.15  80,000 shares)  $2 = $24,000 *** (0.15  80,000 shares)  ($12 − $2) = $120,000

Total assets and all equity accounts are unchanged. There is no journal entry for a stock split because no account balances change.

P 10-73A 1.

Annual dividends on each issue of preferred stock and in total: 12,000  $5  0.09 = 6,000  $10  0.09 = 9,000  $25  0.10 = 10,000  $50  0.12 = Total

$ 5,400 5,400 22,500 60,000 $93,300

Annual amounts in arrears: 9%, Noncumulative ................................................................. 9%, Cumulative ....................................................................... 10%, Cumulative, convertible .................................................. 12%, Nonparticipating ............................................................. Total ..................................................................................

0 5,400 22,500 0 $ 27,900

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P 10-74A 1.

Stockholder Payout:

Dividends per Common Share Common Stock Price $1.16 = $105.45 = $1.10%

Dividend Yield =

Common Dividends Net Income (or Comprehensive Income) $213,440 = $1,358,950 = $15.71%

Dividend Payout =

Common Dividends + Common Stock Repurchase Net Income (or Comprehensive Income) $213,440 + $834,975 = $1,358,950 = $77.15%

Total Payout =

Stock Repurchase Payout = (Total Payout − Dividend Payout)* = 77.15% − 15.71% = 61.44% * Or Common Stock Repurchase/Net Income ** Or $834,975/$1,358,950 = 61.44%

Stockholder Profitability:

Return on Common Equity =

Net Income − Preferred Dividends Average Common Stockholders’ Equity*

$1,358,950 − $100,000 ($3,080,295 − $1,000) + ($2,753,394 − $1,000)/2 = $43.18%

Net Income − Preferred Dividends Average Common Shares Outstanding $1,358,950 − $100,000 = 184,000 = $6.84 per share

EPS =

* Common Stockholders’ Equity = Total Stockholders’ Equity − Preferred Stock

In 2024, both the stockholder payout and the stockholder profitability ratios are above the industry averages and have increased from the previous year. This is positive information when considering whether to buy this stock.

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PROBLEM SET B P 10-67B Steven’s Restoration Balance Sheet (Partial) December 31, 20XX Stockholders’ equity: Preferred stock, $100 par, 75,000 shares authorized 25,000 shares issued and outstanding ...................................... Common stock, $10 par, 1,000,000 shares authorized, 480,000 shares issued and 478,000 outstanding ........................ Additional paid-in capital: Preferred stock ........................................................................ Common stock ......................................................................... Total additional paid-in capital ...................................................... Total capital stock ......................................................................... Retained earnings ......................................................................... Less: Treasury stock (2,000 shares, at cost) ............................... Total stockholders’ equity ...................................................

$2,500,000a 4,800,000b $125,000c 2,400,000d 2,525,000 $9,825,000 94,000e (36,000)f $9,883,000

25,000 shares  $100 = $2,500,000 480,000 shares  $10 = $4,800,000 c 25,000 shares  ($105 − $100) = $125,000 d 480,000 shares  ($15 − $10) = $2,400,000 e $107,000 − $13,000 = $94,000 f 2,000 shares  $18 = $36,000 a

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P 10-68B Journal Account and Explanation

Date a.

Cash Common Stocka Additional Paid-In Capital—Common Stockb (Record sale of common stock) Cash Common Stockc Additional Paid-In Capital—Common Stockd (Record sale of common stock) Cashe Preferred Stockf Additional Paid-In Capital—Preferred Stockg (Record sale of preferred stock) Legal Expense Common Stockh Additional Paid-In Capital—Common Stocki (Record sale of common stock)

Debit 140,000

Credit 50,000 90,000

65,000 10,000 55,000 90,000 50,000 40,000 1,500 100 1,400

25,000 shares  $2 = $50,000 $140,000 − $50,000 = $90,000 c 5,000 shares  $2 = $10,000 d 5,000 shares  ($13 − $2) = $55,000 e 2,000 shares  $45 = $90,000 f 2,000 shares  $25 = $50,000 g 2,000 shares  ($45 − $25) = $40,000 h 50 shares  $2 = $100 I $1,500 − $100 = $1,400 a

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P 10-69B 1. a.

Date Jan.

July

Aug.

Debit 104,000

Credit 104,000

20,800 13,000 33,800 34,000 34,000 55,800 28,000 83,800

8,000 shares  $13 = $104,000 2,600 shares  $8 = $20,800 c 2,600 shares  $13 = $33,800 d 2,000 shares  $17 = $34,000 e 6,200 shares  $9 = $55,800 f (5,400 shares  $13) + (800 shares  $17) = $83,800 a

The four transactions reduced equity by ($61,400): Transaction a b c d Total

Effect on Equity $(104,000) (13,000) 33,800 (34,000) 83,800 (28,000) $(61,400)

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P 10-70B 1.

Journal Account and Explanation

Date a.

Cash Common Stockb Additional Paid-In Capital—Common Stockc (Record sale of common stock) Cashd Preferred Stocke Additional Paid-In Capital—Preferred Stockf (Record sale of preferred stock) Retained Earnings (or Dividends) Cash (Record declaration and payment of dividends) Treasury Stockg Cash (Record purchase of treasury shares) Cashh Additional Paid-In Capital—Treasury Stock Treasury Stocki (Record reissue of treasury shares)

Debit 49,500

Credit 3,300 46,200

105,000 100,000 5,000 8,000 8,000 38,000 38,000 16,800 1,600 15,200

3,300 shares  $15 = $49,500 3,300 shares  $1 = $3,300 c 3,300 shares  ($15 − $1) = $46,200 d 1,000 shares  $105 = $105,000 e 1,000 shares  $100 = $100,000 f 1,000 shares  ($105 − $100) = $5,000 g 1,000 shares  $38 = $38,000 h 400 shares  $42 = $16,800 i 400 shares  $38 = $15,200 a

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Stanley Utilities Inc. Balance Sheet (Partial) December 31, 20X1

Stockholders’ equity: Preferred stock, 12%, $100 par ...................................................... Common stock, $1 par .................................................................. Additional paid-in capital: Preferred ................................................................................. Common .................................................................................. Treasury .................................................................................. Total additional paid-in capital ...................................................... Total capital stock ......................................................................... Retained earnings ......................................................................... Less: Treasury stock .................................................................... Total stockholders’ equity ........................................................

100,000 4,503,300a

$ 5,000 1,421,200b 1,600 1,427,800 $ 6,031,100 267,000c (22,800)d $ 6,275,300

$4,500,000 + $3,300 = $4,503,300 $1,375,000 + $46,200 = $1,421,200 c $188,000 + $87,000 − $8,000 = $267,000 d $38,000 − $15,200 = $22,800 b

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P 10-71B 1. a.

Date Mar.

Apr.

May

June

Aug.

Sept.

Journal Account and Explanation Dividends Declared (or Retained Earnings)a Dividends Payable (Record liability for dividends) Dividends Payable Cash (Record payment of dividends) Treasury Stockb Cash (Record purchase of treasury shares) Cashc Common Stockd Additional Paid-In Capital—Common Stocke (Record sale of common stock) Dividends Declared (or Retained Earnings)f Dividends Payable (Record liability for dividends) Dividends Payable Cash (Record payment of dividends)

Debit 164,000

Credit 164,000

164,000 164,000 156,000 156,000 37,500 20,000 17,500 323,800 323,800 323,800 323,800

820,000 shares  $0.20 = $164,000 13,000 shares  $12 = $156,000 c 2,500 shares  $15 = $37,500 d 2,500 shares  $8 = $20,000 e 2,500 shares  ($15 − $8) = $17,500 f (820,000 shares − 13,000 shares + 2,500 shares)  $0.40 = $323,800 a

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P 10-71B (Continued) 1. g.

Date Oct.

Nov.

Dec.

Journal Account and Explanation 25 Dividends Declared (or Retained Earnings)g Common Stockh Additional Paid-In Capital—Common Stocki (Record small stock dividend) 20 Dividends Declared (or Retained Earnings)j Dividends Payable (Record liability for dividends) 20 Dividends Payable Cash (Record payment of dividends)

Debit 1,214,250

Credit 647,600 566,650

400,703 400,703 400,703 400,703

(0.10  809,500 shares)  $15 = $1,214,250 (0.10  809,500 shares)  $8 = $647,600 i (0.10  809,500 shares)  ($15 − $8) = $566,650 j $0.45  [809,500 shares + (809,500 shares  0.10)] = $400,703 g

2. 3.

The total amount of dividends for the year was: $164,000 + $323,800 + $1,214,250 + $400,703 = $2,102,753 Effects on assets and stockholders’ equity of dividend transactions [(c) and (d) are not dividend transactions]: Transaction a b e f g h i Total effect

Effect on Assets

Effect on Stockholders’ Equity $(164,000)

$(164,000) (323,800) (323,800) no effect on either (400,703) (400,703) $(888,503)

$(888,503)

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P 10-72B 1.

Total assets would have been $3,850,000 ($3,872,000 − $22,000) and retained earnings would have been $389,000 ($411,000 − $22,000). Date Dec.

Journal Account and Explanation 31 Dividends Declared (or Retained Earnings) Cash (Record declaration and payment of dividends)

Debit 22,000

Credit 22,000

If a 12% stock dividend is declared and paid, total assets are unchanged but retained earnings are decreased to $383,400 ($411,000 − $27,600). Date Dec.

Journal Account and Explanation 31 Dividends Declared (or Retained Earnings)* Common Stock** Additional Paid-In Capital—Common Stock*** (Record small stock dividend)

Debit 27,600

Credit 6,000 21,600

* (0.12  10,000 shares)  $23 = $27,600 ** (0.12  10,000 shares)  $5 = $6,000 *** (0.12  10,000 shares)  ($23 − $5) = $21,600

Total assets and all equity accounts are unchanged. There is no journal entry for a stock split because no account balances change.

P 10-73B 1.

Annual dividends on each issue of preferred stock and in total: 30,000  $20  0.09 = 15,000  $25  0.10 = 20,000  $100  0.06 = 8,000  $100  0.08 = Total

$ 54,000 37,500 120,000 64,000 $275,500

Annual amounts in arrears: $20 Par, 9%, noncumulative, 30,000 shares .............................. $25 Par, 10%, cumulative, 15,000 shares .................................. $100 Par, 6%, cumulative, convertible, 20,000 shares ............... $100 Par, 8%, nonparticipating, 8,000 shares ............................ Total ...................................................................................

0 37,500 120,000 0 $157,500

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P 10-74B 1.

Stockholder Payout:

Dividends per Common Share Common Stock Price $1.50 = $58.30 = $2.57%

Dividend Yield =

Common Dividends Net Income (or Comprehensive Income) $300,000 = $1,584,000 = $18.94%

Dividend Payout =

Common Dividends + Common Stock Repurchase Net Income (or Comprehensive Income) $300,000 + $850,000 = $1,584,000 = $72.60%

Total Payout =

Stock Repurchase Payout = (Total Payout − Dividend Payout)* = 72.60% − 18.94% = 53.66%** * Or Common Stock Repurchase/Net Income ** Or $850,000/$1,584,000 = 53.66%

Stockholder Profitability:

Return on Common Equity =

Net Income − Preferred Dividends Average Common Stockholders’ Equity*

$1,584,000 − $50,000 ($3,307,760 − $2,000) + ($2,970,300 − $1,000)/2 = $48.89%

Net Income − Preferred Dividends Average Common Shares Outstanding $1,584,000 − $50,000 = 200,000 = $7.67 per share

EPS =

* Common Stockholders’ Equity = Total Stockholders’ Equity − Preferred Stock

In 2024, both the stockholder payout and stockholder profitability ratios were above the industry averages. However, the stock repurchase payout and total payout have decreased from the previous year. Overall, this could indicate a good investment choice.

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CASES Case 10-75 1.

Roger and Gordon would be partaking in insider trading if they buy stock. The information that they have is not available to the public and should not be used by Roger and Gordon. What they would be doing is both unethical and illegal.

The SEC looks at unusually large amounts of selling or buying of stock around news such as the new contract mentioned in the case. There are penalties for such activities, such as prison time and fines. In fact, Martha Stewart went to prison for selling stock on insider information (the inside information was bad news in her case).

Case 10-76 1.

If the stock had not been issued, equity would have been $40 million and the debt to equity ratio would have been 2.0 ($80 million/$40 million).

Marilyn should raise her concerns with those responsible for the preparation of DTR’s financial statements. If the transaction is structured as Marilyn suspects, then DTR has really taken on additional debt rather than equity, and the debt to equity ratio is 2.25 ($90 million/$40 million). Marilyn should insist that the “real” effects of the transaction be presented in the statements and that the notes to the statements provide additional information about the transaction. Because she is involved in the negotiations with the lenders, Marilyn has a legal obligation to make sure that DTR’s financial statements fairly present its financial position. If she is unable to persuade those responsible for the statements to properly present this transaction, she should consider resigning.

Case 10-77 Return on common equity before acquiring the $500,000 of additional capital: $400,000/$2,500,000 = 16% Return on common equity (assuming the money is acquired from sale of common stock): $400,000/$3,000,000 = 13.3% Return on common equity (assuming the money is acquired from sale of preferred stock): ($400,000 − $75,000)/$2,500,000 = 13% Because of the relatively high dividend on the preferred stock, the return to the common stockholders is larger if the capital is secured from sale of common stock. Since the preferred stock is convertible into 20,000 shares of common stock, there is no difference in eventual dilution between the two alternatives. Therefore, Expansion’s current stockholders would prefer that the additional capital be raised through the sale of common stock.

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Case 10-78 1.

The return on equity before the acquisition: Net Income/Total Equity = $3,300,000/$12,000,000 = 27.50% The return on equity after acquisition if bonds are issued: Income from operations ........................................................... Less: Interest expense* ............................................................ Income before taxes ................................................................ Less: Tax expense (at 34%) ....................................................... Net income ..............................................................................

$ 6,700,000 (1,120,000) $ 5,580,000 (1,897,200) $ 3,682,800

* (0.12  $1,000,000) + $1,000,000 = $1,120,000

Liabilities increase by $1,000,000, but equity remains at $12,000,000. Return on Equity = $3,682,800/$12,000,000 = 30.69% The return on equity after acquisition if common stock is sold: Income from operations .......................................................... Less: Interest expense ............................................................. Income before taxes ............................................................... Less: Tax expense (at 34%) ...................................................... Net income .............................................................................

$ 6,700,000 (1,000,000) $ 5,700,000 (1,983,000) $ 3,762,000

Equity increases by $1,000,000 (50,000 shares  20). Return on Equity = $3,762,000/$13,000,000 = 28.94% 2.

Dividends will be 60% of $3,762,000 ($2,257,200).

Cash outflow for new interest [(0.12  $1,000,000)  (1 − 0.34)] ... Dividends (60% of $3,682,800) ..................................................... Total cash outflow if bonds are issued .....................................

The number of new shares issued is 50,000. The amount of dividends the preacquisition shareholders will receive after the acquisition is: [600,000 shares/(600,000 shares + 50,000 shares)]  $2,257,200 = $2,083,569. Previously, they received 60% of $3,300,000 ($1,980,000). Therefore, they will be receiving more in dividends after the acquisition.

The issuance of the bonds is best because this form of financing provides the current shareholders with the highest return on equity and higher dividends (than if additional stock is issued) without additional investment.

79,200 2,209,000 $ 2,288,000

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Case 10-79 1.

Par Value: $0.008 per share Authorized shares: Common stock = 1,000,000,000 shares Issued shares: Common stock = 63,179,471 shares Outstanding shares: Common stock = 41,417,401 shares*

Priceline has never declared nor paid dividends and does not expect to pay any in the foreseeable future (Item 5, “Dividend Policy,” p. 31). When companies adopt a policy of no dividends, it is often because they intend to reinvest earnings into the business. However, as we'll see next, rather than pay dividends, Priceline has an active stock repurchase plan.

Common stockholders’ equity:

Treasury stock:

$5,933

21,762,070 shares at a cost of $22,864 million

21,762,070 shares at a cost of $22,864 million 5.

Dividend Payout =

Common Stock Dividend Net Income

$0 $4,865 = 0%

Common Stock Repurchase Net Income 8,187 = $4,865 = 168.28%

Stock Repurchase Payout =

* 63,179,471 shares issued − 21,762,070 treasury shares = 41,417,401 shares outstanding ** $8,187 can be found in the Financing Activities section of the Statement of Cash Flows

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Case 10-79 (Continued) Return on Common Equity =

Net Income − Preferred Dividends Average Common Stockholders’ Equity

Average Common Stockholders’ Equity = [(Ending Total Stockholders’ Equity − Ending Preferred Stock) + (Beginning Total Stockholders’ Equity − Beginning Preferred Stock)] / 2 $4,865 − $0 ($5,933 + $8,785)/2 $4,865 = $14,718/2 $4,865 = $7,359.0 = 66.11%

Net Income − Preferred Dividends Average Common Shares Outstanding $4,865 − $0 = 43 shares = $112.92 per share

Earnings per Share =

Case 10-80 Note: All numbers are in thousands. 1.

Kroger

1,130 treasury shares = 58.92% 1,918 shares issued Sprouts Farmers Market

Shares Repurchased 7,950,858 Common Shares = Amount Spent on Share Repurchase $176,310,000 After repurchase, the shares were retired (See the “Share Repurchase” section of Note 20).

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Case 10-80 (Continued) 2.

Kroger

Dividends per Common Share* Common Stock Price $0.55 2018 = $27.58 = 1.98%

Dividend Yield =

$0.62 $28.99 = 2.14%

2019 =

* Dividends declared per common share is given in the Statement of Changes in Shareholders' Equity and Note 20.

Common Dividends** Net Earnings Attributable to The Kroger Co. 437 2018 = 3,110 = 14.05%

Dividend Payout =

486 1,659 = 29.29%

2019 =

** Cash dividends paid is given in the financing activities section of the statement of cash flows.

Sprouts Farmers Market

Dividends per Common Share* Common Stock Price $0.00 2018 = $23.19 = 0.00%

Dividend Yield =

$0.00 $19.35 = 0.00%

2019 =

* Sprouts policy of paying no dividends is discussed in Item 5 under “Dividend Policy.”

Common Dividends* Net Income $0 2018 = $158,536 = 0.00%

Dividend Payout =

$0 $149.629 = 0.00%

2019 =

* Sprouts policy of paying no dividends is discussed in Item 5 under “Dividend Policy.”

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Case 10-80 (Continued) 3.

Common Dividends + Common Stock Repurchases Net Income $437 + $1,927 2018 = $3,110 = 76.01%

Total Payout Kroger =

$486 + $400 $1,659 = 53.41%

2019 =

Sprouts Farmers Market $0 + $258,307 $158,536 = 162.93%

2018 =

$0 + $176,310 $149,629 = 117.83%

2019 =

Stock Repurchase Payout = Total Payout − Dividend Payout Kroger 2018

= =

76.01% − 14.05% 61.96%

2019

= =

53.41% − 22.29% 31.12%

= =

162.93% − 0.00% 162.93%

= =

117.83% − 0.00% 117.83%

Sprouts Farmers Market 2018

2019 4.

Both companies are paying out a relatively large amount of cash to their shareholders, albeit in different ways. Kroger doing it with a mix of dividends and stock repurchases, although well over 50% of the total payout is a result of stock repurchases. Sprouts, on the other hand, is relying entirely on stock repurchases to payout cash to shareholders. While the total payout has trended down, that is partly responsible to lower net income and stock price in 2019.

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Case 10-80 (Continued) 5. Return on Common Equity =

Net Income − Preferred Dividends Average Common Stockholders’ Equity

Kroger $3,076 − $0 $7,370 = 41.74%

2018 =

$1,640 − $0 $8,204 = 19.99%

2019 =

Sprouts Farmers Market $158,536 − $0 $619,945 = 25.57%

2018 =

$149,629 − $0 $585,574 = 25.55%

2019 =

Earnings per Share =

Net Income − Preferred Dividends Average Common Shares Outstanding

Kroger $3,076 − $0 810 = $3.80

2018 =

$1,640 − $0 799 = $2.05

2019 =

Sprouts Farmers Market

$158,536 − $0 128,827 = $1.23 per share

2018 =

$149,629 − $0 119,368 = $ 1.25 per share

2019 =

Kroger’s Return on Common Equity was quite good in 2018 at over 40%. However, it fell dramatically in 2019 because of a substantial drop in Net Income. Sprouts, on the other hand, was able to maintain their Return on Common Equity despite a drop in Net Income because of their aggressive share repurchase program. Kroger also experienced a dramatic decline in EPS (approximately 46%), while Sprouts’ EPS improved slightly.

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Annual Report Problem: (Home Depot) (amounts in millions) (3,116) 5,958 65,196 11,242 1,077

Common stockholders’ equity Common stock dividends Preferred stock dividends Treasury Stock Net Income Common shares outstanding

par value?

3. a. b.

Authorized shares Issued shares

Preferred stock and amount?

Common stockholders’ equity Common stock dividends Preferred stock dividends Treasury Stock Net Income Common shares outstanding

(3,365.28) 6,077.16 66,596 11,579.26 1,070

Return on common equity

3.47

Earnings per share

10.79

Dividend payout

0.52

0.05 10,000 1,786

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Annual Report Problem: (Lowe’s) (amounts in millions) 1,972 1,653 4,325 4,281 763

Common stockholders' equity Common stock dividends Preferred stock dividends Treasury Stock Net Income Common shares outstanding

Par value

$ 0.50

3a. 3b.

Authorized shares Issued shares

5,600 763

Preferred stock and amount

Common stockholders' equity Common stock dividends Preferred stock dividends Treasury Stock Net Income Common shares outstanding

Return on common equity

2.09

Earnings per share

5.81

Dividend payout

0.38

No 2,129.76 1,686.06 4,969 4,409.43 756

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Case 10-95 1. Date June

July

Journal Account and Explanation 15 Cash

Aug.

Sept.

Dec.

Common Stock Additional Paid-In Capital—Common Stock (Record sale of common stock) Cash Preferred Stock Additional Paid-In-Capital—Preferred Stock (Record sale of preferred stock) Treasury Stock* Cash (Record purchase of treasury shares) Dividends (or Retained Earnings) Cash Dividends Payable (Record liability for dividends) Cash Dividends Payable Cash (Record payment of dividends) Cash Treasury Stock** Additional Paid-In Capital—Treasury Stock (Record reissue of treasury shares)

Debit 40,000

Credit 2,000 38,000

225,000 150,000 75,000 11,200 11,200 25,000 25,000 25,000 25,000 6,600 4,800 1,800

* 700 shares  $16 = $11,200 ** 300 shares  $16 = $4,800

Stockholders’ equity: Preferred stock, 8 percent, $50 par, 20,000 shares authorized, 3,000 shares issued and outstanding........................................................... Common stock, $1 par, 25,000 shares authorized, 18,000 shares issued, and 17,600 shares outstanding ...................................................... Additional paid-in capital: Preferred stock....................................................................... Common stock ....................................................................... Treasury stock ........................................................................ Total capital stock ......................................................................... Retained earnings ......................................................................... Less: Treasury stock (400 shares at cost) ................................. Total stockholders’ equity..................................................

$150,000

18,000 75,000 38,000 1,800

$282,800 53,250 (6,400) $329,650

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Making the Connection:

INTEGRATIVE EXERCISE (Chapters 8–10)

Integrating Accounting for Liabilities and Equity Current Assets Current Ratio = Current Liabilities $162,819 2019 = $105,718 = 1.54

$131,339 $115,929 = 1.13

2018 =

(Cash + Short-Term Investments + Receivables) Current Liabilities ($48,844 + $51,713 + $22,926) 2019 = $105,718 = 1.17

Quick Ratio =

($25,913 + $40,388 + $23,186) $115,929 = 0.77

2018 =

(Cash + Short-Term Investments) Current Liabilities ($48,844 + $51,713) 2019 = $105,718 = 0.95

Cash Ratio =

($25,913 + $40,388) $115,929 = 0.57

2018 =

For 2019, Apple is below the industry average for the current and quick ratio, but is above the industry average for the cash ratio. However, because there is little concern about Apple’s ability to sell its inventories, the current ratio provides relatively high confidence that Apple will be able to meet its short-term obligations.

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Total Liabilities Total Equity $248,028 2019 = $90,488 = 274.10%

Debt to Equity =

$258,578 $107,147 = 241.33%

2018 =

Long-Term Debt (including current portion) Total Equity ($91,807 + $10,260) 2019 = $90,488 = 112.80%

Long-Term Debt to Equity =

($93,735 + $8,784) $107,147 = 95.68%

2018 =

Operating Income Interest Expense $63,930 2019 = $3,576 = 17.88

Times Interest Earned (Accrual Basis) =

$70,898 $3,240 = 21.88

2018 =

While Apple is well below the industry averages for all three ratios, long-term solvency is not much of a concern for Apple at this point in time. 3.

Net Income Average Stockholders ’ Equity $55,256 2019 = ($90,488 + $107,147)  2 = 55.92%

Return on Equity =

$59,531 ($107,147 + $134,047)  2 = 49.36%

2018 =

Apple is 266% above the industry average for return on equity for 2019.

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Common Dividends Net Income $14,119 2019 = $55,256 = 25.55%

Dividend Payout =

$13,712 $ 59,531 = 23.03%

2018 =

Stock Repurchases Net Income $66,897 2019 = $55,256 = 121.07%

Repurchase Payout =

$ 72,738 $ 59, 531 = 122.19%

2018 =

Total Payout = Dividend Payout + Stock Repurchase Payout 2019 = 25.55% + 121.07% = 146.62% 2018 = 23.03% + 122.19% = 145.22% Apple is attempting to return capital of $175 billion to shareholders through a share repurchase plan. As for dividends, Apple is paying out approximately $0.75 per share per quarter. Further, it intends to increase its dividends on an annual basis.

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THE STATEMENT OF CASH FLOWS

DISCUSSION QUESTIONS 1.

The statement of cash flows is one of the primary financial statements companies prepare to help analyze operations. This statement provides information about the cash inflows, cash outflows, and the net increase (decrease) in cash during an accounting period in a manner that reconciles the beginning and ending cash balances on the balance sheets. As such, the statement of cash flows helps to meet the information needs of financial statement users who want to know about the amount, timing, and uncertainty of cash flows.

The statement of cash flows provides users with relevant information for decisionmaking. This information helps users, including investors, creditors, and others, to: (1) (2) (3) (4) (5)

Assess a company’s ability to produce future net cash inflows Judge a company’s ability to meet obligations and pay dividends Estimate the company’s need for external financing Understand the relationship between net income and cash flows Evaluate balance sheet effects of both cash and noncash investing and financing transaction

An income statement provides information about a company’s performance on an accrual basis— that is, it records business activities when they occur, which is not necessarily when cash is received or paid. Thus, an accrual-basis income statement does not tell how much cash was generated or used as a result of the company’s operations. A statement of cash flows reports cash flows from operating activities, investing activities, and financing activities. Therefore, the statement of cash flows fills a void in the accrual-basis financial statements by explaining the sources from which a company has acquired cash (inflows of cash) and the uses to which the business has applied cash (outflows of cash).

Cash equivalents are short-term, highly liquid investments that are readily convertible to cash and have original maturities of 3 months or less. Because of their high liquidity or nearness to cash, cash equivalents are treated as cash in the statement of cash flows.

The three categories are operating activities, investing activities, and financing activities. Operating activities include the cash inflows and outflows that relate to acquiring (purchasing or manufacturing), selling, and delivering goods or services in the normal course of business operations. Operating cash flows correspond to the types of items that determine net income (revenue and expenses).

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Investing activities include the cash inflows and outflows that relate to acquiring and disposing of operating assets, acquiring and selling investments (current and long term), lending money, and collecting loans. Financing activities include cash received from obtaining resources from creditors and owners (the issuance of debt or stock) and cash payments to repay the principal amount borrowed, to repurchase a company’s own stock, and to pay dividends. 6.

Noncash investing and financing activities are required to be reported in a supplementary schedule (shown either at the bottom of the statement of cash flows or in the notes to the financial statements) because it provides useful information about a company’s overall financing and investing activities. This requirement to disclose any significant noncash investing and financing activities is consistent with the fulldisclosure principle—any information that would make a difference to financial statement users should be made known.

Direct exchanges of long-term debt for items of property, plant, and equipment are included as supplementary information because they provide useful information about a company’s overall investing and financing activities. Because these noncash investing and financing activities represent resource inflows and outflows, they significantly affect the ability of the firm to secure cash from financing sources in the future. Therefore, even though they do not affect cash, this information is still provided because it could impact a financial statement user’s decisions.

The relationships between the changes in balance sheet accounts and the company’s cash flow need to be analyzed in order to understand the reasons why the cash balance has changed. Starting with the fundamental accounting equation (Assets = Liabilities + Stockholders’ Equity), the changes in cash can be described as follows: Increases in Cash = Increases in Liabilities + Increases in Stockholders’ Equity + Decreases in Noncash Assets Decreases in Cash = Decreases in Liabilities + Decreases in Stockholders’ Equity + Increases in Noncash Assets This analysis reveals that all cash receipts or cash payments are associated with changes in the balance sheet accounts.

A company can choose to report net cash flows from operating activities in either of two methods the indirect method or the direct method. Most companies use the indirect method because it: (1) is easier and less costly to prepare (2) focuses on the differences between net income and net cash flow from operating activities rather than the individual cash flows

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Under the indirect method, a company converts its net income to its net cash flow from operating activities by: (1) adding to net income any noncash expenses and subtracting from net income any noncash revenues (2) adding to net income any losses and subtracting from net income any gains (3) adding to net income any decreases in current assets or increases in current liabilities that are related to operating activities (4) subtracting from net income any increases in current assets and decreases in current liabilities that are related to operating activities The direct method adjusts each individual item on the income statement by the changes in the related current asset or liability accounts. If the direct method is used, companies are required to show a reconciliation of net income with net cash flow from operating activities in the notes to the financial statements. The FASB prefers the use of the direct method because it is more consistent with the purpose of the statement of cash flows. 10. When the indirect method is used, depreciation, depletion, and amortization are added to net income because these three expense items do not consume cash when incurred. That is, these items reduced net income but they did not reduce cash. Cash was reduced when the assets being depreciated, depleted, or amortized were acquired. 11. An increase in inventory implies that purchases of inventory exceeded the amount of inventory sold. Under the indirect method, an increase in inventory is shown as a subtraction from net income in the operating activities section of the statement of cash flows. 12. An increase in accounts payable implies that credit purchases of inventory exceeded the cash payments to suppliers. Under the indirect method, an increase in accounts payable is shown as an addition to net income in the operating activities section of the statement of cash flows. 13. No. The change in cash and cash equivalents is affected by inflows and outflows for investing and financing activities as well as operating activities. Net cash flows from investing and/or financing activities are frequently negative. If the amount of the cash outflows from investing and/or financing activities exceeds the inflow from operations, overall cash and cash equivalents will decline. 14. Under the indirect method, the loss from disposal of equipment would be added back to net income in the operating activities section of the statement of cash flows. The actual receipt of cash for the equipment (i.e., the sales price) would be included as proceeds from the disposal of equipment in the investing activities section of the statement of cash flows. 15. Retained earnings increases with net income (decreases with a net loss) and decreases due to dividends. Under the indirect method, net income appears as a positive amount in © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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the cash flows from operations section of the statement of cash flows. A net loss would be a negative amount in the cash flows from operations section. Dividends paid in cash appear in the financing section of the statement of cash flows as an outflow of cash. 16. The following are the most common cash inflows from financing activities: (1) Sale of stock (2) Issuance of bonds (3) Issuance of notes payable The following are the most common cash inflows from investing activities: (1) Disposal/sale of operating assets (e.g., property, plant, and equipment) (2) Sale of investments (3) Collection of the principal amount of a loan 17. The following are the most common cash outflows from financing activities: (1) Repayment of debt (e.g., notes payable and bonds payable) (2) Payment of dividends The following are the most common cash outflows from investing activities: (1) Purchase of operating assets (e.g., property, plant, and equipment) (2) Purchase of investments (debt or equity securities of other companies) (3) Making loans to other companies (e.g., notes receivable) 18. A company that must rely on sources other than operations to fund its cash outflows would most likely issue debt (e.g., bonds payable) or stock. The cash inflows from these issuances would appear as increases in the common or preferred stock accounts and in the long-term and short-term debt accounts on the balance sheet. In addition, decreases in some asset accounts (e.g., investments) may be observed as assets are sold to provide additional cash for the company. 19. The majority of cash inflows should come from operating activities. Cash secured from operations is more controllable (least risky) and less expensive in terms of issue costs than cash that is secured from investing activities or from financing activities. In addition, cash inflows from operations do not require future outflows that are normally associated with financing activities (e.g., the payment of dividends, interest, and the principal amount of debt). 20. Cash for investment in property, plant, and equipment should come from long-term sources, because these assets are a long-term investment. It is generally desirable to match the time commitment of long-term uses of cash with long-term sources of cash. If short-term sources of cash were used to finance long-term uses of cash, these shortterm sources would likely require repayment before the property, plant, and equipment (a long term use of cash) could provide the necessary cash flows. 21. Under the direct method, the largest component of cash inflows from operating activities is cash collected from customers. This component would include both cash

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sales and collections of credit sales. Other typical cash inflows would arise from cash collected for interest or dividends. 22. Under the direct method, the cash inflows and cash outflows are computed by adjusting each item on the income statement by changes in the related current asset or liability accounts. These calculations are as follows: Cash Collected from Customers = Sales + Decrease (or − Increase) in Accounts Receivable Cash Collected for Interest

= Interest Revenue + Decrease (or − Increase) in Interest Receivable

Cash Paid to Suppliers

= Cost of Goods Sold + Increase (or − Decrease) in Inventory + Decrease (or − Increase) in Accounts Payable

Cash Paid for Operating Expenses = Operating Expenses + Increases (or − Decreases) in Prepaid Expenses + Decreases (or − Increases) in Accrued Liabilities Cash Paid for Interest

= Interest Expense + Decreases (or − Increases) in Interest Payable

Cash Paid for Income Taxes

= Income Tax Expense + Decrease (or − Increase) in Taxes Payable

23. Depreciation expense is a noncash item. Therefore, it is not generally reported on the direct method statement of cash flows. Sometimes depreciation expense is included as part of operating expenses. In this case, depreciation expense must be subtracted from operating expenses to compute the cash paid for operating expenses. 24. Using a spreadsheet to construct the statement of cash flows provides a systematic way for users to analyze changes in the balance sheet amounts, along with information from the income statement and any additional information, to determine their cash effects. Because of the spreadsheet’s systematic approach, it is often helpful in more complex situations. This approach produces spreadsheet entries (made only on the spreadsheet and not in the general ledger) that simultaneously reconstruct and explain the changes in the balance sheet account balances and identify the cash inflows and outflows.

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MULTIPLE-CHOICE QUESTIONS 11-1. b 11-2. d 11-3. c 11-4. a 11-5. a 11-6. c 11-7. c 11-8. b 11-9. a 11-10. c 11-11. a 11-12. c 11-13. d

($55,000 + $12,000 − $6,500 + $10,000) ($14,800 − $20,000) ($150,000 − $50,000) (Free cash flow = $243,000 − $112,900 − $35,800 = $94,300; Cash flow adequacy ratio = $94,300  $122,300) ($252,500 + $21,700 − $12,200) ($325,000 + $6,200 + $8,800)

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BRIEF EXERCISES BE 11-14 a. b. c. d.

Statement of Cash Flows Income Statement, Statement of Cash Flows Balance Sheet, Statement of Cash Flows Statement of Cash Flows

BE 11-15 a. b. c. d. e. f. g. h. i. j. k. l.

Operating activities Investing activities Operating activities Financing activities Financing activities Operating activities Operating activities Investing activities Financing activities Operating activities Financing activities Operating activities

BE 11-16 1.

a. b. c. d.

Operating activities Investing activities Operating activities Financing activities

e. f. g. h.

Operating activities Operating activities Investing activities Operating activities

a. b. c. d.

Cash increase Cash decrease Cash decrease Cash decrease

e. f. g. h.

Cash increase Cash increase Cash increase Cash increase

BE 11-17 Net income .......................................................................................... Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense ............................................................ Decrease in accounts receivable............................................. Increase in inventory ............................................................. Increase in accounts payable ................................................. Decrease in interest payable .................................................. Net cash flows provided by operating activities ....................................

$ 12,750

$ 32,600 21,500 (18,300) 19,800 (1,200)

$67,150

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BE 11-18 Net income ................................................................................... Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense .............................................................. Increase in accounts receivable ................................................ Decrease in inventory .............................................................. Increase in accounts payable .................................................... Decrease in income taxes payable ............................................ Net cash flows provided by operating activities .............................

$28,000

$15,000 (2,500) 3,000 5,000 (1,500) $47,000

BE 11-19 Cash flow from investing activities: Purchase of equipment* ............................................................... Cash received from sale of equipment ........................................... Cash received from sale of long-term investment**....................... Net cash flows used by investing activities ............................................

$(22,000) 3,500 15,000 $ (3,500)

* $46,000 − $32,000 + $8,000 = x = $22,000 (See T-account for additional details on this computation.)

Equipment Beginning balance

32,000 8,000

Purchases Ending balance

Disposal

x 46,000

** $50,000 − 38000 + $3,000 = x = $15,000 (Determined with reference to the journal entry below.)

Journal Date

Account and Explanation

Debit

Cash Investment (long term) Gain on Sale of Investments

Credit x 12,000 3,000

Note: The $3,000 gain is included in the operating activities section of the statement of cash flows.

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BE 11-20 Cash flow from financing activities:........................................................... Cash received from issuance of notes payable* ............................. Cash paid to retire notes payable .................................................. Payment of dividends**................................................................ Cash received from issuing common stock ..................................... Net cash flows used by financing activities ...........................................

$ 55,000 (35,000) (42,000) 40,000 $ 18,000

* See T-account next.

Repayment of principal

Notes Payable 75,000 35,000 x 95,000

Beginning balance Issuance of note Ending balance

Cash received from issuing note = $75,000 + x − $35,000 = $95,000; x = $55,000 ** See T-account next.

Retained Earnings 36,000 x 26,000

Dividends

20,000

Beginning balance Net income Ending balance

Cash paid for dividends = $36,000 + $26,000 − x = $20,000; x = $42,000

BE 11-21 Free Cash Flow

= Net Cash Flow from Operating Activities − Capital Expenditures − Cash Dividends = $425,000 − $275,000 − $60,000 = $90,000

Cash Flow Adequacy Ratio

= Free Cash Flow/Average Amount of Debt Maturing over the Next 5 Years = $90,000/$80,000 = 1.125

Madison has positive free cash flows, which shows promise for the ability to pursue future profitgenerating opportunities. In addition, a cash flow adequacy ratio greater than one implies that the company should be able to meet is maturing debt obligations with internally generated funds.

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BE 11-22 Cash collected from customers:

= $1,240,000 − ($26,850 − $22,150)

= $1,235,300 BE 11-23 Cash paid to suppliers:

= $1,525,000 + $65,410 + $43,190

= $1,633,600 BE 11-24 Cash payments for operating expenses:

= $174,500 − $8,500 + $18,200 = $184,200

BE 11-25 Cash flows from operating activities: ........................................................ Cash collected from customers* ........................................................ Cash paid to suppliers** .................................................................... Cash paid for other expenses ............................................................. Cash paid for taxes*** ....................................................................... Net cash provided by operating activities .................................................

$ 247,500 (152,000) (35,000) (13,500) $ 47,000

* $250,000 − $2,500 (increase in accounts receivable) = $247,500 ** $160,000 − $3,000 (decrease in inventory) − $5,000 (increase in accounts payable) = $152,000 *** $12,000 + $1,500 (decrease in income taxes payable) = $13,500

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EXERCISES E 11-26 a. b. c. d. e. f. g. h. i. j. k. l. m. n.

Operating Investing Financing Operating Investing Operating Noncash Operating Operating Financing Operating Financing Operating Investing for the cash received from the sale; Operating for the gain on the sale

E11-27 1.

a. b. c. d. e. f. g. h. i. j.

Operating Operating Financing Operating for the loss on the disposal; Investing for the cash received from the disposal Investing Operating Noncash Investing Operating Operating

The three statement of cash flow classifications correspond to the three business activities of a company: operating, investing, and financing. Therefore, the classifications provide investors, creditors, and other users insight into how a company’s business activities contributed to or reduced a company’s cash balance. If transactions were improperly classified, misleading information would be provided to financial statement users with respect to how a company generated and used its cash.

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E11-28 1. a. b. c. d. e. f. g. h.

Cash outflow Cash inflow Cash outflow Cash inflow Cash inflow Cash inflow Cash outflow Cash outflow

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

Operating Operating (net income) Operating Financing Operating Operating Financing Investing

E 11-29 a.

Journal Account and Explanation Accounts Receivable Sales Revenue Cost of Goods Sold Inventory This transaction does not affect cash flows. Date

b. Date

Journal Account and Explanation

Cash Accounts Receivable This transaction increases cash flow from operations by $752,600. c. Date

Journal Account and Explanation

Inventory Accounts Payable This transaction does not affect cash flows. d. Date

Journal Account and Explanation Accounts Payable Cash

Debit 825,000

Credit 825,000

560,000 560,000

Debit 752,600

Credit 752,600

Debit 574,300

Credit 574,300

Debit 536,200

Credit 536,200

This transaction decreases cash flow from operations by $536,200.

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E 11-30 1. and 2. Effect on Accounting Equation Assets Liabilities and Equity Current Noncurrent Current Noncurrent Liabilities Liabilities Equity

a. b.

d. e. f. g.

h. i.

k. l.

Transaction Purchased supplies on credit, $18,600 + 18,600 Paid $14,800 cash toward the purchase in transaction a − 14,800 Provided services to customers on credit, $46,925 + 46,925 + 39,650 Collected $39,650 cash from accounts receivable − 39,650 Recorded depreciation expense, $8,175 Employees earned salaries, $15,650 Paid $15,650 cash to employees for salaries earned − 15,650 Accrued interest expense on long-term debt, $1,950 Paid $25,000 on long-term debt, including $1,950 interest from transaction h − 25,000 Paid $2,220 cash for 1 year's insurance coverage + 2,220 in advance − 2,220 Recognized insurance expense, $1,340 − 1,340 Sold old equipment with book value of $7,500 for $7,500 cash + 7,500

Effect on Cash Flows

+ 18,600

none

− 14,800

outflow of $14,800

− 8,175 + 15,650

+ 46,925

none inflow of $39,650

− 8,175

none

− 15,650

none outflow of $15,650

− 15,650 − 1,950

+ 1,950

− 1,950

none

outflow of $25,000

− 23,050

outflow of $2,220 − 1,340 − 7,500

none inflow of $7,500

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E 11-30 (Continued) 1. and 2.

Transaction m. Declared cash dividend, $12,000 n. Paid cash dividend declared in transaction m o. Purchased new equipment for $28,300 cash p. Issued common stock for $60,000 cash q. Used $10,700 of supplies to produce revenues 3.

Effect on Accounting Equation Assets Liabilities and Equity Current Noncurrent Current Noncurrent Liabilities Liabilities Equity + 12,000 − 12,000

− 12,000

Effect on Cash Flows none outflow of $12,000

+ 60,000

outflow of $28,300 inflow of $60,000

− 10,700

none

− 28,300

+ 28,300

Classifications: a. Noncash activity b. Operating activities c. Noncash activity d. Operating activities e. Noncash activity* f. Noncash activity g. Operating activities h. Noncash activity i. $23,050 (Financing), $1,950 (Operating) j. Operating activities k. Noncash activity l. Investing activities m. Noncash activity n. Financing activities o. Investing activities p. Financing activities q. Noncash activity

* While depreciation expense is a noncash activity, it is shown as an addition to net income in the operating activities section of a statement of cash flows prepared using the indirect method.

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E 11-31 1.

Cash flows from operating activities: Net income .............................................................................. Adjustments to reconcile net income to net ................................ cash flow from operating activities: .......................................... Depreciation expense .......................................................... Increase in accounts receivable ........................................... Decrease in inventory.......................................................... Increase in accounts payable ............................................... Net cash provided by operating activities ......................................

$52,000

$11,300 (6,150) 5,975 8,700 $71,825

The company is able to show higher net cash provided by operating activities than net income because noncash expenses (e.g., depreciation expense) are added back in the reconciliation. In addition, the changes in the current asset and liabilities indicate that there were more credit sales than cash collections (causing an increase in accounts receivable), cost of inventory sold was greater than what was purchased (causing a decrease in inventory), and credit purchases were greater than cash paid to the suppliers (causing an increase in accounts payable). After adjusting for these activities, the net result was that operating cash flows were greater than the amount reported as income.

When operating cash flow is greater than net income, many financial statement users interpret this as a signal of higher quality earnings. An understanding of the differences between net income and net cash flow from operating activities allows users to assess the reliability of a company’s reported income.

E 11-32 1.

Cash flows from operating activities: Net income .............................................................................. Adjustments to reconcile net income to net ................................ cash flow from operating activities: .......................................... Depreciation expense ..................................................... Loss on disposal of equipment ........................................ Decrease in accounts receivable ..................................... Increase in inventory ...................................................... Decrease in prepaid rent ................................................ Increase in salaries payable ............................................ Decrease in income taxes payable .................................. Net cash provided by operating activities ......................................

$185,200

$ 52,700 6,450 8,305 (19,900) 4,410 7,100 (3,870) $240,390

The major differences for this company between net income and cash from operating activities are two noncash items: depreciation expense and the loss on disposal of equipment. In addition, the changes in the current assets and liabilities indicate the following: (1) the large increase in inventory during the year indicates that the purchases of inventory were greater than the cost of the inventory sold, (2) the decrease in accounts receivable indicates that there were more cash collections than there were credit sales, (3) the decrease in prepaid rent indicates that more rent expired during the year and was expensed than was paid in cash, (4) the increase in salaries payable indicates that employees earned more salaries (and, therefore, more was recorded as an expense) than were paid in cash, and (5) the decrease in income taxes payable indicates that more was paid in income taxes than was accrued as a liability during the year.

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E 11-33 1.

Ending accumulated depreciation ..................................................... Add: Accumulated depreciation of equipment sold........................

$ 133,900 36,700 $ 170,600 (108,000) $ 62,600

Less: Beginning accumulated depreciation..................................... Depreciation expense ................................................................... Accumulated Depreciation 108,000 Disposal

Beginning balance

36,700 x 133,900

Depreciation expense* Ending balance

* Depreciation expense = $108,000 + x − $36,700 = $133,900; x = $62,600

Ending equipment ........................................................................ Add: Cost of equipment sold .........................................................

$ 325,000 41,000 $ 366,000 (262,000) $ 104,000

Less: Beginning equipment............................................................ Cash paid for equipment (purchase) .............................................. Equipment Beginning balance

262,000 41,000

Purchase* Ending balance

Disposal

y 325,000

* Purchase = $262,000 + y − $41,000 = $325,000; y = $104,000

For the statement of cash flows, the amount of the cash inflow from the disposal of the equipment is $7,500 [($41,000 − $36,700) + $3,200].

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E 11-34 1.

Ending accumulated depreciation ................................................. Less: Beginning accumulated depreciation..................................... Depreciation expense ...................................................................

Disposal

Accumulated Depreciation 13,125,000 0 y 13,900,000

$ 13,900,000 (13,125,000) $ 775,000

Beginning balance Depreciation expense* Ending balance

* Depreciation expense = $13,125,000 + y − $0 = $13,900,000; y = $775,000

Ending aircraft ..................................................................................... Less: Beginning aircraft ........................................................................ Cash paid for aircraft purchased ...........................................................

Beginning balance Purchase* Ending balance

Equipment (Aircraft) 22,250,000 0 x 32,700,000

$ 32,700,000 (22,250,000) $ 10,450,000

Disposal

* Purchase = $22,250,000 + x − $0 = $32,700,000; x = $10,450,000

Ending accumulated depreciation .......................................... Plus: Accumulated depreciation aircraft sold .......................... Less: Beginning accumulated depreciation ............................. Depreciation expense ............................................................

Disposal

$ 13,900,000 3,825,000 $ 17,725,000 (13,125,000) $ 4,600,000

Accumulated Depreciation 13,125,000 Beginning balance 3,825,000 y Depreciation expense* 13,900,000 Ending balance

* Depreciation expense = $13,125,000 + y − $3,825,000 = $13,900,000; y = $4,600,000

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E 11-34 (Continued) b.

Ending aircraft ....................................................................... Plus: Cost of aircraft sold .......................................................

$ 32,700,000 4,100,000 $ 36,800,000 (22,250,000) $ 14,550,000

Less: Beginning aircraft .......................................................... Cash paid for aircraft purchased .............................................

Beginning balance

Aircraft 22,250,000 4,100,000

Purchase* Ending balance

Disposal

x 32,700,000

* Purchase = $22,250,000 + x − $4,100,000 = $32,700,000; x = $14,550,000

Cost of aircraft sold ............................................................... Less: Accumulated depreciation .............................................

$ 4,100,000 (3,825,000) $ 275,000 193,000 $ 468,000

Gain on disposal of aircraft .................................................... Cash from disposal of aircraft.................................................

E 11-35 1.

Notes Payable Repayment of principal

120,000

Beginning balance

Issuance of note*

200,000

Ending balance

* Cash received from issuing note = $120,000 + x − $0 = $200,000; x = $80,000 Cash received from issuance of note payable = 2. Repayment of principal

Notes Payable 120,000 40,000 x 200,000

$ 80,000 Beginning balance Issuance of note* Ending balance

* Cash received from issuing note = $120,000 + x − $40,000 = $200,000; x = $120,000 Items Reported in Financing Activities Section of the Statement of Cash Flows: Cash received from issuance of note payable $120,000 Repayment of principal

(40,000)

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E 11-36

Retired stock

Common Stock 135,000 0 x 210,000

Beginning balance Issued stock* Ending balance

* Cash received from issuing stock = $135,000 + x − $0; x = $75,000

Dividends*

Retained Earnings x 412,800 105,610 495,300

Beginning balance Net income Ending balance

* Payment of dividends = $412,800 + $105,610 − x = $495,300; x = $23,110 Items Reported in Financing Activities Section of the Statement of Cash Flows: Cash received from issuance of common stock Payment of dividends

$ 75,000 (23,110)

E 11-37 1.

Cash flows from operating activities: Net income .............................................................................. Adjustments to reconcile net income to net cash flow from operating activities: Increase in accounts receivable ......................................... Increase in inventory ........................................................ Decrease in accounts payable ........................................... Increase in interest payable .............................................. Depreciation expense, building ......................................... Depreciation expense, equipment* ................................... Net cash provided by operating activities ......................................

$65,800

$(26,540) (32,180) (9,300) 2,120 14,590 50,350 $64,840

* $32,350 + $18,000 = $50,350

2. 3. 4.

Cash proceeds from the disposal of equipment are classified as an investing inflow on the statement of cash flows. The cash dividends are reported as a financing outflow on the statement of cash flows. Because net income was greater than net cash flow from operating activities, many analysts may view this as a signal of low earnings quality. In particular, the large increase in receivables may signal an effort by Service Company to boost declining sales by allowing customers more time to pay or by extending credit to riskier customers. In addition, the large increase in inventory may signal that the company is having trouble selling its merchandise as planned. However, before any conclusions are made, further investigation should be performed.

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E 11-38 1. Free Cash Flowa

Adequacy Ratiod

Ditka Inc ................................................

$1,033,000b

1.05e

McMahon Company ..............................

$ 702,000c

0.58f

b c d

e f

Free Cash Flow = Net Cash from Operating Activities − Capital Expenditures − Cash Dividends $2,475,000 − $1,157,000 − $285,000 = $1,033,000 $1,639,000 − $748,000 − $189,000 = $702,000 Cash Flow Adequacy = Free Cash Flow ÷ Average Amount of Debt Maturing over the Next 5 Years $1,033,000 ÷ $985,000 = 1.05 $702,000 ÷ $1,212,000 = 0.58

Both companies appear to have a substantial amount of free cash flow— approximately 42% ($1,033,000 ÷ $2,475,000) to 43% ($702,000 ÷ $1,639,000) of operating cash flow. The companies are in a good position to pursue any profit-generating opportunities should they arise. In addition, Ditka has a cash flow adequacy ratio more than 1, which indicates that it should have no problem meeting its maturing debt obligations with the operating cash flow it generates. Given this ratio, Ditka appears to have the capacity to obtain more debt if desired. However, McMahon’s cash flow adequacy ratio is less than 1, indicating that it may have difficulty meeting its maturing debt obligations with its operating cash flow and, therefore, may have to seek outside sources of capital in the future.

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E 11-39 Beckwith Products Company Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income ....................................................................... Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense .............................................. Decrease in accounts receivable .............................. Increase in inventory ............................................... Increase in accounts payable ................................... Increase in interest payable ..................................... Decrease in wages payable ...................................... Net cash provided by operating activities ................................. Cash flows from investing activities: Equipment purchase ......................................................... Net cash used for investing activities ........................................ Cash flows from financing activities: Cash received from issuance of notes ................................ Repayment of long-term liabilities .................................... Cash received from stock issue .......................................... Payment of dividends ....................................................... Net cash provided by financing activities .................................. Net increase (decrease) in cash ................................................ Cash, 1/1/2019 ........................................................................ Cash, 12/31/2019..................................................................... 2.

$ 58,400

$ 18,650 2,900 (9,300) 2,100 3,500 (900) $ 75,350 $(103,400) (103,400) $ 50,000 (35,000) 50,000 (25,000) 40,000 $ 11,950 25,000 $ 36,950

Free cash flow = $75,350 − $103,400 − $25,000 = $(53,050) Adequacy ratio: $53,050/$85,000 = (0.62) Beckwith has negative free cash flow and a negative cash flow adequacy ratio. However, these negative amounts are mainly caused by the large investments in productive assets.

Beckwith shows positive operating and financing cash flows but large negative investing cash flows. This pattern of cash flows is consistent with a company that is expanding by making investments in operating assets (property, plant, and equipment). This expansion is being financed with cash generated from operations and cash obtained from borrowing or by investments of owners.

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E 11-40 Cash flows from operating activities: Cash collected from customersa ........................................................................ Cash paid to suppliersb ..................................................................................... Cash payments to employeesc .......................................................................... Cash payments for insuranced .......................................................................... Cash payments for intereste ............................................................................. Cash payments for income taxesf...................................................................... Net cash provided by operating activities ..............................................................

$ 401,400 (208,130) (69,100) (15,330) (13,910) (27,400) $ 67,530

Cash collected from customers equals sales revenue plus the decrease in accounts receivable ($385,800 + $15,600 = $401,400). b Cash paid to suppliers equals cost of goods sold plus the increase in inventory less the increase in accounts payable ($203,100 + $8,710 − $3,680 = $208,130). c Cash payments to employees equals wages expense plus the decrease in wages payable ($62,400 + $6,700 = $69,100). d Cash payments for insurance equals insurance expense plus the increase in prepaid insurance ($13,780 + $1,550 = $15,330). e Cash payments for interest is interest expense less the increase in interest payable ($15,150 − $1,240 = $13,910). f Cash payments for income taxes is the amount of income taxes expense since there was no change reported in income taxes payable.

E 11-41 1.

Cash flows from operating activities: Cash collected from customers ......................................................................... Cash paid to suppliers of merchandise .............................................................. Cash paid to employees and other suppliers of goods and services.................................................................... Cash paid for interest ....................................................................................... Income taxes paid ............................................................................................ Net cash provided by operating activities ..............................................................

$ 785,400 (395,540) (221,750) (22,100) (58,300) $ 87,710

Cash flows from investing activities: ........................................................................... Cash received from disposal of equipment........................................................ Purchase of equipment .................................................................................... Cash received from sale of long-term investments ............................................ Purchase of long-term investments .................................................................. Net cash used for investing activities .....................................................................

$ 42,500 (120,000) 71,400 (75,800) $ (81,900)

Cash flows from financing activities: ........................................................................... Cash received from issuance of long-term debt ................................................. Principal payments on long-term debt .............................................................. Principal payments on mortgage payable ......................................................... Proceeds from issuance of common stock......................................................... Payment of dividends ...................................................................................... Net cash provided by financing activities ...............................................................

$ 40,000 (22,000) (60,000) 85,000 (35,000) $ 8,000

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E 11-42 Rowe Publishing Company Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Cash collected from customersa ........................................ $1,042,000 Cash paid to suppliersb ..................................................... (586,000) c Cash payments to employees .......................................... (347,000) Cash payment for interestd ............................................... (16,000) e Paid income taxes ........................................................... (29,000) Net cash provided by operating activities................................. Cash flows from investing activities: Equipment purchase ........................................................ $ (25,000) Net cash used for investing activities ....................................... Cash flows from financing activities: Repayment of notes payable ............................................ $ (35,000) Proceeds from issuance of bonds payable ......................... 50,000 Payment of dividends....................................................... (35,000) Net cash used for financing activities ....................................... Net increase (decrease) in cash ................................................ Cash, Jan. 1 ............................................................................. Cash, Dec. 31........................................................................... a

$ 64,000

(25,000)

(20,000) $ 19,000 66,000 $ 85,000

Cash collected from customers is sales revenue less the increase in accounts receivable ($1,051,000 − $9,000 = $1,042,000). Cash paid to suppliers is cost of goods sold plus the increase in inventory less the increase in accounts payable ($578,000 + $20,000 − $12,000 = $586,000). Cash paid to employees is salary expense less the increase in salaries payable ($351,000 − $4,000 = $347,000). Cash payments for interest is interest expense since there was no change in interest payable (zero reported at both year ends). Cash payments for income taxes is the amount of income taxes expense plus the decrease in income taxes payable ($22,000 + $7,000 = $29,000).

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E 11-43 Cincinnati Health Club Spreadsheet to Prepare the Statement of Cash Flows For the year ending December 31 Balance Beginning Adjustments Sheet Accounts Balance Debit Credit Cash.......................................... 9,200 — 3,900 Accounts receivable ................... 8,900 (h) 1,600 — Inventory .................................. 18,600 (i) 1,200 — Building ..................................... 490,000 — — Equipment ................................ 270,000 (b) 10,000 — Accumulated depreciation ........................ 120,000 — 28,000 Accounts payable ....................... 36,100 — 19,200 Salaries payable ......................... 11,700 (k) 2,200 — Income taxes payable ................. 9,900 (l) 8,800 — Bonds payable........................... 400,000 (e) 100,000 50,000 Common stock ........................... 150,000 — 30,000 Retained earnings ...................... 69,000 (g) 10,000 2,700 Statement of Cash Flows Cash flow from operating activities: Net income .................................................... Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense ........................... Increase in accounts receivable ............. Increase in inventory ............................ Increase in accounts payable ................ Decrease in salaries payable ................. Decrease in income taxes payable......... Cash flows from investing activities: Purchase equipment ...................................... Cash flows from financing activities: Issued bonds payable ..................................... Retired bonds payable*.................................. Issued common stock ..................................... Paid dividend ................................................. Net increase (decrease) in cash .............................. .............................................................................

(a)

(m)

(d) (f) (a)

Ending Balance 5,300 10,500 19,800 490,000 280,000 148,000 55,300 9,500 1,100 350,000 180,000 61,700

2,700

1,600 1,200 — 2,200 8,800

(h) (i)

10,000

(b)

100,000

(e) (g)

3,900

10,000 —

267,600

(k) (l)

(d) 50,000 (f) 30,000 (m)

* Note: The $100,000 retirement of bonds is not given in the problem but must be logically deduced in order to make the balance sheet account reconcile

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E 11-43 (Continued) Cincinnati Health Club Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income ......................................................................... Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense ................................................ Increase in accounts receivable .................................. Increase in inventory ................................................. Increase in accounts payable ..................................... Decrease in salaries payable ...................................... Decrease in income taxes payable.............................. Net cash provided by operating activities.................................... Cash flows from investing activities: Purchase of equipment ....................................................... Net cash used for investing activities .......................................... Cash flows from financing activities: Proceeds from issuance of bonds payable ............................ Retired bonds payable ........................................................ Issued common stock .......................................................... Payment of dividends.......................................................... Net cash used for financing activities .......................................... Net increase (decrease) in cash ................................................... Cash, Jan. 1 ............................................................................... Cash, Dec. 31 .............................................................................

$ 2,700

$28,000 (1,600) (1,200) 19,220 (2,200) (8,800) $36,100 $(10,000) (10,000) $ 50,000 (100,000) 30,000 (10,000)

(30,000) $ (3,900) 9,200 $ 5,300

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PROBLEM SET A P 11-44A 1.

a. b. c. d. e. f. g. h. i. j. k. l. m. a. b. c. d. e. f. g. h. i. j. k. l. m.

Investing Operating Operating Financing Operating Operating Financing Operating Operating Financing Investing Financing Operating Cash outflow Cash outflow No cash effect Cash inflow No cash effect Cash inflow Cash outflow Cash outflow Cash outflow Cash inflow Cash inflow Cash outflow Cash outflow

P 11-45A 1.

Cash flows from operating activities: Net income .............................................................................. Adjustments to reconcile net income to net ................................ cash flow from operating activities: .......................................... Depreciation expense .......................................................... Bad debt expense................................................................ Increase in accounts receivable ........................................... Increase in inventory ........................................................... Decrease in prepaid expenses.............................................. Increase in accounts payable ............................................... Increase in salaries payable ................................................. Net cash provided by operating activities ......................................

$108,120

$ 246,100 51,700 (182,400) (98,725) 64,100 43,850 54,900 $287,645

The major causes of differences between net income and net cash flow from operating activities are the noncash depreciation expense and the increase in accounts receivable (showing the company did not collect as much money from customers as the revenue it recognized on the income statement).

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P 11-46A 1.

Rolling Meadows Country Club Inc. Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income ...................................................................... Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense, buildings ............................. Depreciation expense, golf carts ............................. Decrease in accounts receivable ............................. Increase in pro shop inventory ................................ Increase in prepaid insurance ................................. Increase in accounts payable .................................. Decrease in wages payable ..................................... Increase in income taxes payable ............................ Net cash provided by operating activities................................. Cash flows from investing activities: Cash paid for new golf carts ............................................. Cash received from disposal of used golf carts ............................................................. Net cash used for investing activities ....................................... Cash flows from financing activities: Proceeds from issuance of note payable Payment on mortgage payable ......................................... Cash from issuance of common stock ............................... Cash paid for dividends .................................................... Net cash provided by financing activities ................................. Net increase (decrease) in cash ................................................ Cash, Jan. 1 ............................................................................. Cash, Dec. 31 ..........................................................................

$ 125,800

$ 35,100 21,250 7,175 (23,300) (12,600) 13,210 (7,400) 2,125 $161,360 $ (85,000) 12,700 (72,300) $ 60,000 (42,000) 41,375 (40,000) 19,375 $108,435 8,500 $116,935

2. Rolling Meadows shows large positive operating cash flow, large negative investing cash flows, and relatively small positive financing cash flows. Rolling Meadows appears to have high quality earnings supported by its cash flows from operations. Given the specific assets purchased (golf carts), it appears that Rolling Meadows is using cash from its operations to maintain its long-term assets.

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P 11-47A Erie Company Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income ................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ....................................... Gain on disposal of equipment* ........................ Gain on sale of investments** .......................... Increase in accounts receivable ......................... Increase in inventory ........................................ Decrease in prepaid rent................................... Decrease in accounts payable ........................... Increase in wages payable ................................ Decrease in interest payable ............................. Increase in income taxes payable ...................... Net cash provided by operating activities........................... Cash flows from investing activities: Proceeds, disposal of equipment ................................ Purchase of equipment .............................................. Proceeds from sale of investments*** ........................ Purchase of investments ............................................ Net cash used for investing activities ................................. Cash flows from financing activities: Repayment of long-term note .................................... Proceeds from issuance of common stock ................... Payment of dividends................................................. Net cash used for financing activities ................................. Net increase (decrease) in cash .......................................... Cash, Jan. 1 ....................................................................... Cash, Dec. 31.....................................................................

$ 20,500

$18,900 (2,500) (4,100) (8,200) (2,000) 4,000) (2,600) 2,500) (1,300) 1,900) $27,100 $ 3,800 (27,350) 32,700 (14,400) (5,250) $(25,000) 31,500 (7,900) (1,400) $20,450 12,750 $33,200

The equipment sold had a book value of $1,300 ($14,800 − $13,500). The gain on the disposal was $2,500 ($3,800 − $1,300). Gains are subtracted from net income because they do not provide a cash inflow in excess of the proceeds that are included in the investments portion of the statement. ** The gain from the sale of the investments is subtracted from net income. *** $28,600 + $4,100 = $32,700 *

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P 11-48A 1.

Monon Cable Television Company Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income ...................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ............................................. Gain on disposal of PP&E (antenna) ........................ Increase in accounts receivable............................... Decrease in supplies ............................................... Decrease in accounts payable ................................. Decrease in rent payable ........................................ Increase in royalties payable .................................. Net cash provided by operating activities ................................ Cash flows from investing activities: Proceeds from disposal of equipment (antenna) ...................................................................... Equipment (antenna) purchased ...................................... Building purchased .......................................................... Trucks purchased ............................................................. Net cash used for investing activities ....................................... Cash flows from financing activities: Proceeds from issue of note ............................................. Payment of dividends ...................................................... Net cash provided by financing activities ................................. Net increase (decrease) in cash................................................ Cash, Jan. 1 ............................................................................ Cash, Dec. 31 ..........................................................................

$ 40,000

$28,000 (800) (5,300) 500 (1,500) (8,700) 200 $ 52,400

$ 1,800 (60,000) (20,000) (6,000) (84,200) $ 40,000 (14,200) 25,800 $ (6,000) 8,000 $ 2,000

While Monon was able to generate positive operating and financing cash flows, its investments consumed slightly more cash than was generated. This suggests a company that is financing its growth with cash generated from operations and obtained from borrowing.

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P 11-49A 1.

Yogurt Plus Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Cash collected from customers .............................................. Cash paid to suppliers ........................................................... Cash payments for operating expenses .................................. Cash payments for interest.................................................... Cash payments for income taxes ........................................... Net cash provided by operating activities...................................... Cash flows from investing activities: Proceeds from disposal of furniture ....................................... Restaurant furniture purchase............................................... Net cash used for investing activities ............................................ Cash flows from financing activities: Proceeds from stock issue ..................................................... Proceeds from issuance of long-term notes ........................... Proceeds from issuance of short-term notes .......................... Principal payment on mortgage ............................................. Paid cash dividends ............................................................... Net cash provided by financing activities ...................................... Net increase (decrease) in cash ..................................................... Cash, Jan. 1 .................................................................................. Cash, Dec. 31................................................................................

$ 334,500 (176,450) (115,210) (24,600) (9,475) $

8,765

$ 11,300 (108,800) (97,500) $ 72,000 50,000 15,000 (35,000) (10,000) 92,000 $ 3,265 21,800 $25,065

In addition, a supplementary schedule should report the $30,000 acquisition of kitchen equipment in exchange for notes. 2.

The large negative investing cash flows and the large positive financing cash flows suggests that Yogurt Plus is expanding its operations by issuing debt.

P 11-50A Cash flows from operating activities: .................................................................................. Cash collected from customers* ............................................................................ $ 4,017,430 Cash paid to suppliers** ....................................................................................... (2,842,085) Cash paid for operating expenses*** .................................................................... (887,700) Net cash provided by operating activities ..................................................................... $ 287,645 * $4,199,830 − $182,400 = $4,017,430 ** $2,787,210 + $98,725 − $43,850 = $2,842,085 *** $1,304,500 − $64,100 − $54,900 − $51,700 − $246,100 = $887,700

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P 11-51A 1.

Endicott & Thurston Associates Spreadsheet to Prepare the Statement of Cash Flows For the year ending December 31 Balance Beginning Adjustments Sheet Accounts Balance Debit Credit Cash ..................................... 17,000 — 15,000 (o) Accounts receivable ............... 219,000 — 141,000 (e) Prepaid rent .......................... 104,000 — 75,000 (f) Long-term investments .......... 40,000 (j) 31,000 20,000 (c) Equipment, computing.......... 362,000 (i) 376,000 250,000 (d) Furniture .............................. 365,000 (k) 35,000 — Accumulated depreciation 554,000 (d) 230,000 42,000 (b) Accounts payable .................. 58,000 (g) 2,000 — Salaries payable..................... 105,000 (h) 16,000 — Long-term notes payable ....... 105,000 (l) 25,000 — Bonds payable ...................... 0 — 140,000 (m) Common stock....................... 225,000 — — Retained earnings .................. 60,000 (n) 38,000 70,000 (a) Statement of Cash Flows Cash flow from operating activities: Net income ......................................... (a) 70,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense .................... (b) 42,000 Loss on sale of investments ............ (c) 2,000 Loss on disposal of PP&E ................ (d) 15,000 Decrease in accounts receivable ..... (e) 141,000 — Decrease in prepaid rent ................ (f) 75,000 — Decrease in accounts payable ......... — 2,000 (g) Decrease in salaries payable ........... — 16,000 (h) Cash flows from investing activities: Sale of investments............................. (c) 18,000 Disposal of computing equipment ....... (d) 5,000 Purchase computing equipment .......... 376,000 (i) Purchase investments ......................... 31,000 (j) Purchase office furniture..................... 35,000 (k) Cash flows from financing activities: Payment on notes payable .................. 25,000 (l) Issued bonds payable.......................... (m) 140,000 Paid dividend...................................... 38,000 (n) Net increase (decrease) in cash .................. (o) 15,000 — 1,276,000 1,276,000

Ending Balance 2,000 78,000 29,000 51,000 488,000 400,000 366,000 56,000 89,000 80,000 140,000 225,000 92,000

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P 11-51A (Continued) Endicott & Thurston Associates Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income ....................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense .................................................. Loss on sale of investments .......................................... Loss on disposal of PP&E .............................................. Decrease in Accounts receivable................................... Decrease in Prepaid rent .............................................. Decrease in Accounts payable ...................................... Decrease in Salaries payable ........................................ Net cash provided by operating activities ................................. Cash flows from investing activities: Proceeds from sale of investments .................................... Proceeds from disposal of computing equipment .............. Purchase of computing equipment .................................... Purchase of investments ................................................... Purchase of office furniture............................................... Net cash used for investing activities ........................................ Cash flows from financing activities: Payment on notes payable ................................................ Proceeds from issuance of bonds payable ......................... Payment of dividends ....................................................... Net cash provided by financing activities .................................. Net increase (decrease) in cash ................................................ Cash, Jan. 1 .............................................................................. Cash, Dec. 31 ........................................................................... 2.

$ 70,000

$ 42,000 2,000 15,000 141,000 75,000 (2,000) (16,000) 327,000 $ 18,000 5,000 (376,000) (31,000) (35,000) (419,000) $ (25,000) 140,000 (38,000) 77,000 $ (15,000) 17,000 $ 2,000

The assets acquired by Endicott & Thurston are expected to provide operating cash flows over a long period of time. The company secured a portion of the financing of these assets from creditors (issued bonds payable) who expect returns on their cash over a long period of time. Therefore, one may conclude that, with respect to a portion of the assets, Endicott & Thurston has matched the timing of its prospective inflows of cash (generated by long-lived assets) and its future outflows of cash (required to pay its bondholders). The remaining portion of the assets was financed by cash generated from operating activities. Endicott & Thurston appears to have adequate operating cash flow to support the purchase of these assets.

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PROBLEM SET B P 11-44B 1.

a. b. c. d. e. f. g. h. i. j. k. l.

Financing Operating Investing Operating Noncash Financing Operating Operating Operating Financing Investing Operating

a. b. c. d. e. f. g. h. i. j. k. l.

Cash outflow Cash outflow Cash outflow Cash outflow No cash effect Cash inflow Cash outflow Cash inflow No cash effect Cash inflow Cash inflow No cash effect

P 11-45B 1.

Cash flows from operating activities: Net income .............................................................................. Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense .......................................................... Bad debt expense................................................................ Decrease in accounts receivable .......................................... Decrease in inventory.......................................................... Increase in prepaid expenses ............................................... Decrease in accounts payable .............................................. Increase in salaries payable ................................................. Net cash provided by operating activities ............................................. 2.

$ 45,300

$ 214,500 37,000 85,150 138,620 (112,400) (67,225) 18,300 $359,245

The major causes of differences between net income and net cash from operating activities are the noncash depreciation expense, the decrease in inventory (showing the company sold more inventory than it purchased with cash), and the increase in prepaid expenses (showing that the company paid for more expenses in advance than were expensed on the income statement).

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P 11-46B 1.

Fannin Company Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income ........................................................................... Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense .................................................. Increase in accounts receivable .................................... Decrease in inventory .................................................. Decrease in prepaid insurance ..................................... Decrease in accounts payable ...................................... Increase in wages payable ........................................... Decrease in income taxes payable ............................... Net cash provided by operating activities ..................................... Cash flows from investing activities: Cash from sale of investment ................................................ Cash paid for property, plant, and equipment ......................................................................... Net cash used for investing activities ............................................ Cash flows from financing activities: Proceeds from issuance of notes ........................................... Payment on bonds payable ................................................... Cash from issuance of common stock .................................... Cash paid for dividends ......................................................... Net cash used for financing activities ............................................ Net increase (decrease) in cash ..................................................... Cash, Jan. 1 ................................................................................. Cash, Dec. 31 ...............................................................................

$594,600

$ 93,410 (23,400) 61,250 47,600 (31,550) 18,200 (7,600) $752,510 $ 22,850 (101,325) (78,475) $ 50,000 (200,000) 20,000 (30,000) (160,000) $514,035 118,250 $632,285

Fannin’s large operating cash flow and negative investing and financing cash flows is indicative of a company with strong operations using its cash generated from operations to buy fixed assets and pay down its debt.

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P 11-47B Volusia Company Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net income............................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense .................................................. Loss on disposal of PP&E* ............................................ Loss on sale of investments** ...................................... Decrease in accounts receivable ................................... Decrease in inventory .................................................. Increase in prepaid rent ............................................... Increase in accounts payable ........................................ Increase in interest payable.......................................... Decrease in wages payable ........................................... Decrease in income taxes payable ................................ Net cash provided by operating activities ...................................... Cash flows from investing activities: Proceeds, disposal of equipment............................................ Purchase of equipment .......................................................... Proceeds from sale of investments*** ................................... Purchase of investments ........................................................ Net cash used for investing activities ............................................. Cash flows from financing activities: Repayment of long-term note ................................................ Proceeds from issuance of notes ............................................ Proceeds from issuance of common stock.... Payment of dividends ............................................................ Net cash used for financing activities............................................. Net increase (decrease) in cash ..................................................... Cash, Jan. 1 .................................................................................. Cash, Dec. 31 ...............................................................................

$ 18,300

$ 24,800 4,200 1,500 6,225 4,100 (2,100) 3,700 1,400 (2,300) (1,700) $58,125 $

4,500 (37,025) 19,700 (32,900) (45,725)

$ (15,000) 20,000 7,900 (13,500) (600) $11,800 16,300 $28,100

The equipment sold had a book value of $8,700 ($25,000 − $16,300). The loss on the disposal was $4,200 ($8,700 − $4,500). Losses are added to net income because losses do not affect cash flow beyond the proceeds that are included in the investing section of the statement. ** The loss from the sale of the investments is added back to net income. *** $21,200 − $1,500 = $19,700 *

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P 11-48B 1.

SDPS Inc. Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net loss.................................................................................. Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ................................................... Loss on disposal of PP&E (vehicles).. Increase in Accounts receivable .................................... Decrease in Supplies, fuel ............................................. Increase in Accounts payable ........................................ Decrease in Wages payable........................................... Increase in repair & maintenance payable ...................................................................... Increase in rent payable ................................................................ Net cash provided by operating activities ....................................... Cash flows from investing activities: Proceeds from disposal of vehicles ......................................... Vehicles purchased ................................................................ Net cash used for investing activities ............................................. Cash flows from financing activities: Principal payment on long-term note ..................................... Net cash used for financing activities ............................................. Net increase (decrease) in cash ...................................................... Cash, Jan. 1 ................................................................................... Cash, Dec. 31 .................................................................................

$(23,000)

$215,000 3,000 (17,000) 14,000 40,000 (7,000) 7,000 41,000 $278,000 $130,000 (425,000) (295,000) $(25,000) (25,000) $(42,000) 82,000 $40,000

Cash decreased primarily because of the large purchase of vehicles. A smaller factor was the cash paid to decrease the mortgage.

SDPS was able to finance its investment in property, plant, and equipment through its operating cash flow. Contributing to SDPS’s net loss was a large noncash expense relating to depreciation. Because depreciation does not involve a cash outflow, SDPS was able to generate positive operating cash flows even though it had a net loss. In addition, several current liabilities (e.g., accounts payable, rent payable) increased dramatically during the year, contributing to SDPS’s positive operating cash flow.

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P 11-49B 1.

Befuddled Corporation Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Cash collected from customers .................................... Cash paid to suppliers ........................................................... Cash payments for operating expenses ................................. Cash payments for interest ................................................... Cash payments for income taxes ........................................... Net cash provided by operating activities ..................................... Cash flows from investing activities: Proceeds from disposal of equipment ................................... Purchases of equipment........................................................ Net cash used for investing activities ............................................ Cash flows from financing activities: Proceeds from issuance of notes payable .............................. Repayment of short-term notes payable ............................... Payment of dividends ........................................................... Net cash provided by financing activities ...................................... Net increase (decrease) in cash .................................................... Cash, Jan. 1 ................................................................................. Cash, Dec. 31 ............................................................................... 2.

$ 956,500 (534,900) (193,200) (36,400) (21,300) $ 170,700 $ 11,250 (217,150) (205,900) $ 30,000 (20,000) (38,000) (28,000) $ (63,200) 89,200 $ 26,000

The large negative investing cash flows suggests that the company is expanding its operations using cash flow generated by operations. In addition, Befuddled is using cash from operations to pay its shareholders a dividend.

P 11-50B Cash flows from operating activities: .......................................................................... Cash collected from customers* ....................................................................... Cash paid to suppliers**................................................................................... Cash paid for operating expenses***................................................................ Net cash provided by operating activities ..............................................................

$ 3,669,750 (2,486,105) (824,400) $ 359,245

* $3,584,600 + $85,150 = $3,669,750 ** $2,557,500 − $138,620 + $67,225 = $2,486,105 *** $981,800 + $112,400 − $18,300 − $37,000 − $214,500 = $824,400

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P 11-51B 1.

Fleet Limousine Service Inc. Spreadsheet to Prepare the Statement of Cash Flows For the year ending December 31 Balance Beginning Adjustments Sheet Accounts Balance Debit Credit Cash ........................................ 0 (p) 7,200 — Accounts receivable ................. 0 (c) 15,900 — Supplies ................................. 0 (d) 3,100 — Long-term investments ........... 0 (o) 15,000 — Land ....................................... 0 (i) 11,000 — Building .................................. 0 (j) 175,000 — Equipment.............................. 0 (k) 233,400 — Accumulated depreciation ....... 0 — 35,500 Accounts payable ................... 0 — 12,700 Unearned service revenue ...... 0 — 21,800 Salaries payable...................... 0 — 4,600 Rent payable .......................... 0 — 8,200 Notes payable ........................ 0 (m) 5,000 100,000 Common stock........................ 0 — 300,000 Retained earnings ................... (a) 17,200

Statement of Cash Flows Cash flow from operating activities: Net loss ............................................................................ Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense .............................................. Increase in accounts receivable ............................... Increase in supplies ................................................. Increase in accounts payable ................................... Increase in unearned service revenue ...................... Increase in salaries payable ..................................... Increase in rent payable .......................................... Cash flows from investing activities: Purchase of land ............................................................... Purchase of building ......................................................... Purchase of equipment ..................................................... Purchase of investments* ................................................. Cash flows from financing activities: Issued note payable .......................................................... Paid principal on note payable .......................................... Issued common stock ....................................................... Net increase (decrease) in cash ................................................ *

(b)

(e) (f) (g) (h)

(b) (e) (f) (g) (h) (l) (n)

Ending Balance 7,200 15,900 3,100 15,000 11,000 175,000 233,400 35,500 12,700 21,800 4,600 8,200 95,000 300,000 (17,200)

—

17,200 (a)

35,500 — — 12,700 21,800 4,600 8,200

— 15,900 (c) 3,100 (d) — — — — 11,000 (i) 175,000 (j) 233,400 (k) 15,000 (o)

(l) (n)

100,000 5,000 (m) 300,000 — 7,200 965,600 965,600

Note: The $15,000 purchase of investments is not given in the problem but must be logically deduced in order to make the balance sheet account reconcile.

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P 11-51B (Continued) Fleet Limousine Service Inc. Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Net loss ............................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ............................................. Increase in Accounts receivable ............................... Increase in Supplies ................................................ Increase in Accounts payable .................................. Increase in Unearned service revenue ..................... Increase in Salaries payable..................................... Increase in Rent payable ......................................... Net cash provided by operating activities ................................. Cash flows from investing activities: Purchase of land ............................................................... Purchase of building ......................................................... Purchase of equipment ..................................................... Purchase of investments ................................................... Net cash used for investing activities ........................................ Cash flows from financing activities: Payment on notes payable................................................ Proceeds from issuance of long-term note payable............ Issuance of common stock ................................................ Net cash provided by financing activities .................................. Net increase (decrease) in cash ................................................ Cash, Jan. 1 .............................................................................. Cash, Dec. 31 ........................................................................... 2.

$(17,200)

$ 35,500 (15,900) (3,100) 12,700 21,800 4,600 8,200 $46,600 $(11,000) (175,000) (232,400) (15,000) (434,400) $ (5,000) 100,000 300,000 395,000 $ 7,200 0 $ 7,200

These newly acquired assets are expected to provide operating cash flows over a long period of time. Fleet secured the resources for these investments from creditors and stockholders who expect returns on their cash over a long period of time. Therefore, one may conclude that Fleet has matched the timing of its prospective inflows of cash (generated by long-lived assets) and its future outflows of cash (required to pay its bondholders and stockholders).

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CASES Case 11-52 1.

No. Depreciation expense approximates the investment in new equipment for the 2 years. Year 1 Year 2 Total

Depreciation $37,000 41,000 $78,000

Equipment $40,000 45,000 $85,000

This implies that the declining service potential of the assets has roughly been maintained over the 2 years. 2.

June should be able to secure the loan. Cash provided by operations is stable and is providing more resources than are needed to pay dividends, repay current debt, and replace operating assets being consumed.

If the second store is as profitable as the current store, then $25,000 to $30,000 in additional resources ought to be available from that store each year [see the net increase (decrease) in cash for each year] to add to the $25,000 to $30,000 being generated from the current store. If resources provided by operations from both stores are used to repay the loan, 3 to 4 years would be required to repay the loan plus interest.

Case 11-53 1.

Cash provided by operations should decrease as net income declines in response to decreased sales volume. Of course, the exact amount of the decrease in cash provided by operations will depend on the simultaneous changes in the various factors that explain the difference between net income and cash provided by operations. Thus, we lack sufficient information to calculate the effect of the anticipated further decline.

As depreciation decreases, net income will always increase; however, cash flow provided by operations will be unaffected by changes in depreciation because the full amount of depreciation is added back to net income in the calculation of cash flow provided by operating activities. In other words, the recording of depreciation expense does not affect cash flow from operating activities.

Businesses experiencing declining sales volume do not always consume cash. As long as cash collected from customers is larger than cash paid for merchandise and for various operating expenses, cash from operations will be positive. Of course, if sales volume declines sufficiently far, cash collected from customers can fall short of cash paid for merchandise and for various other expenses, many of which are fixed and do not decline with sales volume.

Current assets and current liabilities may buffer operating cash flow against the impact of a sales volume decline. Drawing down receivables and inventories and increasing current liabilities will increase cash provided by operations. Although a company may be able to make such changes in receivables, inventories, and current liabilities in the short run, it will be unable to sustain them in the long term. Thus, although current assets and the availability of short-term credit provide a buffer against the consumption of cash in the short run, the operations of a declining business will eventually begin to consume cash.

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Case 11 -54 1.

Fitness Outfitters Inc. Prospective Statement of Cash Flows For the year ending December 31 Cash flows from operating activities: Cash collected from customers*..................................... Cash paid to suppliers** ................................................ Cash payments for operating expenses*** ..................... Net cash used for operating activities .................................... Cash flows from investing activities: Equipment purchase ...................................................... Net cash used for investing activities ..................................... Cash flows from financing activities: Cash received from stock issue....................................... Net cash provided by financing activities ............................... Net prospective cash outflow ................................................ Cash at beginning of year ...................................................... Prospective cash balance at end of year ................................ Desired cash balance at end of year ...................................... Shortfall of cash ....................................................................

$ 629,000 (307,000) (340,000) $ (18,000) $ (97,000) (97,000) $ 100,000 100,000 $ (15,000) 0 $ (15,000) 5,000 $ (20,000)

Cash collected from customers is assumed to be equal to sales revenue because there are no accounts receivable at year end. ** Cash paid to suppliers is cost of goods sold plus the increase in inventory less the increase in accounts payable ($291,000 + $53,000 − $37,000). *** Cash paid for operating expenses is assumed to be equal to operating expenses less the amount of depreciation expense ($355,000 − $15,000). Recall that depreciation expense does not require a cash outflow.

At this point, the prospective year end cash balance falls short of the desired year end balance by $20,000. Jane and Harvey could sell additional stock or borrow funds from a lender.

Yes. You can anticipate future cash shortages and respond by securing additional cash or reducing cash outflows. Cash planning is a particularly important activity for a new business. You can also anticipate cash surpluses that might develop and plan to invest excess cash wisely.

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Case 11-55 1.

Schedule of annual cash flows: Year 1 Loans made ........................

Year 3

$(5,000,000)

Principal collected .............. Interest received................ $(5,000,000) 2.

Year 2

Year 4

$0 $ 800,000 $ 800,000

$ 200,000 1,000,000 $1,200,000

Year 2

Year 3

Year 4

Schedule of effect on annual net income: Year 1 Interest revenue ............... Uncollectible notes expense .....................

$400,000

400,000

$400,000

(1,500,000) $(1,100,000)

500,000

$ 500,000

(2,000,000) $(1,500,000)

(1,300,000) $ (800,000)

* Calculation of Year 4 uncollectible notes expense: Maturity amount ........................................................................... Amount recovered ......................................................................... Additions to allowance ($1,500,000 + $2,000,000) .......................... Uncollectible note expense ............................................................

$6,000,000 1,200,000 $4,800,000 3,500,000 $1,300,000

When the allowance procedure is properly used, the sequence of net income figures gives earlier signals of the impending loss than does the sequence of cash flow figures. The income sequence signals an estimated loss of $1,500,000 in Year 2, and $2,000,000 in Year 3.

Cash flows have no capacity to signal future losses that are unusual or nonrecurring. Thus, when conditions change and the frequency or amount of losses changes, current cash flows are a poor basis for predicting future cash flows.

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Case 11-56 1.

Dissenting members of the FASB believed that interest and dividends received should have been classified as cash inflows from investing activities and that interest paid should have been classified as a cash outflow from financing activities. The FASB justified classifying both as cash flows from operations on three bases: (1) virtually all companies classified such items as cash flows from operations under the existing standards; (2) banks and financial institutions classify such items as cash flows from operations, and it would be hard to argue otherwise; and (3) such items are included in determining net income, and to remove them from the operating category on the cash flows statement would make it more difficult to understand the relationship between net income and cash flows from operations.

Dissenters believed that, by permitting continued use of the indirect method, the FASB allowed companies to withhold important cash flow information from users of financial statements. In their view, “Reporting information about cash received from customers, cash paid to suppliers and employees, income taxes paid, and other operating receipts and payments (the direct method) provides a description of operating activities of an entity that is both more informative and more consistent with the primary purpose of a statement of cash flows. . . .” The FASB justified permitting continued use of the indirect method on three bases: (1) The indirect method concentrates on the relationship between net cash flows from operating activities and net income. This relationship provides useful information for investors and creditors who estimate future net cash flows from operations by first estimating future income and then adjusting future income for estimated differences between net income and the cash flows from operations. (2) Many companies told the FASB that the direct method would be more costly to apply than the indirect method. (3) For many companies, questions remain as to the best classification of operating cash flows and the best methods by which to compute them. It should be noted that companies using the indirect method are required to disclose in a footnote the amount of interest paid and income taxes paid (see last sentence of paragraph 29 in Statement No. 95), which is a step toward requiring the direct method.

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Case 11-57 1.

Alphabet used the indirect method of computing net cash flows from operating activities. This is evident because it adjusts net income in computing net cash flows provided by operating activities. 2018

2019

$47,971,000,000

$54,520,000,000

2. Net cash provided by operating activities

The most significant adjustments in both years made to net income in order to reach net cash provided by operating activities were provisions for depreciation and impairment of property, plant, and equipment, stock-based compensation expense, changes in income taxes, and changes in accrued liabilities. 3.

Cash paid for income taxes:

$8,203,000,000

The provision for depreciation and amortization is a noncash expense, and therefore must be added back to net income to find the amount of cash that was provided by or used for operating activities.

A few of Alphabet’s significant uses of cash in the investing section were purchases of marketable securities and property, plant, and equipment. Significant uses of cash in the financing activities section were repurchases of capital stock and payments related to stock-based awards. A few of the significant sources of cash related to investing activities were the maturities of marketable securities. Significant sources of cash related to financing activities included proceeds from the issuance of debt and proceeds from the sale of interests in consolidated entities.

Amazon did not pay a cash dividend for the current year.

Amazon appears to have matched the time commitment of inflows and outflows adequately. Amazon is actively involved in acquiring assets such as investments and property, plant, and equipment. However, these acquisitions are largely offset by sales of investments and a strong operating cash flow. Similarly, Amazon has obtained financing through the issuance of long-term debt; however, it has also paid down a large portion of its debt. While investing and financing activities result in a net cash outflow, Amazon has cash inflows from operating activities that can be used to cover the investing and financing outflows.

In the current year, Amazon generated a significant amount of cash from operating activities, and Amazon appears well positioned to maintain these large cash inflows. Creditors will look at Amazon’s profitability to estimate its ability to repay the amounts borrowed. Amazon has not borrowed significantly, and it has also shown the ability to repay the amounts borrowed. Therefore, this borrowing capacity does not appear to be overused. Amazon should be able to obtain debt and equity financing in the future.

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 11: The Statement of Cash Flows

Case 11-58 1.

Kroger used the indirect method of computing cash flows from operating activities, as did Sprouts. You could expect these to be the same, with the vast majority of companies using the indirect method of computing net cash from operating activities.

Kroger’s net cash provided by operating activities for the year ending February 1, 2020: $4,664,000,000 Sprouts’ net cash provided by operating activities for the year ending December 29, 2019: $355,210,000 Significant adjustments for both companies include depreciation and amortization and changes in balance sheet accounts such as changes in inventories, accounts payable, receivables, and prepaid expenses and other assets. Both companies also had large adjustments for stock-based compensation. Because for both Kroger and Sprouts cash provided by operating expenses exceeds net income, you can conclude that both companies seem to be doing a good job of producing quality earnings figures on the income statement.

Kroger’s significant uses of cash (financing and investing) include the purchase of property, plant, and equipment (capital expenditures), and payment of long-term debt. Kroger’s significant sources of cash (financing and investing) include proceeds from issuing debt and commercial paper, and proceeds for the sale of assets. Sprouts’ significant uses of cash (financing and investing) include purchase of property, plant, and equipment (capital expenditures), repayment of debt, and the repurchase of common stock. Sprouts’ significant sources of cash (financing and investing) include proceeds from short-term borrowings (revolving credit facilities) and the exercise of stock options.

Both Kroger and Sprouts appear to have matched the timing of cash inflows and cash outflows. Both companies had capital expenditures that were financed primarily with operating activities (e.g., the capital expenditures were less than the cash generated by operations). Therefore, both companies appear to have been able to finance the incremental investments with cash flows generated by operating activities.

Both companies have significant long-term debt, but they also have access to a revolving credit line and relatively strong cash flow from operations. Company profitability is a key factor in assessing a creditor’s willingness to lend money or an investor’s willingness to invest in a company. Given the strong performance of each company with respect to current operating cash flows as well as each company’s ability to generate positive net income, it appears that both companies will be able to utilize debt and equity financing in the future if they wish.

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Annual Report Problem (amounts in millions) 1

Accounts receivable Inventory Property, plant, and equipment Accounts payable and short-term debt Long-term debt Depreciation and amortization expense Net Income

2,106.00 14,531.00 22,770.00 8,761.00 28, 670.00 1,989.00 11,242.00

Forecasted balances Accounts receivable Inventory Property, plant, and equipment Short-term debt Long-term debt Depreciation expense Net Income

2,063.88 14,676.31 23,453.10 8,410.56 29, 816.80 2,028.78 13,490.40

Cash flows from operating activities

13,460.69

Major source of cash (investing)

Sales of property, plant, and equipment

Major use of cash (investing)

Capital expenditures

Major source of cash (financing)

Issuance of debt

Major use of cash (financing)

Repurchases of common stock

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Case 11-59 Front Row Entertainment Inc. Statement of Cash Flows For the year ending December 31, 2024 Cash flows from operating activities Net income ....................................................................... $ 73,665 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation expense .................................................. $ 51,675 Amortization of discount on bonds payable .................. 12,170 Increase in accounts receivable.... (81,250) Increase in prepaid expenses........................................ (76,200) Decrease in supplies..................................................... 1,500 Increase in inventory.................................................... (58,530) Decrease in accounts payable ....................................... (9,790) Decrease in salaries payable ......................................... (1,190) Increase in interest payable.......................................... 38,667 Decrease in unearned sales revenue ............................. (26,870) Decrease in income taxes payable ................................ (1,630) Net cash used for operating activities ....................................... Cash flows from investing activities: Purchase of buildings* ...................................................... $(1,477,250) Purchase of trademark...................................................... (25,000) Purchase of equipment** ................................................. (12,350) Net cash used for investing activities ........................................ Cash flows from financing activities: Cash received from issuance of bonds ............................... $ 1,378,300 Cash received from issuance of common stock .................. 40,000 Cash received from issuance of preferred stock ................. 225,000 Cash paid for dividends ..................................................... (25,000) Purchased treasury stock .................................................. (11,200) Cash received from sale of treasury stock .......................... 6,600 Net cash provided by financing activities .................................. Net increase (decrease) in cash ................................................ Cash and cash equivalents, 1/1/2024........................................ Cash and cash equivalents, 12/31/2024 .................................... Supplementary Schedule: Equipment was acquired in exchange for a note payable .......... Building was acquired in exchange for a note payable ...............

$ (77,783)

(1,514,600)

1,613,700 21,317 9,005 $ 30,322 $

8,000 380,000

* $1,857,250 − $380,000 = $1,477,250 ** $27,350 − $7,000 − $8,000 = $12,350

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Case 11-59 (Continued) 2.

Front Row Entertainment has large negative investing cash flows, which indicate that it is making large investments in long-term assets. A closer examination reveals that the largest expenditures involved the purchase of buildings relating to the company’s venue operations. In addition, the company shows negative operating cash flow, primarily due to large increases in the company’s assets (e.g., inventory and accounts receivable). Finally, the company has large positive financing cash flows due in large part to the issuance of bonds and stock (both common and preferred). Together, this pattern of cash flows is consistent with a rapidly growing company that is financing its growth through the issuance of debt and equity.

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FINANCIAL STATEMENT ANALYSIS

DISCUSSION QUESTIONS 1.

While customers, suppliers, employees, creditors, and investors all use financial statement data to make decisions, each group uses the information to answer different questions. For example, customers can use financial data to estimate the likelihood that a potential supplier will be able to deliver goods or services now and in the future. Suppliers use financial data because they are concerned about the resources available to pay for items purchased, as well as other claims against those resources. Employees use financial data to be sure that the company will provide competitive salary and benefits, experiences that will prepare them to assume increased responsibility, and a secure position for the foreseeable future. A creditor obviously needs to know whether the borrower will be able to repay the loan and its interest and can use the financial statements to help determine this. Investors who buy stock in a corporation expect to earn returns on their investment from dividends and an increase in the value of the stock. Analyzing the financial statements will help them to evaluate if the company is profitable enough to provide them with dividends and increases in stock value.

The annual report on Form 10-K provides a comprehensive overview of the corporation’s business and financial condition and includes audited financial statements. Although similarly named, the annual report on Form 10-K is distinct from the “annual report to shareholders,” which a corporation must send to its stockholders when it holds an annual meeting to elect directors. For larger filers, the 10-K must be filed within 60 days of their fiscal year end.

The 10-K is the company’s financial performance for an entire fiscal year. The financial statements supplied in the 10-K are audited by an independent, external auditor. The 10-Q, on the other hand, provides a continuing view of the company’s financial position during a year. The 10-Q is not audited, but it may be reviewed by external auditors. The 10-Q report must be filed for each of the first three fiscal quarters of the corporation's fiscal year. For larger firms this must be done within 40 days of the end of the quarter.

Item 1 outlines the history of the company, discusses recent developments, and provides an overview of its industry and competitors. There is a detailed discussion of such things as major products, major suppliers and sources of raw materials, key customers, seasonalities, government regulations, and risk factors. A thorough read of this section is a good way to better understand the business and determine whether the company has a good strategy for creating profits.

Item 7 is Management’s Discussion and Analysis, more frequently referred to as MD&A. This is one of the key parts of the 10-K. In this section, management discusses its views of the financial condition and performance of the company. Management is

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required to disclose trends, events, or uncertainties known to management that would materially affect the company. Included in this section are many statements about what will happen in the future. Although there is obviously uncertainty about whether these future events will happen, this information is designed to provide investors with information management believes necessary to understand the company and predict, or forecast, future performance. Item 7A is where the effect of market risk factors, such as fluctuating interest or currency exchange rates, on the company’s financial performance is discussed. 6.

Item 8 contains the corporation’s balance sheets for the last 2 years and the income statements and statements of cash flows for the last 3 years. These three financial statements are the primary sources of information for analysts. One part of Item 8 that should not be ignored is the footnotes that are provided as a supplement to the financial statements. This is where you will find information about the corporation’s accounting policies, as well as disclosures providing additional detail about various accounts listed on the financial statements. Item 8 also includes the auditor’s opinions on the effectiveness of the corporation’s system of internal controls over financial reporting and the appropriateness of the financial statements and accompanying footnotes.

The difference between time series and cross sectional analysis is that cross sectional analysis compares one corporation to another corporation and to industry averages, whereas time series analysis looks at one firm over a time period.

In horizontal analysis, each financial statement line item is expressed as a percent of the base year (typically the first year shown). Vertical analysis, on the other hand, expresses each financial statement line item as a percentage of the largest amount on the statement. The largest amount on the income statement is sales revenue, while the largest amount on the balance sheet is total assets.

The difference between the current and quick ratios is that the current ratio uses all current assets in the numerator, while the quick ratio excludes some current assets, such as inventory, and only includes cash, short-term investments, and receivables in the numerator. The quick ratio is a more conservative measure of short-term liquidity because only assets that can be converted into cash almost immediately are included.

10. The operating cash flow ratio differs from the current, quick, and cash ratios in that this ratio looks at the ability of operations to generate cash, which recognizes the more general concept that current obligations will be paid through operations. 11. Debt management ratios provide information on two aspects of debt. First, they provide information on the relative mix of debt and equity financing. Second, debt management ratios also try to show the corporation’s ability to meet its debt obligations through operations because interest and principal payments must be made as scheduled or a company can be declared bankrupt.

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12. Higher asset turnover ratios are considered to be better because a higher ratio indicates that the asset is being turned over faster. The faster an asset is turned over, the more efficiently it is being used. 13. Profitability ratios measure two aspects of a corporation’s profits: (1) Those elements of operations that contribute to profit (2) The relationship of profit to total investment and to investment by stockholders 14. The two categories of stockholder ratios are those that deal with the creation of value and those that deal with the distribution of value. 15. Dupont analysis breaks down return on equity into net profit margin, asset turnover, and leverage. 16. You must carefully analyze the accounting policies of a company when performing financial statement analysis because accounting amounts are often not precise statements of a company’s assets, liabilities, equity, revenues, and expenses. In many cases, the amounts are estimates. In other cases, amounts are determined largely by the accounting policies adopted by management. Certain portions of the financial statements can be substantially affected by accounting policy choices or estimates. When analyzing inventory, all else being equal, a corporation that uses LIFO will have different inventory turnover and gross profit ratios than a corporation that uses FIFO. A company that uses FIFO will have inventory on its balance sheet that is valued more closely to actual market prices than a company that uses LIFO, which could be valued with very old prices.

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MULTIPLE-CHOICE QUESTIONS 12-1. d 12-2. b 12-3. c 12-4. a 12-5. c 12-6. d 12-7. d 12-8. b 12-9. d 12-10. b 12-11. b 12-12. a 12-13. c

Current Assets Current Liabilities $67,500,000 = $17,000,000 = 3.97

12-14. d

Current Ratio =

12-15. b

Current Ratio =

Current Assets Current Liabilities $30,000 = $15,000 =2

12-16. a 12-17. a

12-18. c

Cash + Short-Term Investments Current Liabilities $20,000 + $25,000 = $40,000 = 1.125

Current Ratio =

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12-19. a 12-20. d 12-21. c 12-22. a Long-Term Debt

12-23. b

(Including Current Portion) Total Assets $350,000 + $250,000 = $600,000 + $85,000 + $900,000 $600,000 = $1,585,000 = 37.9%

Long-Term Debt toTotal Assets Ratio =

12-24. b 12-25. c 12-26. c 12-27. a 12-28. d 12-29. b

12-30. b

Cost of Goods Sold Average Inventory $65,000 = $30,000 = 2.17

Inventory Turnover Ratio =

Operating Cycle = Days Sales in Inventory + Days Sales in Receivables = (365/Inventory Turnover) + (365/Receivables Turnover) = (365/7.3) + (365/9.6) = 50 days + 38 days = 88 days

12-31. b 12-32. b 12-33. a

Net Income Average Inventory $240,000 = $1,220,000 * = 20%

Return on Equity =

* $600,000 + $250,000 + $370,000 = $1,220,000

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12-34. d 12-35. b 12-36. d 12-37. c 12-38. c

Net Income − Preferred Dividends Average Common Shares Outstanding $40,000 − $15,000 = 8,000 shares $25,000 = 8,000 shares = $3.13 per share

Earnings per Share =

12-39. a 12-40. a 12-41. d 12-42. c 12-43. d 12-44. d 12-45. d

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BRIEF EXERCISES BE 12-46 One of the biggest weaknesses of cross sectional analysis is that it is often difficult to find a good comparison corporation, and even corporations classified in the same industry frequently have different aspects to their operations.

BE 12-47 It is not always bad if a company’s cost of sales is increasing from year to year because the cost of sales could be increasing due to an increase in sales.

BE 12-48 1.

Accounts receivable: $18,000 increase Merchandise inventory: $3,000 decrease Total assets: $35,000 increase Net sales: $35,000 increase Cost of goods sold: $30,000 decrease

From 2022 to 2023, accounts receivable increased as a percentage of total assets from 14% to 17%, and merchandise inventory as a percentage of total assets decreased from 6% to 5%. Cost of goods sold as a percentage of net sales increased significantly from 2022 to 2023. In 2022, cost of goods sold was 43% of net sales as opposed to 32% in 2023.

BE 12-49 Larry Company appears to be the most liquid company because it has the highest current ratio, meaning that its current assets will more than cover its current liabilities. Moreover, Larry also has a high quick ratio, which means that its most liquid current assets (cash and receivables) will more than cover its current liabilities. Also, Larry has a strong inventory turnover ratio compared to the other two companies. Moe does appear to turn over its inventory more frequently but subsequently has a hard time collecting receivables as is evidenced by its low quick ratio.

BE 12-50 Rocky's debt to equity ratio increased from 2.36 in 2022 to 2.69 in 2023. The company should be concerned by the rising debt to equity ratio because it could indicate that the company is using too much debt financing in comparison to equity financing, and the company may struggle to make interest payments in the future.

BE 12-51 Duffy Company’s debt to equity ratio increased from 0.67 in 2022 to 1.35 in 2023 and the current ratio increased from 3 to 7.33. While it may seem that Duffy is improving by the increase in its current ratio, it is important to look at the debt to equity ratio in conjunction with the current ratio. Because current assets increased and current liabilities decreased, the current ratio improved. However, Duffy took on $5,000 of long-term debt, which greatly increased the debt to equity ratio. In 2022, Duffy had less debt than equity, but in 2023, it had much more debt than equity. This could indicate a potential problem.

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BE 12-52 Net Sales Average Accounts Receivable $422,596 = $17,380 = 24.32

1. Receivable Turnover Ratio =

Net Sales Average Total Assets $422,596 = $132,116 = 3.20

Asset Turnover Ratio =

365 3.20 = 114 days

Conversion into Days =

BE 12-53 Net Income Average Equity $425,000 = $800,000 = 53.1%

Return on Equity =

BE 12-54 Net Income Average Equity $115,000 = $500,000* = 23.00%

Return on Equity =

*Average Equity = (Beginning Equity + Ending Equity)/2 = [($270,000 + $205,000) + ($280,000 + $245,000)]/2 = $1,000,000/2 = $500,000

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BE 12-55 (Net Income − Preferred Dividends) Average Number of Common Shares Outstanding ($230,000 − $11,000) = 108,000 = $2.03

Earnings per Share =

BE 12-56 Common Dividends Paid Net Income $64,000 = $210,000 = 30.48%

Dividend Payout Ratio =

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EXERCISES E 12-57 The Form 10-Q includes unaudited financial statements and provides a continuing view of the corporation’s financial position during the year. The report must be filed for each of the first three fiscal quarters of the corporation’s fiscal year. For larger filers, this must be done within 40 days of the end of the quarter.

E 12-58 1.

The MD&A is one of the key parts of the 10-K. In this section, management discusses their views of the financial condition and performance of the company. Management is required to disclose trends, events, or uncertainties known to management that would materially affect the company. Included in this section are many statements about what will likely happen in the future. Although there is obviously uncertainty about whether these future events will happen, this information is designed to provide investors with information management believes necessary to understand the company and predict, or forecast, future performance. Item 7A is where the effect of market risk factors, such as fluctuating interest or currency exchange rates, on the company’s financial performance is discussed.

Student answers should list the following five important items included in Form 10-K: ● An overview of the business ● Description of the properties owned by the company ● A description of any lawsuits in which the company is involved ● The financial statements ● The auditor's opinions concerning the financial statements and internal controls ● A list of executives and executive compensation

E 12-59 1.

Columbia’s apparel is manufactured in 12 countries, with Vietnam and China accounting for approximately 50% of 2019 production. (Item 1, “Manufacturing and Sourcing” section on p. 2)

The four primary brands are Columbia, SOREL, Mountain Hard ware and prAna. (Item 1, “Brand and Products” section, p. 1)

8,900 (Item 1, “Employees” section, p. 4).

Columbia is involved in litigation and various legal matters arising in the normal course of business. However, they do not believe the ultimate resolution will have a material adverse effect on their financial condition. (Item 3)

$1,782.8 million were to the Wholesale channel and $1,259.7 were to the DTC channel (Item 7— Sales by Channel section, p. 23)

Columbia uses straight-line depreciation. The useful lives range from 3 to 10 years for furniture and equipment. (Note 2 to the financial statement, Item 8, p. 41)

Deloitte & Touche are Columbia's auditor. The audit opinion was signed on February 27, 2020. (Item 8, p. 33)

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E 12-60 1.

When you select an employer, you want to be sure that the company will provide: (1) competitive salary and benefits (2) experiences that will prepare you to assume increased responsibility (3) a secure position for the foreseeable future

A company that is considering selling goods or providing services to another company wants to know whether its customer will be able to: (1) pay for the purchase as agreed (2) continue to purchase and pay for goods and services

E 12-61 1.

Cooper Manufacturing Consolidated Income Statements 2023 142.36%

2022 112.56%

2021 100.00%

Operating income ................................................. Interest and other income, net .............................. Income before income taxes ................................. Provision for income taxes .................................... Net income ...........................................................

170.95% 98.32% 84.25% −253.71% 138.03% 177.00% −44.30% 163.88% 133.67% 179.51%

127.55% 110.37% 94.40% 641.71% 121.34% 42.35% 59.07% 43.34% 17.55% 56.68%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Earnings per common and common equivalent share ...............................

166.69%

57.35%

100.00%

Sales..................................................................... Costs and expenses: Cost of goods sold ............................................ Research and development............................... Selling, general, and administrative .................. Restructuring costs and other ...........................

In 2022, net income decreased despite an increase in sales. This is primarily due to two factors: (1) cost of goods sold increased at a far greater rate than sales (which means their gross profit ratio dropped) and (2) restructuring costs and other increased by over 600%. However, in 2023, net income was up dramatically, despite the continued deterioration of gross profit (i.e., cost of goods sold increasing faster than sales). This increase in income is due to drops in (1) research and development, (2) selling, general, and administrative, and (3) restructuring costs and other.

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E 12-62 1.

Winged Manufacturing Consolidated Balance Sheets ASSETS Current assets: Cash and cash equivalents ........................................ Short-term investments ............................................ Accounts receivable, net of allowance for doubtful accounts of $90,992 ($83,776 in 2022) ...... Inventories............................................................... Deferred tax assets .................................................. Other current assets ................................................. Total current assets ...................................................... Property, plant, and equipment: Land and buildings ................................................... Machinery and equipment ....................................... Office furniture and equipment ................................ Leasehold improvements ......................................... Accumulated depreciation and amortization ............ Net property, plant, and equipment .............................. Other assets ................................................................. Total assets ..................................................................

Dec. 31, 2023

Dec. 31, 2022

22.70% 1.03%

13.08% 4.17%

29.82% 20.53% 5.53% 4.82% 84.42% *

26.72% 29.13% 5.18% 5.60% 83.89% *

9.14% 10.80% 2.98% 4.46% 27.39% * −14.81% 12.58% 3.00% 100.00%

7.83% 11.18% 3.25% 5.06% 27.32% −14.56% 12.75% * 3.36% 100.00%

5.51% 16.63% 2.58% 3.36% 1.10% 7.49% 36.67% 5.74% 12.65% 55.06%

15.92% 14.36% 2.80% 3.38% 5.95% 6.09% 48.50% 0.14% 12.18% 60.82%

LIABILITIES AND STOCKHOLDER’S EQUITY Current liabilities: Short-term borrowing .............................................. Accounts payable ..................................................... Accrued compensation and employee benefits ......... Accrued marketing and distribution ......................... Accrued restructuring costs ...................................... Other current liabilities ............................................ Total current liabilities .................................................. Long-term debt ............................................................. Deferred tax liabilities................................................... Total liabilities .............................................................. * Differences due to rounding.

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E 12-62 (Continued)

Stockholders’ equity: Common stock, no par value: 320,000,000 shares authorized; 119,542,527 shares issued and outstanding in 2023 (116,147,035 shares in 2022) .................................................. Retained earnings ............................................... Accumulated translation adjustment ..................... Total stockholders’ equity .......................................... Total liabilities and stockholders’ equity ......................

Dec. 31, 2023

Dec. 31, 2022

5.62% 39.53% −0.20% 44.94% * 100.00% *

3.94% 35.63% −0.38% 39.18% * 100.00% *

* Differences due to rounding.

Winged appears to have secured the resources for the asset increase through long-term debt, which saw an extreme increase from 2022 to 2023, and from operations (i.e., the increase in retained earnings).

E 12-63 1.

Butler Corporation Consolidated Income Statements

Net sales .............................................................. Costs and expenses: Cost of goods sold ............................................ Selling, general, and administrative ................................................ Amortization of intangible assets............................................................. Operating income ................................................. Interest expense ................................................... Interest income .................................................... Income before income taxes ................................. Provision for income taxes .................................... Net income ...........................................................

2023 135.44%

December 31, 2022 2021 128.45% 100.00%

120.96%

107.45%

100.00%

129.69%

114.66%

100.00%

195.87% 244.19% 93.32% 54.89% 298.12% 139.68% 469.56%

127.65% 323.46% 95.50% 70.36% 409.57% 99.93% 744.60%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

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E 12-63 (Continued) 2.

Income Taxes Income before Taxes $834.6 2023 = $3,427.5 = 24.35%

Tax Rate =

$597.1 $4,708.8 = 12.68%

2022 =

$597.5 $1,149.7 = 51.97%

2021 =

The primary reason is that cost of goods sold grew less rapidly than did sales. Because cost of goods sold is the largest expense, small changes in its growth rate have a large dollar effect on net income.

E 12-64 1.

Total assets increased by 13.1% [($23,705.80 − $20,951.20)/$20,951.20].

Asset Category Total current assets Investments in affiliates and other assets Property, plant, and equipment, net Intangible assets, net

Percent Change +6.6% +2.9% +19.0% +13.9%

All four asset categories grew at different rates. Total current assets and investments in affiliates grew less rapidly than total assets, while property, plant, and equipment and intangible assets grew more rapidly. 3.

Butler secured the capital to finance its $2,754.6 million asset growth by: • increasing current liabilities by $2,017.3 million • increasing deferred income taxes by $325.3 million • selling additional common stock for $211.9 million • retaining $1,102.2 million of net income

Liability and Equity Category Total current liabilities Long-term debt Other liabilities Deferred income taxes Total liabilities Total stockholders’ equity

Percent Change +44.3% −6.6% −3.5% +19.3% +11.4% +18.4%

All five liability and equity categories grew at different rates. Most of the current liabilities grew more rapidly than total liabilities and equity. The largest dollar and percentage growth among current liabilities was in short-term borrowings ($1,484.4 million and 210.0% larger). Long-term debt and other liabilities both decreased. Deferred income taxes increased more rapidly than total liabilities and equity. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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E 12-65 1.

Steele Inc. Consolidated Income Statements Net sales .............................................................. Cost of goods sold................................................. Gross margin ........................................................ General and administrative expenses .................... Special and nonrecurring items ............................. Operating income ................................................. Interest expense ................................................... Other income ....................................................... Gain on sale of investments .................................. Income before income taxes ................................. Provision for income taxes .................................... Net income ...........................................................

2023 100.00% −72.96% 27.04% −17.39% 0.04% 9.68% * −0.88% 0.10% 0.00% 8.91% * −3.51% 5.40%

2022 100.00% −71.33% 28.67% −17.31% 0.00% 11.36% −0.90% 0.15% 0.13% 10.74% −4.18% 6.56%

2021 100.00% −70.83% 29.17% −17.58% 0.00% 11.59% −1.04% 0.19% 0.00% 10.74% −4.18% 6.56%

Dec. 31, 2023

Dec. 31, 2022

7.75% 25.56% 17.74% 2.65% 53.70% 40.30% 5.99% 100.00% *

1.07% 21.77% 20.89% 2.65% 46.38% 47.16% 6.46% 100.00%

6.05% 8.41% 0.38% 2.26% 17.11% * 15.72% 6.65% 1.48% 40.96%

8.04% 7.13% 0.00% 3.57% 18.74% 14.08% 7.15% 1.08% 41.05%

* Differences due to rounding.

Steele Inc. Consolidated Income Statements ASSETS Current assets: Cash and equivalents ................................................ Accounts receivable .................................................. Inventories ............................................................... Other ........................................................................ Total current assets ...................................................... Property and equipment, net ........................................ Other assets ................................................................. Total assets .................................................................. LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable ...................................................... Accrued expenses ..................................................... Other current liabilities ............................................. Income taxes............................................................. Total current liabilities .................................................. Long-term debt ............................................................. Deferred income taxes .................................................. Other long-term liabilities ............................................. Total liabilities ..............................................................

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E 12-65 (Continued)

Stockholders’ equity: Preferred stock ......................................................... Common stock .......................................................... Additional paid-in capital—common stock ................. Retained earnings ..................................................... Less: Treasury stock, at cost....................................... Total stockholders’ equity ......................................... Total liabilities and stockholders’ equity ........................

Dec. 31, 2023

Dec. 31, 2022

2.42% 2.17% 3.12% 57.97% 65.68% −6.64% 59.04% 100.00%

2.60% 2.33% 3.32% 55.55% 63.81% * −4.85% 58.95% * 100.00% *

* Differences due to rounding.

No, gross margin did not grow as fast as sales from 2021 to 2022 (gross margin increased 11% while sales increased 12.9%) or from 2022 to 2023 (gross margin decreased 1.6% while sales increased 4.3%). You can see this because gross income as a percentage of sales for 2022 and 2023 was less than in 2021.

Steele’s current assets increased, while property and equipment and other assets decreased. Among current assets, cash and cash equivalents and accounts receivable increased, while inventory decreased.

As a proportion of total assets, total liabilities decreased, while stockholders’ equity remained essentially unchanged. Among the current liabilities, accounts payable and income taxes decreased, while accrued expenses increased. Long-term debt and other long-term liabilities increased, while deferred income taxes decreased.

The increase in assets appears to have been financed by increases in long-term debt and retained earnings. While accrued expenses increased, accounts payable and income taxes decreased, which more than offset that increase.

E 12-66 1.

The decreases in income from operations were caused by increases in selling and administrative expenses that were much larger than the increases in sales revenues. The increases in selling and administrative expenses are apparent when the component percentages are examined. The component percentage for selling and administrative expenses increased from 26.6% to 28.3% to 35.3% during the 3-year period. For that same 3-year period, the component percentage for cost of goods sold declined, from 60.7% to 60.3% to 59.9%.

Yes. Current assets have increased from 16.1% to 31.4% of total assets. Investments have decreased from 22.0% to 6.6% of total assets.

Yes. The capital supplied by creditors increased. The total liability component percentages were 43.7% in 2021, 44.0% in 2022 and 47.1% in 2023.

Current liabilities increased substantially from 6.9% to 14.6%, and there was a reduction in investments over the same period.

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E 12-67 Current Assets Current Liabilities $4,821 2023 = $3,075 = 1.57

Current Ratio =

$4,414 $2,750 = 1.61

2022 =

(Cash + Short-Term Investments + Receivables) Current Liabilities ($521 + $0 + $1,536) 2023 = $3,075 = 0.67

Quick Ratio =

($117 + $0 + $1,514) $2,750 = 0.59

2022 =

(Cash + Short-Term Investments) Current Liabilities ($521 + $0) 2023 = $3,075 = 0.17

Cash Ratio =

($117 + $0) $2,750 = 0.04

2022 =

Operating Cash Flows Current Liabilities $501 2023 = $3,075 = 0.16

Operating Cash Flow Ratio =

$394 $2,750 = 0.14

2022 =

For a retail organization, the quick ratio would be appropriate because there may be some concern that the inventory on hand will not sell. By taking the inventory out of the ratio, the quick ratio gives a more conservative and possibly more accurate view of the liquidity of a retail organization. To further assess the short-term liquidity, it would be important to know how quickly the inventory is turned over and how likely it is that the company will collect on its receivables.

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E 12-68 1. Operating Income Interest Expense $701,556 2023 = $63,685 = 11.02

Times Interest Earned (Accrual Basis) =

$788,698 $62,398 = 12.64

2022 =

Total Liabilities Total Equity $1,693,812 2023 = $2,441,293 = 0.69

Debt to Equity Ratio =

$1,578,833 $2,267,617 = 0.70

2022 =

Total Liabilities Total Assets $1,693,812 2023 = $4,135,105 = 0.41

Debt to Total Assets Ratio =

$1,578,833 $3,846,450 = 0.41

2022 =

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E 12-68 (Continued) Long-Term Debt Total Equity $650,000 2023 = $2,441,293 = 0.27

Long-Term Debt to Equity Ratio =

$541,639 $2,267,617 = 0.24

2022 =

Long-Term Debt Total Assets $650,000 2023 = $4,135,105 = 0.16

Long-Term Debt to Total Assets Ratio =

$541,639 $3,846,450 = 0.14

2022 =

Steele’s debt management ratios are generally stable across 2022 and 2023. The exception is the times interest earned ratio, which is approximately 13% lower. However, the times interest earned ratios, as well as all the other ratios, are very strong, suggesting that Steele does not have significant long-term solvency concerns.

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E 12-69 1. Net Sales Average Accounts Receivable $7,245,088 2023 = [($1,056,911 + $837,377)/2] = 7.65

Accounts Receivable Turnover Ratio =

$6,944,296 [($837,377 + $752,945)/2] = 8.73

2022 =

Cost of Goods Sold Average Inventory $5,286,253 2023 = [($733,700 + $803,707)/2] = 6.88

Inventory Turnover Ratio =

$4,953,556 [($803,707 + $698,604)/2] = 6.59

2022 =

Net Sales Average Total Assets $7,245,088 2023 = [($4,135,105 + $3,846,450)/2] = 1.82

Asset Turnover Ratio =

$6,944,296 [($3,846,450 + $3,485,233)/2] = 1.89

2022 =

The length of the operating cycle is the inventory turnover (in days) plus the accounts receivable turnover (in days): 2023 = = = 2022 = = =

(365/6.88) + (365/7.65) 53.05 + 47.71 100.76 days (365/6.59) + (365/8.73) 55.39 + 41.81 97.20 days

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E 12-70 1. Profitability Ratios: Gross Profit Net Sales $1,958,835 2023 = $7,245,088 = 27.04%

Gross Profit Percentage =

$1,990,740 $6,944,296 = 28.67%

2022 =

Income from Operations Net Sales $701,556 2023 = $7,245,088 = 9.68%

Operating Margin Percentage =

$788,698 $6,944,296 = 11.36%

2022 =

Net Income Net Sales $391,179 2023 = $7,245,088 = 5.40%

Net Profit Margin Percentage =

$455,497 $6,944,296 = 6.56%

2022 =

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E 12-70 (Continued) Net Income + [Interest Expense  (1 − Tax Rate*)] Average Total Assets $391,179 + [$63,685  (1 − 0.3937)] 2023 = ($4,135,105 + $3,846,450)/2 = 10.77%

Return on Assets =

$455,497 + [$62,398  (1 − 0.3890)] ($3,846,450 + $3,485,233)/2 = 13.47%

2022 =

*Tax Rate = 2023 =

Provision for Income Taxes Income before Income Taxes $254,000 $645,179

= 39.37% 2022 =

$290,000 $745,497

= 38.90%

Net Income Average Equity $391,179 2023 = [($2,441,293 + $2,267,617)/2] = 16.61%

Return on Equity =

$455,497 [($2,267,617 + $2,083,122)/2] = 20.94%

2022 =

These ratios suggest that Steele is less profitable in 2023 than it was in 2022. In order to further assess Steele's profitability, it would be helpful to know industry averages, and if there are any unusual things that happened to Steele in 2023, then that would affect the net income or the general profitability of the company.

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E 12-71 (Net Income − Preferred Dividends) Average Number of Common Shares Outstanding ($391,179 − $24,000) 2023 = 362,202 = $1.01

Earnings per Share =

($455,497 − $24,000) 364,398 = $1.18

2022 =

Net Income Average Common Equity Common Equity = Total Stockholders ’ Equity − Preferred Stock −

Return on Common Equity =

Additional Paid-in Capital − Preferred Stock $391,179 [($2,441,293 − $100,000 − $0) + ($2,267,617 − $100,000 − $0)/2] = 17.35%

2023 =

$455,497 [($2,267,617 − $100,000 − $0) + ($2,083,122 − $0 − $0)/2] = 21.43%

2022 =

Dividends per Common Share Closing Market Price per Share for the Year $0.36 2023 = $78.42 = 0.46%

Dividend Yield Ratio =

$1.54 $66.36 = 2.32%

2022 =

Common Dividends Net Income $130,861 2023 = $391,179 = 33.45%

Dividend Payout Ratio =

$561,172 $455,497 = 123.20%

2022 =

All four of the stockholder ratios decreased from to 2023, indicating that there may be some financial concern for investors in 2023. Steele was a better investment in 2022.

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E 12-72 1.

Net Income Sales Average Total Assets   Sales Average Total Assets Average Equity $391,179 $7,245,088 ($4,135,105 + $3,846,450)/2 2023 =   $7,245,088 ($4,135,105 + $3,846,450)/2 ($2,441,293 + $2,267,617)/2 = 0.054  1.82  1.69 ROE =

= 16.61% $455,497 $6,944,296 ($3,846,450 + $3,485,233)/2   $6,944,296 ($3,846,450 + $3,485,233)/2 ($2,267,617 + $2,083,122)/2 = 0.0656  1.89  1.69

2022 =

= 20.94% * * There is a slight difference due to rounding when compared to calculating ROE as (Net Income/Average Common Equity).

In 2022, Steele’s profit margin and asset turnover approximated the industry averages. However, Steele achieved significantly higher than average return on equity because leverage was significantly above industry averages. In 2019, although Steele’s leverage was unchanged, the industry average increased dramatically. Despite now possessing leverage that approximated the industry averages, Steele’s return on equity was significantly above industry averages because its profit margin and asset turnover were significantly above industry averages. It is clear that something dramatic changed in the industry during 2023 as both profit margins and asset turnover decreased dramatically. Despite the fact that Steele’s profit margins decreased by approximately 18% in 2023, the decrease was not nearly as large as the 36% decrease in profit margins at the industry level. Further, although asset turnover declined by 58% at the industry level, Steele’s asset turnover fell by only about 4%.

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PROBLEM SET A P 12-73A While Bing’s sales and asset growth are above average, its profitability growth is below average. Bing’s current ratio is below average, but its debt to equity ratio is above average. Inventory turnover is lower than average, while receivables turnover is above average. The last four ratios for 2023 are much less favorable than averages for the years 2019–2023. These factors provide mixed signals. However, none of the below-average items is so far below as to suggest that Bing has serious problems. Therefore, Bing should be granted credit and its performance monitored frequently for improvement or decline. Should there be a decline, it may be advisable to withdraw approval for Bing to purchase on credit.

P 12-74A Over the last 5 years, Opal and Hunt are growing more rapidly than average, while Main and Darcy are growing less rapidly than average. Hunt’s assets and equity are earning higher returns than Opal and are higher than industry averages. Hunt’s dividend payout ratio is lower than Opal’s. Collectively, these factors indicate that Hunt is outperforming the other firms, with Opal a close second. Main and Darcy are not as attractive as are Hunt and Opal for investment at this time.

P 12-75A 1.

2017–2019 changes: Jolly Fun Inc. Consolidated Income Statements 2023 Revenues: Theme parks and resorts ................................... Filmed entertainment ....................................... Consumer products ........................................... Costs and expenses: Theme parks and resorts ................................... Filmed entertainment ....................................... Consumer products ........................................... Operating income: Theme parks and resorts ................................... Filmed entertainment ....................................... Consumer products ...........................................

Year ending December 31, 2022 2021

123.13% 141.63% 195.46% 139.55%

118.34% 120.11% 149.43% 122.77%

100.00% 100.00% 100.00% 100.00%

119.85% 134.08% 214.43% 135.62%

118.47% 114.56% 161.66% 120.95%

100.00% 100.00% 100.00% 100.00%

136.64% 195.60% 154.66% 157.56%

117.82% 159.79% 123.15% 131.14%

100.00% 100.00% 100.00% 100.00%

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P 12-75A (Continued) Corporate activities: General and administrative expenses ................ Interest expense ............................................... Investment and interest income ........................ Income (loss) on investment in Asian theme park......................................................... Income before income taxes ................................. Income taxes ........................................................ Net income ........................................................... 2.

102.11% 150.19% 155.86% 92.76%

92.16% 120.76% 109.13% 98.84%

100.00% 100.00% 100.00% 100.00%

−806.74% 106.14% 107.30% 105.45%

17.55% 128.65% 129.26% 128.29%

100.00% 100.00% 100.00% 100.00%

Net income increased from 2021 to 2022 because revenues grew more rapidly than did expenses. This result occurred because expenses associated with corporate activities actually decreased. Although the revenue and expense trends are similar from 2022 to 2023, net income decreased because of the loss on the investment in the Asian theme park.

P 12-76A 1.

Net income has declined primarily because the selling and administrative expenses as a proportion of sales have increased and because the dollar amount of sales has decreased substantially.

The firm may be facing price competition and refusing to lower its prices to meet competitors’ prices, resulting in a decrease in sales. The sales that do take place are for goods with a slightly higher gross profit than those previously sold.

P 12-77A 1.

Sales growth has been approximately 50%(a), net income growth has been approximately 42%(b), and asset growth has been approximately 61%(c).

Twisted financed its asset growth through a 164%(d) increase in retained earnings and a 360%(e) increase in current liabilities.

Twisted's current ratio as of 12/31/23 was 2.06(f), and its quick ratio was 0.93(g). These ratios indicate that liquidity was adequate. It should be noted that these ratios are significantly lower than prior years because current liabilities have increased, and this may become a concern if the trend continues.

Interest expense is increasing because short-term notes payable, an interest bearing obligation, is increasing.

If the 2023 relationships among the income statement accounts hold in 2024, the 2024 net income would be: $2,849(h).

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P 12-77A (Continued) 6.

Asset growth expected: $4,129(i) Retained income will provide: $1,424.50(j) Capital to be raised: $2,704.50(k)

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k)

($51,638 − $34,425)/$34,425 = 50% ($2,279 − $1,603)/$1,603 = 42% ($16,516 − $10,281)/$10,281 = 61% ($3,264 − $1,236)/$1,236 = 164% ($5,377 − $1,170)/$1,170 = 360% ($11,082/$5,377) = 2.06 ($360 + $4,658)/$5,377 = 0.93 $2,279  1.25 = $2,849 0.25  $16,516 = $4,129 0.5  $2,849 [from Part (5)] = $1,424.50 $4,129 − $1,424.50 = $2,704.50

P 12-78A 1.

Venus Industries Consolidated Income Statements Year ending December 31, 2023 2022 2021 152.42% 128.66% 100.00%

Revenues.............................................................. Costs and expenses: Cost of goods sold ............................................ 111.04% 104.16% Selling and administrative ................................ 138.88% 125.92% Interest ............................................................ 97.61% 108.18% Other expenses (income) .................................. −3,430.23% −4,979.07% Total costs and expenses....................................... 117.79% 109.64% Income before income taxes ................................. 460.53% 297.90% Income taxes ........................................................ 131.37% 110.25% Net income ........................................................... 907.23% 552.57%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

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P 12-78A (Continued) 2.

Net income increased by 907% primarily because revenues increased faster than cost of goods sold.

Venus Industries Consolidated Balance Sheets ASSETS Current assets: Cash and equivalents ................................................ Accounts receivable, less allowance for doubtful accounts of $19,447 and $20,046 ........................... Inventories ............................................................... Deferred income taxes .............................................. Prepaid expenses...................................................... Total current assets ...................................................... Property, plant, and equipment .................................... Less accumulated depreciation ................................. Net property, plant, and equipment .............................. Goodwill....................................................................... Other assets ................................................................. Total assets .................................................................. LIABILITIES AND STOCKHOLDERS’ EQUITY ASSETS Current liabilities: Current portion of long-term debt ............................. Notes payable .......................................................... Accounts payable ..................................................... Accrued liabilities ..................................................... Income taxes payable ............................................... Total current liabilities .................................................. Long-term debt ............................................................. Noncurrent deferred income taxes ................................ Other noncurrent liabilities ........................................... Commitments and contingencies .................................. Redeemable preferred stock ......................................... Total liabilities .............................................................. Stockholders’ equity: Common stock at stated value: Class A convertible—26,691 and 26,919 shares outstanding ........................................................ Class B—49,161 and 48,591 shares outstanding ..... Capital in excess of stated value ............................ Treasury stock (common at cost) ........................... Retained earnings ................................................. Total stockholders’ equity ............................................. Total liabilities and stockholders’ equity ........................

December 31, 2023 2022 12.33%

13.46%

35.02% 25.11% 1.12% 1.72% 75.30% * 24.18% −8.17% 16.01% 7.38% 1.31% 100.00% *

31.90% 26.56% 1.47% 1.71% 75.09% * 25.77% −7.86% 17.92% 5.71% 1.28% 100.00% *

2023

2022

2.24% 4.58% 5.75% 5.87% 0.73% 19.16% * 0.64% 1.27% 1.85% 0.00% 0.01% 22.93% *

0.19% 5.47% 6.98% 6.94% 2.20% 21.78% * 3.99% 1.40% 1.23% 0.00% 0.02% 28.41% *

0.01% 0.12% 4.59% −0.33% 72.69% 77.07% * 100.00% *

0.01% 0.14% 4.86% −0.36% 66.94% 71.59% * 100.00% *

*Any differences due to rounding.

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P 12-78A (Continued) 4.

The proportion of dollars invested in various asset accounts did not have any dramatic changes. The two biggest changes were an increase in account receivable and slight decrease in net property, plant and equipment, but both were under 4%. Overall, there has not been a significant difference between the liabilities and the stockholders’ equity accounts in the 2 years. The biggest difference is a decrease in long-term debt in 2023 and an increase in the current portion of long-term debt in 2023. However, these amounts are not significant; each difference amounts to under 4%. Venus’ performance and financial position are pretty consistent over the time period observed. Net income is steadily increasing, and the balance sheet accounts are relatively steady. Based on these two financial statements, Burch's appears to be a stable investment.

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P 12-79A 1. Net Sales Average Accounts Receivable $51,638 2023 = [($4,658 + $3,690)/2] $51,638 = $4,174 = 12.37

Accounts Receivable Turnover Ratio =

$41,310 [($3,690 + $3,285)/2] $41,310 = $3,488 = 11.85

2022 =

Cost of Goods Sold Average Inventories $31,050 2023 = [($6,064 + $4,478)/2] $31,050 = $5,271 = 5.89

Inventory Turnover Ratio =

$24,840 [($4,478 + $3,442)/2] $24,840 = $3,960 = 6.27

2022 =

Net Sales Average Total Assets $51,638 2023 = [($16,516 + $12,646)/2] $51,638 = $14,581 = 3.54

Asset Turnover Ratio =

$41,310 [($12,646 + $10,281)/2] $41,310 = $11,464 = 3.60

2022 =

Receivables turnover has increased by a small amount, while inventory and asset turnovers have decreased by small amounts. Because the changes are small, efficiency is essentially unchanged.

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P 12-79A (Continued) 2. Gross Profit Net Sales $20,588 2023 = $51,638 = 39.87%

Gross Profit Percentage =

$16,470 $41,310 = 39.87%

2022 =

Income from Operations* Net Sales ($3,164 + $1,237) 2023 = $51,638 $4,401 = $51,638 = 8.52%

Operating Margin Percentage =

($2,666 + $765) $41,310 $3,431 = $41,310 = 8.31%

2022 =

* Income from Operations = Income before Income Taxes + Interest

Net Income Net Sales $2,279 2023 = $51,638 = 4.41%

Net Profit Margin Percentage =

$1,920 $41,310 = 4.65%

2022 =

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P 12-79A (Continued) Net Income + [Interest Expense  (1 − Tax Rate)] Average Total Assets {$2,279 + [$1,237  (1 − 0.28*)]} 2023 = [($16,516 + $12,646)/2] ($2,279 + 891.0) $14,581 = 21.74%

Return on Assets =

* $885/$3,164 = 0.28 There may be a slight difference due to rounding.

{$1,920 + [$765  (1 − 0.28*)]} [($12,646 + $10,281)/2] ($1,920 + 550.8) $11,464 = 21.55%

2022 =

* $746/$2,666 = 0.28 There may be a slight difference due to rounding.

Net Income Average Equity $2,279 2023 = [($7,989 + $6,863)/2] $2,279 = $7,426 = 30.69%

Return on Equity =

$1,920 [($6,863 + $5,961)/2] $1,920 $6,412 = 29.94%

2022 =

The gross profit percentage was the same each year. The operating margin percentage increased by a small amount each year, and the net profit margin income ratio decreased by a small amount each year. The return on assets ratio was essentially the same in 2023 and 2022. The return on equity ratio was larger in 2023 than in 2022 but only by a small amount. Taken together, these ratios suggest that profitability has remained essentially the same.

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P 12-79A (Continued) 3. Operating Income Interest Expense ($2,279 + $885 + $1,237) 2023 = $1,237 $4,401 = $1,237 = 3.56

Times Interest Earned Ratio (Accrual Basis) =

($1,920 + $746 + $765) $765 $3,431 = $765 = 4.48

2022 =

Long-Term Debt (including current portion) Total Equity $3,150 2023 = $7,989 = 0.39

Long-Term Debt to Equity =

$3,150 $6,863 = 0.46

2022 =

Total Liabilities Total Equity $8,527 2023 = $7,989 = 1.07

Debt to Equity Ratio =

$5,783 $6,863 = 0.84

2022 =

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P 12-79A (Continued) Long-Term Debt (including current portion) Total Assets $3,150 2023 = $16,516 = 0.19

Long-Term Debt to Total Assets Ratio =

$3,150 $12,646 = 0.25

2022 =

Total Liabilities Total Assets $8,527 2023 = $16,516 = 0.52

Total Debt to Assets Ratio =

$5,783 $12,646 = 0.46

2022 =

The times interest earned ratio decreased dramatically; however, the ratio in 2023 was large enough to suggest that interest payments are adequately covered by earnings. The debt to equity and debt to total assets ratios increased each year, while the long-term debt to equity and long-term debt to total assets ratios declined each year. The increase in the total debt ratios is the result of significant increases in short-term notes payable. On the other hand, the long-term debt ratios declined because long-term debt remained constant, while stockholders’ equity and total assets increased. Taken together, the debt management ratios suggest that creditors were reasonably secure in 2023. However, creditors were not as secure in 2023 as they were in 2022.

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P 12-80A 1. 2.

Klein has the weakest current ratio. Its ratio of 1.0 means its current assets are equal to its current liabilities, whereas the other three firms have current assets slightly greater than current liabilities. Turnover ratios vary greatly among the four firms because of the varying nature of the products sold by the firms. It can be expected that Reagan, the newspaper publisher, will sell more units of product (newspapers) than Badgley, the heavy equipment manufacturer, will sell pieces of equipment. Newspapers are purchased by many people each day, whereas equipment is bought by much fewer people and not on a daily basis. Also, it is reasonable to believe that Badgley has longer outstanding receivables because the purchases from Badgley are more expensive than the other firms. Further, Taylor, the grocery chain, has an extremely high accounts receivable turnover because most of its sales are for cash. The return on equity is larger than the return on assets for these firms because the total assets of these firms are substantially higher than stockholders’ equity due to the presence of debt. This illustrates the power of financial leverage. As long as a firm can borrow at a rate below the return it can earn on the borrowed funds, debt will increase return on equity. The large differences in the return on equity can exist over time because of the varying levels of risk inherent with each company. The return on equity for less risky companies will be lower than the return on equity for riskier companies.

P 12-81A 1. Short-Term Liquidity Ratios: Current Assets Current Liabilities $1,620,647 2023 = $452,564 = 3.58

Current Ratio =

$1,387,758 $420,588 = 3.30

2022 =

(Cash + Short-Term Investments + Receivables) Current Liabilities ($291,284 + $0 + $667,547) 2023 = $452,564 $958,831 = $452,564 = 2.12

Quick Ratio =

($260,050 + $0 + $596,018) $420,588 $856,068 = $420,588 = 2.04

2022 =

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P 12-81A (Continued) (Cash + Short-Term Investments) Current Liabilities ($291,284 + $0) 2023 = $452,564 = 0.64

Cash Ratio =

($260,050 + $0) $420,588 = 0.62

2022 =

Cash Flows from Operating Activities Current Liabilities $190,000 2023 = $452,564 = 0.42

Operating Cash Flow Ratio =

$150,000 $420,588 = 0.36

2022 =

Debt Management Ratios: Operating Income Interest Expense ($365,016 + $229,500 + $25,739) 2023 = $25,739 = 24.10

Times Interest Earned Ratio (Accrual Basis) =

($329,218 + $192,600 + $30,665) $30,665 = 18.02

2022 =

Long-Term Debt (including current portion) Total Equity ($15,033 + $52,985) 2023 = $1,646,026 = 0.04

Long-Term Debt to Equity Ratio =

($77,022 + $3,652) $1,324,149 = 0.06

2022 =

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P 12-81A (Continued) Total Liabilities Total Equity $541,437 2023 = $1,646,026 = 0.33

Debt to Equity Ratio =

$548,712 $1,324,149 = 0.41

2022 =

Long-Term Debt (including current portion) Total Assets ($15,033 + $52,985) 2023 = $2,187,463 = 0.03

Long-Term Debt to Total Assets Ratio =

($77,022 + $3,652) $1,872,861 = 0.04

2022 =

Total Liabilities Total Assets $541,437 2023 = $2,187,463 = 0.25

Debt to Total Assets Ratio =

$548,712 $1,872,861 = 0.29

2022 =

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P 12-81A (Continued) Asset Efficiency Ratios: Net Credit Sales or Net Sales Average Accounts Receivable $3,930,984 2023 = [($667,547 + $596,018)/2] $3,930,984 = $631,782.50 = 6.22

Accounts Receivable Turnover Ratio =

$3,405,211 [($596,018 + $521,588)/2] $3,405,211 = $558,803 = 6.09

2022 =

Cost of Goods Sold Average Inventory $2,386,993 2023 = [($592,986 + $471,202)/2] $2,386,993 = $532,094 = 4.49

Inventory Turnover Ratio =

$2,089,089 [($471,202 + $586,594)/2] $2,089,089 = $528,898 = 3.95

2022 =

Net Sales Average Total Assets $3,930,984 2023 = [($2,187,463 + $1,872,861)/2] $3,930,984 = $2,030,162 = 1.94

Asset Turnover Ratio =

$3,405,211 [($1,872,861 + $1,708,430)/2] $3,405,211 = $1,790,646 = 1.90

2022 =

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P 12-81A (Continued) Profitability Ratios: Gross Profit Net Sales $2,350,852* 2023 = $4,578,041 = 39.28%

Gross Profit Percentage =

* Gross Profit = Revenues − Cost of Goods Sold = $4,578,041 − $2,227,189 = $2,350,852

$1,775,235* $3,864,324 = 38.65%

2022 =

* Gross Profit = Revenues − Cost of Goods Sold = $3,864,324 − $2,089,089 = $1,775,235

Income from Operations* Net Sales ($365,016 + $229,500 + $25,739) 2023 = $3,930,984 = 15.78%

Operating Margin Percentage =

($329,218 + $192,600 + $30,665) $3,405,211 = 16.22%

2022 =

* Income from Operations = Net Income + Income Taxes + Interest

Net Income Net Sales $365,016 2023 = $3,930,984 = 9.29%

Net Profit Margin Percentage =

$329,218 $3,405,211 = 9.67%

2022 =

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P 12-81A (Continued) Net Income + [Interest Expense  (1 − Tax Rate)] Average Total Assets $365,016 + [$25,739  (1 − 0.386*)] 2023 = ($2,187,463 + $1,872,861)/2 $380,819.02 = $2,030,162 = 18.76%

Return on Assets Ratio =

* $229,500/$594,516

$329,218 + [$30,665  (1 − 0.369*)] ($1,872,861 + $1,708,430)/2 $348,564.73 = $1,790,646 = 19.47%

2022 =

* $192,600/$521,818

Net Income Average Equity $365,016 2023 = [($1,646,026 + $1,324,149)/2] $365,016 = $1,485,087.5 = 24.58%

Return on Equity Ratio =

$329,218 [($1,324,149 + $1,032,789)/2] $329,218 = $1,178,469.0 = 27.94%

2022 =

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P 12-81A (Continued) Stockholder Ratios: (Net Income − Preferred Dividends) Average Number of Common Shares Outstanding ($365,016 − $0) 2023 = 77,063 = $4.74

Earnings per Share (EPS) =

($329,218 − $0) 76,602 = $4.30

2022 =

Net Income Average Common Equity Common Equity = Total Stockholders’ Equity − Preferred Stock

Return on Common Equity* =

− Additional Paid-In Capital − Preferred Stock Average Common Equity = (Beginning Common Equity + Ending Common Equity)/2 $365,016 [($1,646,026 + $1,324,149)/2] $365,016 = $1,485,087.5 = 24.58%

2023 =

$329,218 [($1,324,149 + $1,032,789)/2] $329,218 = $1,178,469.0 = 27.94%

2022 =

* Since there is no preferred stock, the return on common equity will be the same as the return on equity previously computed.

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P 12-81A (Continued) Dividends per Common Share Closing Market Price per Share for the Year $0.75 2023 = $86.33 = 0.87%

Dividend Yield Ratio =

$0.59 $71.65 = 0.82%

2022 =

Common Dividends Paid Net Income $57,797 2023 = $365,016 = 15.83%

Dividend Payout Ratio =

$45,195 $329,218 = 13.73%

2022 =

(Common Dividends + Common Stock Repurchases) Net Income ($57,797 + $930,111) 2023 = $365,016 = 270.65%

Total Payout Ratio =

($45,195 + $581,134) $329,218 = 190.25%

2022 =

Stock Repurchase Payout = Total Payout Ratio − Dividend Payout Ratio 2023 = 270.65% − 15.83% = 254.82% 2022 = 190.25% − 13.73% = 176.52%

Burch’s short-term liquidity is adequate, assuming that there is a strong likelihood that all accounts receivable will be collected. Looking at the cash ratio, it is apparent that cash and shortterm investments alone are not enough to cover the current liabilities, but when including accounts receivable, there is more than enough coverage for the current liabilities.

It appears that Burch uses its assets efficiently because the receivables turnover and inventory turnover appear strong. However, the asset turnover is below the industry average. This discrepancy is something that can be further explained through a Dupont analysis.

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P 12-81A (Continued) 4.

Although return on equity has declined from 2022 to 2023, it still appears that Burch is a profitable business. Profit margin is much larger than the industry average, and all other profitability ratios appear strong.

Burch carries little debt relative to equity. Therefore, creditors are likely to regard Burch as a lowrisk firm. Because it has more than enough income to cover its interest expense and very little debt in comparison to equity, creditors can feel confident that they will be able to collect any outstanding balances from Burch.

Dupont Analysis = Net Profit Margin  Asset Turnover  Total Leverage = (Net Income/Sales)  (Sales/Average Total Assets)  (Average Total Assets/Average Equity) 2023 = 0.0929  1.94  1.37a = 24.69%* 2022 = 0.0967  1.90  1.52b = 27.93%

* Answer differs from return on common equity due to rounding in the individual components of the Dupont analysis. a $2,030,162/$1,485,088 = 1.37 b $1,790,646/$1,178,469 = 1.52

P 12-82A 1.

2023

2022

2021

LIFO: Beginning inventory .......................................... Add: Purchases ..................................................... Goods available for sale ........................................ Less: Ending inventory .......................................... Cost of goods sold.................................................

$ 310,000 $ 280,000 5,370,000 5,105,000 $5,680,000 $5,385,000 (328,000) (310,000) $5,352,000 $5,075,000

$ 260,000 4,770,000 $5,030,000 (280,000) $4,750,000

FIFO: Beginning inventory .............................................. Add: Purchases ..................................................... Goods available for sale ........................................ Less: Ending inventory .......................................... Cost of goods sold.................................................

$ 495,000 $ 450,000 5,370,000 5,105,000 $5,865,000 $5,555,000 (525,000) (495,000) $5,340,000 $5,060,000

$ 420,000 4,770,000 $5,190,000 (450,000) $4,740,000

2. Year 2023 2022 2021

Book Value $1,450,000 1,330,000 1,240,000

Depreciation Expense 10% 5% $145,000 $72,500 133,000 66,500 124,000 62,000

Difference $72,500 $66,500 $62,000

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P 12-82A (Continued) 3.

If Lemon had used the 10% depreciation and LIFO in 2021, cost of goods sold would have increased by $10,000 ($4,750,000 − $4,740,000) and depreciation expense would have increased by $62,000 ($124,000 − $62,000). This would have decreased the net income before taxes by $72,000. The after-tax cost of this increase in expenses is a reduction in net income of $56,880 [$72,000  (1 − 0.21)]. Therefore, we see that the new net income for 2021 is $47,120 ($104,000 − $56,880). In 2022, the expenses would have increased by $81,500 before taxes [from an increase in cost of goods sold of $15,000 ($5,075,000 − $5,060,000) and an increase in depreciation expense of $66,500]. Therefore, we see that the new net income, after accounting for the change in income taxes, for 2022 is $48,615 ($113,000 − $64,385). In 2023, the expenses would have increased by $84,500 before taxes [from an increase in cost of goods sold of $12,000 ($5,352,000 − $5,340,000) and an increase in depreciation of $72,500]. Therefore, we see that the new net income for 2023, after accounting for income taxes, is $52,245 ($119,000 − $66,755).

Lime has materially changed the financial statements by selecting FIFO and a 5% depreciation. Its net income would have been different by $56,880 in 2021, $64,385 in 2022 and $66,755 in 2023. In percentage terms, the net income changed by approximately 55% in 2021, 57% in 2022, and 56% in 2023.

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CASES Case 12-83 Even though Kelsey's boss has asked her to reconsider her downgrade, Kelsey should not do so. If after analyzing and documenting her investigation of Protech Kelsey has determined that Protech is worthy of the downgrade, it would be unethical of her to change her mind because of pressure from her boss. Kelsey should tell her boss that she will not change her decision. If her boss still disagrees with her and wants her to change her decision, she should discuss the matter with her boss’s boss. She can also seek counsel from her company’s ethics officer or call the ethics hotline if one is available to her.

Case 12-84 1.

On the financial statements of coal-dependent electric utilities you would expect to observe the effects of this legislation in the property, plant, and equipment section of the balance sheet because the devices on the smokestacks are likely to be capitalized. Also, if the company is burning coal with a lower sulfur content, the cost of the inventory will increase because the higher quality coal will cost more. Overall, these changes are probably summarized in the notes to the financial statements and discussed in Item 7 (MD&A) of the company’s 10-K.

The coal companies may not experience direct financial impacts, unless they are are selling the higher quality coal for more than they sold the high-sulfur coal. In this case, there would be an increase in sales for the coal companies. This is probably also discussed in the notes to the financial statements and in Item 7 (MD&A) of the 10-K.

Case 12-85 1.

The CEO may suggest that the airline try to recoup some of the cost of the increased fuel by raising the cost of airline tickets. Another way to cover some of the increased cost would be to provide discounted tickets for flights that are not filling up. The decreased cost of the flight may entice people who were not planning on traveling to book a flight. Because the plane is going to fly anyway, it is better for the company to make a little less money per ticket than to fly with empty seats. The CEO may also suggest checking into the flights that typically do not fill up and determining whether it is still profitable to fly those routes at all or as often.

The financial statements of the airline would show a decrease in gross profit because the increased cost of fuel would increase the cost of sales and decrease the gross profit. In response, the airline is likely to try to either increase sales or decrease the cost of sales, or both, in order to maintain a healthy gross profit percentage.

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Case 12-86 1.

Vertical Analysis Initech Corporation Consolidated Income Statements

Net revenues ........................................................ Cost of goods sold................................................. Research and development ................................... Marketing, general, and administrative expenses .................................... Operating costs and expenses ............................... Operating income ................................................. Interest expense ................................................... Interest income and other, net .............................. Income before taxes ............................................. Provision for taxes ................................................ Net income ...........................................................

Three years ending December 31, 2023 2022 2021 100.00% 100.00% 100.00% 37.03% 43.75% 48.46% 11.05% 13.35% 12.93% 13.30% 61.38% 38.62% −0.57% 2.14% 40.20% * 14.06% 26.13% *

17.40% 74.50% 25.50% −0.92% 2.28% 26.85% * 8.59% 18.26% *

16.01% 77.40% 22.60% −1.72% 4.12% 25.01% 7.87% 17.14%

*Differences due to rounding.

Horizontal Analysis Initech Corporation Consolidated Income Statements

Net revenues ..................................................... Cost of goods sold .............................................. Research and development ................................ Marketing, general, and administrative expenses ................................. Operating costs and expenses ............................ Operating income .............................................. Interest expense ................................................ Interest income and other, net ........................... Income before taxes .......................................... Provision for taxes ............................................. Net income ........................................................ 2.

Three years ending December 31, 2023 2022 2021 183.76% 122.28% 100.00% 140.41% 110.41% 100.00% 156.96% 126.21% 100.00% 152.68% 145.72% 314.07% 60.98% 95.43% 295.40% 328.46% 280.22%

132.94% 117.71% 137.96% 65.85% 67.51% 131.30% 133.51% 130.28%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Initech’s profits increased more rapidly than sales for 2022 and 2023 because cost of goods sold is the largest expense item and it decreased from 48% of net revenues in 2021 to 37% of net revenues in 2023.

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Case 12-86 (Continued) 3.

Initech Corporation Consolidated Balance Sheets

ASSETS Current assets: Cash and cash equivalents .................................... Short-term investments ........................................ Accounts and notes receivable, net of allowance for doubtful accounts of $22 ($26 in 2022) ................................................ Inventories ........................................................... Deferred tax assets ............................................... Other current assets .............................................. Total current assets ................................................... Property, plant, and equipment: Land and buildings ................................................ Machinery and equipment .................................... Construction in progress........................................ Less accumulated depreciation .................................. Net property, plant, and equipment, net ................... Long-term investments ............................................. Other assets .............................................................. Total assets ...............................................................

LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Short-term debt .................................................... Long-term debt redeemable within 1 year ............. Accounts payable .................................................. Deferred income on shipments to distributors ....... Accrued compensation and benefits ...................... Other accrued liabilities......................................... Income taxes payable ............................................ Total current liabilities .............................................. Long-term debt ......................................................... Deferred tax liabilities ............................................... Other long-term liabilities ......................................... Total liabilities ..........................................................

December 31, 2023 2022 14.62% 13.02%

22.78% 12.28%

12.76% 7.39% 2.73% 0.62% 51.15%

13.22% 6.61% 2.53% 0.57% 57.99%

16.29% 36.57% 2.79% 55.65% −20.42% 35.23% 12.48% 1.15% 100.00%

18.09% 35.53% 3.84% 57.46% −22.65% 34.81% 6.13% 1.06% 100.00%

December 31, 2023 2022 3.52% 0.86% 3.76% 1.76% 4.80% 3.30% 3.45% 21.45% 3.76% 2.62% 6.06% 33.89%

2.50% 1.36% 3.47% 1.84% 5.38% 3.78% 4.44% 22.77% 3.08% 2.23% 4.61% 32.69%

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Case 12-86 (Continued) Stockholders’ equity: Preferred stock, $0.001 par value, 50 shares authorized; none issued ...................................... Common stock, $0.001 par value, 1,400 shares authorized, issued, and outstanding in 2023 and 2022 ............................................................. Additional paid-in capital—common stock ............. Retained earnings ................................................. Total stockholders’ equity ......................................... Total liabilities and stockholders’ equity ....................

0.00%

0.01% 19.33% 46.77% 66.11% * 100.00%

0.01% 21.94% 45.36% 67.31% * 100.00%

* Differences due to rounding.

5. 6.

Overall, the proportion of assets invested in various classes of assets did not change significantly. There was a decrease in cash and cash equivalents, and there was an increase in long-term investments. However, these changes are not significant. Initech has financed its growth in assets through an increase in short-term debt and an increase in retained earnings. The income statement changed more between 2022 and 2023 than did the balance sheet. Net income increased significantly due to a large decrease in cost of sales and operating expenses.

Case 12-87 1.

Dowsett’s performance in 2023 has significantly improved from 2022. Revenues have increased, while operating expenses have decreased. Rentals and landing fees have decreased, and so have fuel expense and restructuring charges. The restructuring charges provided the most significant change from 2022 to 2023.

The primary factor for the loss in 2022 was the large amount of restructuring charges. In 2023, the $254,000 restructuring charge changed to $12,500 restructuring income.

Dowsett financed the increase in assets through an increase in accounts payable, long-term debt, and other liabilities. There was also an increase in retained earnings of $62,960, which may have helped to finance the increase in assets.

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Case 12-88 1. Short-Term Liquidity Ratios:

Current Assets Current Liabilities $325,552 = $56,197 = 5.79

Current Ratio =

Cash + Short-Term Investments + Accounts Receivable Current Liabilities $30,322 + $0 + $98,250 = $56,197 = 2.29

Quick Ratio =

Cash + Short-Term Investments Current Liabilities $30,322 + $0 = $56,197 = 0.54

Cash Ratio =

Cash Flows from Operating Activities Current Liabilities $(77,783)* = $56,197 = (1.38)

Operating Cash Flow Ratio =

* Calculated in Chapter 11 Continuing Problem.

Debt Management Ratios:

Operating Income Interest Expense $73,665 + $22,000 + $98,087 = $98,087 = 1.98

Times Interest Earned (Accrual) =

Cash Flows from Operations + Income Taxes Paid + Interest Payments Interest Payments $(77,783)* + $23,630** + $59,420*** = $59,420 = 0.09

Times Interest Earned (Cash) =

* Provided in the problem information but may also be calculated in Chapter 11 Continuing Problem. ** Income Taxes Expense ($22,000) + Decrease in Income Taxes Payable ($1,630) *** Interest Expense ($98,087) − Increase in Interest Payable ($38,667)

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Case 12-88 (Continued) Long-Term Debt (including current portion) Total Equity $1,795,470 = $329,650 = 5.45

Long-Term Debt to Equity Ratio =

Total Liabilities Total Equity $1,851,667 = $329,650 = 5.62

Debt to Equity Ratio =

Long-Term Debt (including current portion) Total Assets $1,795,470 = $2,181,317 = 0.82

Long-Term Debt to Total Assets Ratio =

Total Liabilities Total Assets $1,851,667 = $2,181,317 = 0.85

Debt to Total Assets Ratio =

3. Asset Efficiency Ratios:

Net Sales Average Accounts Receivable* $3,778,800 = ($98,250 + $17,000)/2 = 65.58

Accounts Receivable Turnover Ratio =

Cost of Goods Sold Average Inventories $74,800 = ($61,380 + $2,850)/2 = 2.33

Inventory Turnover Ratio =

Net Sales Average Total Assets $3,778,800 = ($2,181,317 + $94,595)/2 = 3.32

Assets Turnover Ratio =

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* Average Balance = (Beginning Balance + Ending Balance)/2

Case 12-88 (Continued) 4. Profitability Ratios:

Gross Profit* Net Sales $1,569,740 = $3,778,800 = 41.54%

Gross Profit Percentage =

* Net Sales − Artist Fee Expense − Cost of Goods Sold

Income from Operations* Net Sales $193,752 = $3,778,800 = 5.13%

Operating Margin Percentage =

* Net Income + Interest Expense + Income Taxes Expense

Net Income Net Sales $73,665 = $3,778,800 = 1.95%

Net Profit Margin Percentage =

Net Income + [Interest Expense  (1 − Tax Rate*)] Average Total Assets $73,665 + [$98,087  (1 − 0.23)] = ($2,181,317 + $94,595)/2 $149,192 = $1,137,956 = 13.11%

Return on Assets =

* Income Taxes ÷ Income before Taxes

Net Income Average Equity $73,665 = ($329,650 + $20,585)/2 = 42.07%

Return on Equity =

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Chapter 12: Financial Statement Analysis

Case 12-88 (Continued) 5. Stockholder Ratios:

Net Income − Preferred Dividends Average Number of Common Shares Outstanding $73,665 − $0 = 16,400 shares = $4.49

Earnings per Share Ratio =

Net Income Average Common Equity* $73,665 = [($329,650 − $150,000 − $75,000) + ($20,585 − $0 − $0)]/2 $73,665 = $62,618 = 117.64%

Return on Common Equity =

* Common Equity = Total Equity − Preferred Stock − Additional Paid-In Capital—Preferred Stock

Dividends per Common Share Closing Market Price per Share for the Year $1.45* = $17.55 = 8.26%

Dividend Yield Ratio =

* Provided in problem, but can be obtained from information in Chapter 10 Continuing Problem [$25,000/(16,000 + 2,000 − 700)].

Common Dividends Paid Net Income $25,000* = $73,665 = 33.94%

Dividend Payout Ratio =

* Provided in problem, but is also given in Chapter 10 Continuing Problem.

Common Dividends + Common Stock Repurchases Net Income $25,000* + $11,200 = $73,665 = 49.14%

Total Payout Ratio =

* Obtained from Chapter 10 Continuing Problem, but also provided in additional information.

Stock Repurchase Payout Ratio = Total Payout Ratio − Dividend Payout Ratio = 49.14% − 33.94% = 15.20%

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

APPENDIX 1

Data Analytics and Accounting Information

Analysis Using Excel to Calculate FIFO and LIFO Cost 1. Explain the FIFO and LIFO methods. FIFO and LIFO are two different ways of calculating the costs of ending inventory and of the goods sold in the period. The FIFO method calculates costs as if the goods are sold in the order in which they were purchased. In other words, the first layer of goods purchased will also be the first layer of goods sold. Once the first layer is sold out, then the second layer will be sold and so on. This is why the method is called “first-in, first-out.” LIFO makes the opposite assumption. The last layer of goods purchased will be the first layer of goods sold. Once the last layer is sold out, then the previous layer will be sold and so on. That is why this method is called “last-in, first-out.” Note that the physical flow of goods does not have to follow the cost flow assumption used, although it may. 2. Explain how you use an “intermediate column” to keep track of numbers such as cumulative numbers needed in further calculations. When a task is complex, students should think about how to break it down. For example, when using FIFO, how can you know whether a layer has been sold out? You can do this by finding the cumulative units purchased and checking to see whether the number of units sold exceeds the cumulative number of units purchased. If so, the layer is sold out. If not, some or none of the layer is sold out. For example, if column B contains the units purchased for each layer and column D contains the cumulative units purchased, then the cumulative units in D9 will be = D8 + B9 (i.e., the previous cumulative number plus the number of units in the new layer). 3. Explain how to set up Excel calculations using cell references so that you can populate a spreadsheet efficiently. What happens when you copy and paste cell references from one row to the next row? If you want to create an Excel spreadsheet efficiently, you should avoid using “hard-coded” numbers. Instead, design the spreadsheet so that you can take advantage of the cell references in Excel. In Excel, every cell is referenced by its row (1, 2, 3, …) and column (A, B, C, …). You can create a formula by referring to other cells. For example, if you want to calculate the cost of a purchase (i.e., units purchased * unit cost), do not simply type in the number of units purchased * the unit cost (e.g., 70 * 20) into a cell. Instead, refer to the column that contains the unit purchased and the column that contains the unit cost. Let’s say that column B is units purchased, column C is unit cost, and row 8 is the first transaction. If you want to calculate the purchase cost, then in F8, you can enter “=B8 * C8”. When you copy F8 and paste it into F9,

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Excel will automatically update the formula to be B9 * C9. In other words, Excel will update a pasted formula using cell references that reflect the location of the cell that you paste it into. This is very helpful when you have many transactions; instead of typing “hard-coded” formulas in one row at a time, you can copy and paste the same formula to all the rows. 4. Explain why you may sometimes not want to use relative cell references when copying and pasting, but instead use an absolute reference to a specific cell. If you use relative cell references, then the reference will be updated when that formula is copied and pasted into a new cell. This is not always desirable. For example, if you want to figure out how many units of each layer still remain, you need to calculate cumulative number of units purchased minus the total number of units sold. If you have total units sold in cell B5, then when you copy and paste the formula into cells in subsequent rows, it will become B6, B7, …, which is not correct. To fix the reference so that it is always B5, you can add a dollar sign to make it B$5, which is an absolute reference. That way, when it is copied and pasted, it will still refer to B5. Remember that you should place $ before the column letter if you want the column to be fixed, and place $ right before the row number if you want the row to be fixed. Placing $ before both the column letter and the row number will cause both the row and the column to be fixed. 5. Explain how to sort a date data field in Excel. Sorting can be applied not only to the column of data you want to sort but also to all other columns based on that column. For example, if you want to sort your entries by date, you sort all data by the Date column and all of the other information will move with the corresponding date (so that the information in each row stays together). When you sort data by date, you can sort from the Newest to the Oldest or from the Oldest to the Newest. We use both in this assignment because FIFO and LIFO consider purchases from the first and from the last, respectively.

Activity The student is to build a spreadsheet that can calculate the inventory cost and the cost of goods sold. 1. In business, you are likely to have so many transactions that you cannot simply calculate everything manually. Using an Excel spreadsheet will allow you to automate the calculations. Before you create calculations in Excel, you should think about the inputs that you will need to solve this problem. You should also list the major steps that you need Excel to perform. A major teaching point for this case is that a complex Excel task can be broken down into smaller tasks. Then you can make a plan to accomplish each small task step by step. For example, FIFO inventory analysis may seem like a complex task, but it can be broken down into the following steps: a. Sort the layers according to their purchase dates: for FIFO, the oldest purchases should be listed first; for LIFO, the newest purchases should be listed first. b. Calculate the purchase cost for each layer. c. Calculate how many units have been cumulatively purchased at each purchase date. d. Compare the cumulative units purchased and the total units sold to determine the number of remaining units after the sale.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

e. f. g. h.

Calculate how many units remain from each layer after the sale. Calculate the number of units sold from each layer. Calculate the inventory cost for each layer Calculate the cost of goods sold for each layer.

Students should understand the problem-solving process before moving on to the specific solution. Otherwise, they will simply be copying and pasting the solution without understanding it or being able to apply it in the future. After you have thought through the steps, go to cengage.com and locate the student resources for this title. Open the Excel file FIFO_LIFOCaseData.xlsx. Save the file as Lastname_Firstname_FIFO_LIFOSolution.xlsx (where “Lastname” is your actual last name and “Firstname” is your actual first name). To help you get started, the file already has a list of columns for you to fill out. To accomplish this task, complete the following steps. 2. Perform FIFO analysis: the purchases in the file were entered according to their purchase dates, from oldest to newest. a. Sort the layers according to their purchase dates: for FIFO, the oldest purchases should be listed first; for LIFO, the newest purchases should be listed first.

b. Calculate the purchase cost for each layer.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Exhibit 1 Calculate the Purchase Cost The purchase cost is equal to the number of units purchased times the unit cost. First, set D8=B8*C8.

As in Exhibit 1 , once you have created the formula in D8, you can copy and paste D8 to all of the cells in the D column, that is, D9 through D31. c. Calculations using an “intermediate column”: to find the cumulative units in inventory, calculate the total number of units purchased up to that purchase date from column D.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Exhibit 2 First Cell for the Cumulative Units Purchased At the date of the first purchase, there is no beginning inventory, so cumulative units purchased is equal to the first units purchased. First, set E8=B8.

For subsequent purchases, the cumulative units purchased will be equal to the previous value of cumulative units purchased plus the units purchased for the current inventory layer. Next, E9 should be =B9+E8, as in Exhibit 2. Exhibit 3 Second Cell for the Cumulative Units Purchased

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

As in Exhibit 3, once you have created the formula in E9, you can copy and paste E9 to all of the cells in the E column, that is, E10 through E31. d. Calculations using absolute references and the Excel max function: In column F, calculate the number of units remaining at the end of the month. When the total number of units purchased is less than the number of units sold, the company has sold the entire inventory layer and no more units remain from this layer. As in Exhibit 4 , enter the following in E8: =MAX(0,D8-B$5) The MAX(0,D8-B$5) function sets all negative numbers to zero, and the dollar sign before the 5 ensures that when it is copied and pasted, 5 remains as 5. Exhibit 4 Total Units Remaining after Sale

Copy and paste F8 to F9 through F31. Students should see that column F is zero through Oct. 12. This means that the layers up through Oct. 12 are sold out. e. Calculate how many units remain from each layer after the sale. Next for each inventory layer, calculate the number of units remaining in inventory after the sale. For the first layer, this will be equal to the total number of units after the sale. As in Exhibit 5, set G8=F8. Exhibit 5 Remaining Units in the First Layer

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

For subsequent layers, the units remaining from this layer will be equal to the number of units by which the total number of units increased due to this layer. Set G9=F9-F8. Exhibit 6 Remaining Units in Subsequent Layers

As in Exhibit 6, copy and paste G9 to G10 through G31. f.

Calculate the number of units sold from each layer.

Units sold from this layer will equal units purchased minus units remaining from this layer.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Set H8=B8-F8. Exhibit 7 Units Sold from This Layer

As in Exhibit 7, copy and paste H8 to H9 through H31. g. Calculate the inventory cost from each layer. Inventory cost for this layer will equal units remaining from this layer times the unit cost. Set I8=G8*C8. Exhibit 8 Inventory Cost from This Layer

As in Exhibit 8, copy and paste I8 to I9 through I31. h. Calculate the cost of goods sold from each layer.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Cost of goods sold (COGS) from this layer will equal the units sold from this layer times the unit cost. As in Exhibit 9, set J8=H8*C8. Exhibit 9 Cost of Goods Sold from This Layer

Copy and paste J8 to J9 through J31. i.

Cost calculations: find total purchase cost, units on hand, total inventory cost, and cost of goods sold. (Hint: cost of goods sold = total purchase cost – total inventory cost.)

Total purchase cost: D34 should be =SUM(D8:D31) Units on hand: G34 should be =SUM(G8:G31) Total inventory cost: G34 should be =SUM(I8:I31) Cost of goods sold: J34 should be =SUM(J8:J34). This will also equal total purchases minus ending inventory, D34-I34. 3. After you complete FIFO, perform LIFO analysis. Hint: You need to sort the data by date first. Then you can perform the same steps as in FIFO. This exercise will allow students to determine whether they can apply what they learned through FIFO. All that needs to be changed is to sort the data from the newest date to the oldest date. To sort the data, click on A7 and choose Custom Sort. The following window will appear:

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Choose Sort by Purchase Date, from Newest to Oldest. Click OK and the data will be sorted. Once it has been sorted, repeat the same steps as for FIFO. 4. Compare the results using FIFO and LIFO. What happens to the relative inventory costs and the costs of goods sold if the unit cost increases over time? Students should observe that the total purchase cost is the same for FIFO and LIFO. The difference is whether you cost the goods sold from the earlier or the later layers. Cost of goods sold = total purchase cost – total inventory cost. If unit cost increases over time, the inventory cost will be lower and the cost of goods sold will be higher under LIFO than under FIFO. With a higher cost of goods sold, a business will report lower profits. In this example, using FIFO, the total inventory cost is $115,459.00, which is higher than the total inventory cost using LIFO, which is $108,321.00. The cost of goods sold using FIFO is $105,813.00, which is lower than the $112,951.00 cost of goods sold using LIFO.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Analysis Using the Accounts Receivable Aging Method 1. Explain what bad debt expense is and how it is determined. When customers make purchases on credit, the amount owed by the customer is an account receivable. There is always some risk that the customer will be unable or unwilling to pay when the receivable is due. When a customer fails to pay what it owes, the seller has an “uncollectible account.” The seller has already recorded a sale for the amount of the receivable, but when an account is uncollectible, it will record an expense equal to the amount that it cannot collect. This expense is usually called bad debt expense but can be called uncollectible accounts expense or doubtful accounts expense. Because U.S. GAAP requires that companies use the matching principle and companies often do not learn that an account is uncollectible until a later accounting period, they estimate the current period’s bad debt expense in order to match the expense with the sales revenue. Two methods are available for determining bad debt expense: the percentage of credit sales method and the aging method. Under the aging method, the ending allowance for doubtful accounts is estimated as a percent of the ending receivables balance. Then the bad debt expense is determined. It is the “plug” figure that adjusts the allowance for doubtful accounts to the estimated ending balance. 2. Explain the aging method for estimating bad debt expense. The main idea of the aging method for estimating bad debt expense is that accounts that are further past due have a higher likelihood of becoming uncollectible. Knowing how long uncollected receivables have been outstanding is important so that managers can focus their collection efforts, manage cash flows, and determine customer credit limits; it is also important for estimating bad debt expense using the aging method. The main steps in this method are as follows: <NL> 1. Determine the number of days that each account is past due. 2. Create an aging schedule. An aging schedule places each account into an age category, for example, not past due (or current), or past due 1–30 days, 31–60 days, or more than 60 days. 3. Find the total amount for each age category in the aging schedule. 4. Multiply the amount in each age category by an estimated likelihood that an account outstanding for that period of time will become uncollectible. The likelihood is assumed to be the same for all accounts in a category. For example, accounts that are not yet overdue have a 3 % probability of becoming uncollectible,and all accounts that are 1–30 days past due have a 5% probability of becoming uncollectible. The probability increases with the age of the category. For example, all accounts that are 31–60 days past due have a 10% probability of becoming uncollectible, and the oldest accounts, which are more than 60 days past due, have the highest probability of being uncollectible, at 15%.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

5. Sum the estimated uncollectible amounts in all the age categories to find the estimated ending balance of the allowance for doubtful accounts. 6. Subtract the beginning balance of the allowance for doubtful accounts from the estimated ending balance. This difference is the required bad debt expense.

3. Explain how to set up Excel calculations using cell references so that you can populate a spreadsheet efficiently. What happens when you copy and paste cell references from one row to the next row? If you want to create an Excel spreadsheet efficiently, you should avoid using “hard-coded” numbers. Instead, design the spreadsheet so that you can take advantage of the cell references in Excel. In Excel, every cell is referenced by its row (1, 2, 3, …) and column (A, B, C, …). You can create a formula by referring to other cells. For example, if you want to calculate a purchase of 100 units at a cost of $105, do not simply type 105*100 in Excel. Instead, have a column that is used for unit cost and a column that is used for units purchased. Let’s assume that column C is unit cost and column B is units, and let’s assume that your first transaction appears in row 8. If you want to calculate the purchase cost and place it in column F, then in F8, you can enter “=C8*B8”. When you copy F8 and paste it into F9, Excel will automatically update the formula to be C9*B9. In other words, Excel automatically updates a pasted formula using cell references based on the location of the cell you paste it to. This is very helpful when you have a long list of records; instead of typing “hardcoded” formulas one row at a time, you can copy and paste the same formula to all of the rows. 4. Explain why you may sometimes not want Excel cell references to update when copying and pasting, but instead have the cell reference remain fixed at a specific cell. If you use cell references, then, by default, the reference will be updated when the formula is copied and pasted to a new cell. This is not always desirable. For example, suppose that you want to use today’s date for calculating the number of days past due. If you have today’s date in cell B5, then when you copy and paste the formula to cells in subsequent rows, the date will become B6, B7, etc., which is not correct. To fix the reference so that it will always refer to B5, when you copy it elsewhere in the spreadsheet, you can add dollar signs in front of both the column letter and the row number to make it $B$5. That way, when it is copied and pasted, it will still refer to cell B5. Place $ before the column letter if you want the column to be fixed, and place $ before the row number if you want the row to be fixed. Place $ before column letter and $ before row number if you want both the row and the column to be fixed. 5. Explain conditional logic and provide an example of how to apply it. In Excel, conditional logic allows a cell to change its value based on some user-defined logic. For example, if an account is not past due and you want to show the account’s amount in the “not past due” column, but not display if the account is past due, you can use conditional logic. Specifically, if C7 is the account balance and D7 is the number of days that the account is past due, you can use the following conditional logic, as an If statement, in E7, based on what is stated in D7: =IF(D7<=0,C7,"") © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

The first item is a condition check. In this example, it is checking whether D7 is the number of days past due. If D7 is less than or equal to zero, then the account is not past due. The second item is the value for E7 if the condition is met. In this example, if the account is not past due, E7 will be C7, which is the account’s balance. The third item is the value for E7 if the condition is not met. In this example, if the account is past due (i.e., days past due >0), E7 will be blank, specified as "". In this case, conditional logic can help us create an aging schedule. 6. Explain what to do when you need to combine two conditions in a criterion. Sometimes more than one criterion needs to be met. For example, for an aging schedule, a category of receivables may be 1–30 days past due, meaning that an account not only has to meet the condition of being at least 1 day past due but also has to meet the condition of being at most 30 days past due. One simple way to incorporate multiple conditions is to use an AND statement. For example, in cell F7, if you want to show the balance if the account is 1–30 days past due but leave the cell blank otherwise, you can use the following statement in F7: =IF(AND(D7>=1,D7<=30),C7,"") The first item is a condition check. In this example, D7 is the number of days past due. If D7 is at least 1 and at most 30, then the account will be categorized with other accounts that are between 1 and 30 days past due. The AND statement combines the two conditions: D7>=1 and D7<=30. The second item is the value for F7 if the condition is met. In this example, if the account is between 1 and 30 days past due, F7 will be C7, which is the account’s balance. The third item is the value for F7 if the condition is not met. In this example, if the account is not between 1 and 30 days past due (i.e., if it is less than 1 day past due or greater than 30 days past due), F7 will be blank, specified as "". Besides AND, another useful way to combine conditions is OR. AND means that all conditions need to be met; OR means that at least one of the conditions needs to be met. The OR statement works in a similar manner as the AND statement.

Activity Students will build a spreadsheet that will (i) show whether each account is current (i.e., not past due) or past due 1–30 days, 31–60 days, or by more than 60 days; (ii) calculate the total for each category; (iii) calculate the estimated amount of uncollectible accounts for each category; and (iv) calculate the total April 30 estimate for the allowance for doubtful accounts. From this, students will need to subtract the April 1 balance of the allowance to arrive at the estimated bad debt expense for April. 1. In business, you are likely to have so many transactions that you cannot simply calculate everything manually. Using an Excel spreadsheet will allow you to automate the calculations. Before you create calculations in Excel, you should think about the inputs that you will need to solve this problem. You should also list the major steps that you need Excel to perform. Students should realize that the main steps in the accounts receivable aging method must be implemented in Excel:

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

1. Calculate the number of days that each account is past due. Excel cell references should be used instead of hard-coding numbers. Furthermore, because today’s date is the same for every account, an absolute reference should be used. 2. Create an aging schedule. This task requires the use of conditional logic. For example, if the number of days is negative, it means that the account is not past due. If it is at least 1 day and at most 30 days past due, then the If statement developed by students should place the amount of the receivable in the 1–30 days past due category. 3. Use Sum to find the total amount for each category in the aging schedule. 4. Multiply the amount in each aging category by the estimated likelihood that the account becomes uncollectible. The likelihood is assumed to be the same for all accounts in a category. For example, all accounts that are 1–30 days past due have a 5% probability of becoming uncollectible, all accounts that are 31–60 days past due have a 10% probability of becoming uncollectible, and the oldest accounts, which are more than 60 days past due, have the highest probability of being uncollectible, at 15%. 5. Sum the estimated uncollectible amounts in all aging schedule categories to find the estimated allowance for doubtful accounts. 6. Subtract the April 1 balance of the allowance for doubtful accounts from the estimated ending balance to determine the bad debt expense for the month.</NL> After you have thought through the steps, go to cengage.com and locate the student resources for this title. Open the Excel file ARAgingSchedule_CaseData.xlsx. Save the file as Lastname_Firstname_ARAgingScheduleSolution.xlsx (where Lastname is your actual last name and Firstname is your actual first name). To help you get started, the file already has a list of columns for you to fill out. To accomplish this task, complete the following steps.

2. Create formulas to find the number of days that each account is past due, where a negative number means that an account is not past due. In cell D7, enter the following formula: =B$4-B7 Students should realize that it is B4 – B7, not B7 – B4, because we are calculating the number of days past due. If today’s date is larger (i.e., newer) than the due date, then the account is past due. As shown in Exhibit 1 >, students should realize that $ is needed in B$4 because we want to be able to copy and paste the formula to the entire D column. B$4 ensures that the formulas always refer to today’s date in B4.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Exhibit 1 Calculate the Number of Days Past Due

After entering the formula in D7, copy and paste it to the other records in column D. 3. For each age category, show the customer’s account if it is in that category, and show a blank if it is not in that category. a. Not past due In E7, enter the following formula: =IF(D7<=0,C7,"") This conditional logic will show the account balance (C7) in E7 if the account is not past due and will show a blank otherwise, as shown in Exhibit 2 >. Exhibit 2 Conditional Logic for Not Past Due

After entering the formula in E7, copy and paste it to the other records in column E. b. 1–30 days past due In F7, enter the following formula:

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

=IF(AND(D7>=1,D7<=30),C7,"") This conditional logic checks to see if the number of days past due (D7) is at least 1 and at most 30; if so, it shows the account balance (C7), and if not, it shows a blank, as in Exhibit 3 >. Exhibit 3 Conditional Logic for 1–30 Days Past Due

After entering the formula in F7, copy and paste it to the other records in column F. c. 31–60 days past due In G7, enter the following formula: =IF(AND(D7>=31,D7<=60),C7,"") This conditional logic checks to see if the number of days past due (D7) is at least 31 and at most 60; if so, it shows the account balance (C7), and if not, it shows a blank, as in Exhibit 4 >. Exhibit 4 Conditional Logic for 31–60 Days Past Due

After entering the formula in G7, copy and paste it to the other records in column G. d. 61+ days past due

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

In H7, enter the following formula: =IF(D7>=61,C7,"") This conditional logic will show the account balance (C7) in H7 if it is at least 61 days past due and will show a blank otherwise, as shown in Exhibit 5 >. Exhibit 5 Conditional Logic for 61+ Days Past Due

After entering the formula in H7, copy and paste it to the other records in column H. 4. Find the dollar value of the accounts receivable for each age. For ease of visualization, you can change the display format of cells representing accounting numbers to accounting number format, as shown in Exhibit 6 .

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

Exhibit 6 Accounting Number Format

As shown in Exhibit 7, to find the total for each age category, enter the following formula in E38: =SUM(E7:E36) Exhibit 7 Sum the Amounts for Each Age Category

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

To find the totals of the other age categories, students should realize that copying and pasting will work. Students can copy E38 and paste it into F38, G38, and H38. 5. For each age category, estimate the uncollectible amount. To find the estimated uncollectible amount for each age category, enter the following formula in E41: =E38*E39 Exhibit 8 Estimate the Uncollectible Amount for Each Age Category

To calculate the estimates for other age categories, students should realize that copying and pasting will work. Students can copy E41 and paste it into F41, G41, and H41, as shown in Exhibit 8 >. 6. Find the total estimated uncollectible amount. To find the total estimated uncollectible amount, enter the following formula in I43: =SUM(E41:H41) The answer is $1,067.67.

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4]

7. Using this information, calculate the bad debt expense for April. Now that the estimate of the uncollectible accounts has been determined, the final step in determining bad debt expense is to subtract the beginning balance in the allowance for doubtful accounts from the newly determined estimate. Cell I45 should be =I43-I44. The estimated bad debt expense is $836.14.

8. What is the journal entry to record the bad debt expense? The entry to record bad debt expense is: Bad Debt Expense

836.14

Allowance for Doubtful Accounts

836.14

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 2: Investments

APPENDIX 2 INVESTMENTS DISCUSSION QUESTIONS 1.

The three classifications for investments in debt are as follows: a. Held-to-maturity securities are debt investments that management intends to hold until the debt contract requires the borrower to repay the debt in its entirety. On the balance sheet, held-to-maturity securities are classified as noncurrent assets unless the date of maturity is within 1 year or one operating cycle, whichever is longer. b. Trading securities are debt investments that management intends to sell in the near term. Trading securities are bought and sold frequently and typically are owned for under 1 month. Trading securities are always classified as current assets on the balance sheet. c. Available-for-sale securities are debt investments that management intends to sell in the future, but not necessarily in the near term. Therefore, investments in debt securities that do not warrant inclusion as trading securities or held-tomaturity securities are considered available-for-sale. On the balance sheet, available-for-sale securities are classified as current or noncurrent assets depending on whether they will be sold within 1 year or one operating cycle, whichever is longer.

The amortized cost method is used for investments in debt securities that are to be held to maturity. It is implemented by: ● Recording securities purchased at cost ● Carrying those investments on the balance sheet at cost adjusted for unamortized premium or discount amortization during the holding period ● Recording receipt of interest income with appropriate amortization of premium/discount each accounting period ● Removing cost from the accounting records when the securities are redeemed at maturity

Investment income is recognized for: (1) the amortized cost method when interest is earned each accounting period and when amortization of premium or discount is recorded, (2) the fair value method when interest or dividends are received and when investments are sold, and (3) the equity method when the investee earns income (or loss) and when investments are sold.

The fair value method is used for investments in debt securities that are classified as trading or available-for-sale. It is implemented by: ● Recording securities purchased at cost (fair value on the date of purchase) ● Adjusting the carrying amount of those investments to their fair (or market) value at the end of each accounting period

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●

● ●

Recognizing the adjustment to the carrying amount (for unrealized gains or losses) of these investments as a separate element of stockholders’ equity (available-forsale debt securities) or as income on the income statement (investments in debt securities classified as trading) Recording interest or dividends as income as they are realized each accounting period Removing the investment carrying amount from the accounting records when the securities are sold and recognizing a gain (or loss) measured by the difference between the selling price and the cost of the investment

The fair value method is also used to account for equity securities. The accounting for equity securities under the fair value method mirrors that of the accounting for debt securities classified as trading securities. 5.

Trading securities are debt investments that management intends to sell in the near term. Trading securities are bought and sold frequently and typically are owned for less than 1 month. Trading securities are always classified as current assets. On the income statement, unrealized gains (losses) on trading securities are included on the income statement as part of net income. Available-for-sale securities are debt investments that management intends to sell in the future but not necessarily in the near term. On the balance sheet, available-for-sale debt securities are classified as current or noncurrent assets depending on whether they will be sold within 1 year or one operating cycle, whichever is longer. Unrealized gains (losses) on available-for-sale securities are not included on the income statement; instead, they are reported in accumulated other comprehensive income, which is an element of stockholders’ equity.

The allowance to adjust short-term investments to market is the valuation account containing unrealized gains and losses on the short-term investment portfolio. It is adjusted at year end to the current amount of unrealized gain or loss and is reported on the balance sheet to adjust the cost of the portfolio to its current market value. Use of this allowance reveals the current cash-generating potential of the short-term investments; reporting only their cost would deny this information to users of the financial statements.

The equity method is used to account for long-term investments in common stock, which enables the investor to significantly influence the operations of another business. When an investment represents an ownership of 20% or more, the investor can usually influence the operations of the investee, and the equity method is used. It is implemented by: ● Recording securities purchased at cost ● Recognizing as income the investor’s share of investee net income (or net loss) ● Adding the investor’s share of investee net income (or subtracting the investor’s share of net loss) to the investment account

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● ●

Recording dividends received as a reduction in the investment account Removing the investment carrying amount from the accounting records when the securities are sold and recognizing a gain (or loss) measured by the difference between the selling price and the carrying amount

Under the equity method, the investor recognizes its share of investee net income as the income is earned by the investee. The investor records income when income is earned by the investee and not when a dividend is declared and paid. Dividends are recorded as a reduction in the Investment account. This prevents the investor’s income from being manipulated by investor-stimulated changes (since they possess significant influence over the investee through having greater than 20% stock ownership) in an investee’s dividend policy. As explained in advanced accounting courses, the equity method also prevents manipulation through intercorporate transactions, whose effects must be eliminated.

A parent is an investor whose investment in the stock of another firm enables it to control the other firm (the subsidiary). A subsidiary is a firm whose operations are controlled by another entity through that entity’s investment in the subsidiary firm’s stock. Usually, ownership of 50% or more of the outstanding voting stock is sufficient to give a parent control over a subsidiary.

10. Noncontrolling interest is the portion of a subsidiary’s common stock that is not held by the parent. This amount must be shown as a component of stockholders’ equity on the consolidated balance sheet. It represents the equity interest of the noncontrolling stockholders in the subsidiary’s assets and liabilities. 11. The consolidated balance sheet is essentially the same as the parent’s corporate balance sheet except that the parent’s Investment—Equity Method account is replaced with the detailed assets and liabilities of the subsidiary. In addition, other differences may arise from intercorporate transactions described in advanced accounting courses. 12. Because a parent and subsidiary are two separate legal entities, they often engage in business transactions such as buying or selling inventory, borrowing funds, and so on. Further, because they keep separate accounting records, these transactions produce, for example, sales revenue, receivables, and payables in the financial statements. However, in consolidation, the two separate legal entities are reported as a single accounting entity. Because a single entity cannot sell to itself or owe money to itself, these intercompany transactions must be eliminated in consolidation. 13. An asset acquisition is a business combination in which the assets and liabilities of another company are acquired. A stock acquisition is a business combination in which the common stock of another company is acquired with the parent’s own common stock.

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14. Goodwill represents intangible assets that cannot be specifically identified or separated from the business, such as a reputation for quality products. It is calculated by subtracting the fair value of identifiable net assets received from the acquisition price.

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MULTIPLE-CHOICE QUESTIONS A2-1.

A2-2.

A2-3.

A2-4.

A2-5.

A2-6.

A2-7.

A2-8.

A2-9.

A2-10. a A2-11. b A2-12. c A2-13. c A2-14. b A2-15. a A2-16. d

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EXERCISES E A2-17 1.

E A2-18 1.

Journal Date Account and Explanation Dec. 31 Investment in Equity Securities Unrealized Gain (Loss) on Equity Securities

Debit 14,000

Credit

14,000

* [($39.50 − $38.00)  20,000 shares] + [($16.50 − $17.00)  32,000 shares] = $14,000

For equity securities, the unrealized gain is included in the income statement. It would increase earnings before income taxes by $14,000 and would thus flow into retained earnings.

E A2-19 1. Date Dec. 31

Journal Account and Explanation Allowance to Adjust Available-for-Sale Securities to Market* Unrealized Gain (Loss) on Available-for-Sale Securities

Debit

Credit

2,000 2,000

* [$520,000 − $500,000] + [$950,000 − $968,000] = $2,000

For available-for-sale securities, the unrealized gain is not included on the income statement. Instead, it is included as part of “Other Comprehensive Income,” a separate account included in stockholders’ equity.

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E A2-20 Date Dec. 31

Journal Account and Explanation Allowance to Adjust Available-for-Sale Securities to Market* Unrealized Gain (Loss) on Available-for-Sale Securities

Debit

Credit

4,200 4,200

* See the following T-account.

Allowance to Adjust Available-for-Sale Securities to Market 7,200 Beginning balance Necessary adjustment to achieve desired ending balance 4,200 3,000 Desired ending balance

E A2-21 1.

Journal Account and Explanation

Date 2022 Dec. 31 Allowance to Adjust Trading Securities to Market* Unrealized Gain (Loss) on Trading Securities 2023 Dec. 31 Allowance to Adjust Trading Securities to Market* Unrealized Gain (Loss) on Trading Securities 2024 Dec. 31 Unrealized Gain (Loss) on Trading Securities Allowance to Adjust Trading Securities to Market*

Debit

Credit

5,100 5,100 5,800 5,800 2,700 2,700

* See T-account on next page.

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E A2-21 (Continued) Allowance to Adjust Trading Securities to Market 8,500 Necessary adjustment to achieve desired 12/31/2022 balance

Necessary adjustment to achieve desired 12/31/2023 balance 12/31/2023 desired balancec

12/31/2021 Balancea

5,100 3,400

12/31/2022 desired balanceb

2,700 300

Necessary adjustment to achieve desired 12/31/2024 balance 12/31/2024 desired balanced

5,800 2,400

$153,800 − $162,300 = −$8,500 $106,200 − $109,600 = −$3,400 c $151,300 − $148,900 = $2,400 d $138,700 − $139,000 = −$300 a

The 2024 income statement effect is a $2,700 loss resulting from the $2,700 debit to unrealized gain (loss) on trading securities in the December 12, 2024 journal entry.

The 2024 income statement effect is $0, because unrealized gains and losses on available-for-sale securities do NOT go to the income statement. Instead, they are part of “Accumulated Other Comprehensive Income.”

E A2-22 1. Date Apr. 9 June 30 Aug. 30 Oct. 10

Journal Account and Explanation Investment in Equity Securities Cash Investment in Equity Securities Cash Cash* Dividend Income Cash** Dividend Income

Debit 14,600

Credit 14,600

14,500 14,500 240 240 900 900

* 200 shares  $1.20 = $240 ** 500 shares  $1.80 = $900

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E A2-22 (Continued) 2.

Market value of portfolio on December 31: 200 Southwestern shares at $75 per share ................................... 500 Montgomery shares at $25 per share..................................... Portfolio market value .........................................................

$15,000 12,500 $27,500

An adjusting entry is needed to adjust the portfolio to its market value. The total market value of the portfolio ($27,500) is $1,600 less than its acquisition cost ($14,600 + $14,500 = $29,100).

Journal Date Account and Explanation Dec. 31 Unrealized Gain (Loss) on Equity Securities Investment in Equity Securities 4.

Debit 1,600

Credit 1,600

Current assets: Investments: Equity securities, at fair value .....................................................................

$27,500

E A2-23 1.

Fair value method is used because Nadal owns under 20% of Cutler’s outstanding common stock (10,000 shares/75,000 shares = 13.3%). Journal Date Account and Explanation Jan. 1 Investments in Equity Securities Cash 1 Cash Dividend Income Dec. 31 Investment in Equity Securities Unrealized Gain (Loss) on Equity Securities

Debit 100,000

Credit 100,000

8,000 8,000 20,000 20,000

Equity method is used because Nadal owns 20% or more of Cutler’s outstanding common stock (10,000 shares/40,000 shares = 25%). Date Jan.

Dec.

Account and Explanation 1 Investments—Equity Method Cash 1 Cash Investments—Equity Method 31 Investments—Equity Method Investment Income—Equity Method

Debit 100,000

Credit 100,000

8,000 8,000 12,400

12,400

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E A2-24 1.

Because Miller owns less than 20% of Graceland’s stock (1,500 shares/10,000 shares = 15%), the fair value method is used. Journal Date Account and Explanation Debit Credit Jan. 1 Investments in Equity Securities 24,000 Cash 24,000 a Oct. 1 Cash 3,000 Dividend Income 3,000 Nov. 13 Cash 5,000 Investment in Equity Securities 4,800 Gain on Sale of Investments 200 Dec. 31 Unrealized Gain (Loss) on Equity Securitiesc 1,200 Investment in Equity Securities 1,200

1,500 shares  $2 = $3,000 300 shares  ($24,000/1,500 shares) = $4,800 c (1,500 shares − 300 shares)  ($16 − $15 market price) = $1,200 a

Noncurrent assets: Investment in equity securities, fair value ...............................

$18,000

Stockholders’ equity: Retained earnings* ................................................................

3,200

* $3,000 dividend income + $200 gain on sale = $3,200

E A2-25 1.

Journal Date Account and Explanation Jan. 1 Investments—Equity Method Cash Dec. 31 Investments—Equity Method* Investment Income—Equity Method 31 Cash** Investments—Equity Method

Debit 60,000

Credit 60,000

12,000 12,000 4,600 4,600

* 40%  $30,000 = $12,000 ** 40%  $11,500 = $4,600

Noncurrent assets: Investments—equity method*** ............................................ Stockholders’ equity: Retained earnings ..................................................................

$67,400 $12,000

*** $60,000 + $12,000 − $4,600 = $67,400

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E A2-26 Milstein Fair value method $6,000 $500 (the dividend) $6,450 (fair value)

1. 2. 3. 4.

Heifetz Equity method $20,000 $3,750 (25% of Heifetz’s net income) $22,050*

* $20,000 + $3,750 − $1,700 = $22,050

E A2-27 1.

Journal Date

a. b. c.

d. e.

Account and Explanation Investments—Trading Securities Cash Cash Interest Income Cash Loss on Sale of Trading Securities Investments—Trading Securities Investments—Trading Securities Cash Cash Interest Income

Debit 12,800

Credit 12,800

320 320 2,440 120 2,560 20,900

20,900 380 380

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E A2-27 (Continued) 2.

An entry is required to adjust the short-term investments from cost to market value. The market value is given as follows: $10,240 Bartco bonds Newton debt

20,900

Portfolio fair value

$31,140

This means a debit balance of $31,140 is needed in the allowance account to adjust the investment account up from its $31,140 cost basis to its $0 beginning balance. Journal Date Account and Explanation Dec. 31 Allowance to Adjust Trading Securities to Market Unrealized Gain (Loss) on Trading Securities

Debit 31,140

Credit 31,140

Allowance to Adjust Trading Securities to Market

Jan. 1 balance Necessary adjustment to achieve Dec. 1 desired ending balance

31,140

Dec. 31 desired balancee

31,140

$0 − $31,140 = −$31,140

Because these short-term investments are considered trading securities, the unrealized gain of $31,140 is included in net income.

Investments—Trading securities, at fair value ..............................................

$31,140

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E A2-28 1.

Journal Date Account and Explanation Dec. 31 Investments—Equity Method Cash

Debit 1,500

Credit 1,500

Dear Corporation will make no entry because the combination transaction is between Augusta Inc. and the stockholders of Dear Corporation. 2.

Augusta Inc. Balance Sheet (Immediately after Acquisition) Cash* ................................................................................................. Investments—equity method ............................................................. Equipment (net) ................................................................................. Total assets ........................................................................................

$ 1,600 1,500 9,500 $12,600

Common stock ................................................................................... Retained earnings .............................................................................. Total liabilities and stockholders’ equity .............................................

$ 9,100 3,500 $12,600

* $3,100 − $1,500 = $1,600

Dear Corporation Balance Sheet (Immediately after Acquisition) Cash .................................................................................................. Equipment (net) ................................................................................. Total assets........................................................................................

$ 180 930 $1,110

$ 700 410 $1,110

Dear’s postcombination balance sheet is unchanged from its precombination balance sheet. 4.

$1,500

Acquisition price................................................................................ Current value of identifiable net assets received: Book value of net assets received ...............................................

$1,110

Adjustment to current value, equipment* ..................................

170

Current value of net assets received ..................................................

1,280

Goodwill ...........................................................................................

$ 220

* $1,100 − $930 = $170

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Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 2: Investments

E A2-28 (Continued) 5.

Augusta Inc. Consolidated Balance Sheet (Immediately after Acquisition) Cash .................................................................................................. Equipment (net) ................................................................................ Goodwill ........................................................................................... Total assets .......................................................................................

$ 1,780 10,600 220 $12,600

Common stock .................................................................................. Retained earnings ............................................................................. Total liabilities and stockholders’ equity ............................................

$ 9,100 3,500 $12,600

E A2-29 1.

Acquisition cost .................................... Current value of identifiable net assets acquired: Book value of assets acquired ................................... Adjustment to current value, equipment* ............................. Less: Book value of liabilities acquired ........................... Adjustment to current value ................................ Goodwill .............................................

$23,000,000

$27,800,000 4,400,000

$32,200,000

$10,000,000 0

10,000,000

22,200,000 $ 800,000

Debit

Credit

* $20,700,000 − $16,300,000 = $4,400,000

Journal Date

Account and Explanation

2. Jan. 3.

1 Investments—Equity Method Cash 1 Accounts Receivable Inventory Property, Plant, and Equipment Goodwill Accounts Payable Notes Payable Cash

23,000,000 23,000,000 6,800,000 4,700,000 20,700,000 800,000

2,000,000 8,000,000 23,000,000

722

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

APPENDIX 3

THE TIME VALUE OF MONEY

DISCUSSION QUESTIONS 1.

The timing of the receipt (or payment) of money affects the value of that receipt (or payment). Money received now can earn interest. Money received in the future forgoes an opportunity to earn interest and therefore is less valuable than money received now.

Future value of a single amount: An amount is put on deposit and earns compound interest until maturity. Present value of a single amount: An amount is to be paid or received at some future time. The value today of that future flow is the present value. Future value of an annuity: A series of payments at equal intervals of time of the same amount are put into a fund and earn compound interest until maturity, at which time the interest plus the annuity payments are returned. Present value of an annuity: A series of regular payments of the same amount are to be received or paid. The value today of these payments is the present value of the annuity.

Compound interest is computed by multiplying the interest rate times the balance of the account at the beginning of the interest period and adding the product to the account. A future value is the amount to which a single deposit or a series of deposits will grow by a specified future time when interest is compounded. A present value is the value today of a single payment or a series of payments to be received in the future.

An annuity is a series of payments or receipts (cash flows) of the same amount with payments exactly one period apart. From the viewpoint of a lender, the present value of the annuity is the amount lent, and the repeating cash flows repay the loan with interest.

Time-value-of-money may be used to measure the present value of an installment note liability. The periodic payment includes an amount for interest and for principal repayment. Using the present value interest factor of an annuity multiplied by the installment amount will provide the amount of the liability to be recorded on the balance sheet.

722

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

BRIEF EXERCISES BE A3-1 Tables: Future Value

= = =

Investment  (FV of a Single Amount, 20 Periods, 3%) $6,000  1.80611 $10,836.66

Future Value

= =

$6,000  1.0320 $10,836.67*

Formula:

Calculator:** N 20 * **

I/Y 3

PV −6,000

PMT 0

FV Compute

Solution 10,836.67*

Differs from value calculated with the tables due to rounding. The columns in this table have been put in the order of the keys on most, if not all, financial calculators. The key with “Compute” underneath it is what you are solving for in this problem. The order in which you press the keys does not matter; however, you should press the compute key last. The last column shows the solution to the problem. For annuity problems involving a periodic payment other than 0, be sure that your calculator is programmed for the payment to be paid (or received) at the end of each year and not at the beginning of the year.

BE A3-2 Tables: Future Value

= = =

Investment  (FV of a Single Amount, 30 Periods, 4%) $1,40,000  3.24340 $4,54,076.00

Future Value

= =

$1,40,000  1.0430 $4,54,075.65*

Formula:

Calculator:** N 30

I/Y 4

PV −140,000

PMT 0

FV Compute

Solution 4,54,075.65*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

723

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

BE A3-3 Tables: Present Value

= = =

Investment  (PV of a Single Amount, 7 Periods, 7%) $7,000  0.62275 $4,359.25

Present Value

= =

$7,000  (1/1.077) $4,359.25

Formula:

Calculator:** N 7

I/Y 7

PV Compute

PMT 0

FV −7,000

Solution 4,359.25

* See footnote explanation for BE A3-1.

BE A3-4 Tables: Present Value

= = =

Investment  (PV of a Single Amount, 4 Periods, 6%) $600  0.79209 $475.25

Present Value

= =

$600  (1/1.064) $475.26*

Formula:

Calculator:** N 4

I/Y 6

PV Compute

PMT 0

FV −600

Solution 475.26*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

BE A3-5 Tables: Present Value

= = =

Investment  (PV of a Single Amount, 4 Periods, 3%) $3,000  0.88849 $2,665.47

Present Value

= =

$3,000  (1/1.034) $2,665.46*

Formula:

Calculator:** N 4

I/Y 3

PV Compute

PMT 0

FV −3,000

Solution 2,665.46*

* See footnote explanation for BE A3-1.

724

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

BE A3-6 Tables: Future Value

= = =

Investment  (FV of an Annuity, 8 Periods, 4%) $500  9.21423 $4,607.12

Future Value

= =

$500  [(1.048−1)/0.04] $4,607.11*

Formula:

Calculator:** N 8

I/Y 4

PV 0

PMT −500

FV Compute

Solution 4,607.11*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

BE A3-7 Tables: Future Value

= = =

Investment  (FV of a Annuity, 20 Periods, 7%) $2,000  40.99549 $81,990.98

Future Value

= =

$2,000  [(1.0720−1)/0.07) 81,990.98

Formula:

Calculator:* N 20

I/Y 7

PV 0

PMT −2,000

FV Compute

Solution 81,990.98

* See footnote explanation for BE A3-1.

BE A3-8 Tables: Future Value

= = =

Investment  (FV of an Annuity, 3 Periods, 6%) $500  3.18360 $1,591.80

Future Value

= =

$500  [(1.063−1)/0.06] $1,591.80

Formula:

Calculator:* N 3

I/Y 6

PV 0

PMT −500

FV Compute

Solution 1,591.80

* See footnote explanation for BE A3-1.

725

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

BE A3-9 Tables: Present Value

= = =

Investment  (PV of a Annuity, 10 Periods, 6%) $200  7.36009 $1472.02

Present Value

= =

$2,00  {[1−(1/1.0610)]/0.06} $1,472.02

Formula:

Calculator:* N 10

I/Y 6

PV Compute

PMT −200

FV 0

Solution 1,472.02

* See footnote explanation for BE A3-1.

BE A3-10 Tables: Present Value

= = =

Investment  (PV of an Annuity, 10 Periods, 6%) $20,000  7.36009 $1,47,201.80

Present Value

= =

$20,000  {[1−(1/1.0610)]−1)]/0.06} $1,47,201.74*

Formula:

Calculator:** N 10

I/Y 6

PV Compute

PMT −20,000

FV 0

Solution 1,47,201.74*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

726

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

EXERCISE E A3-11 a.

Tables: Future Value

= = =

Investment  (FV of a single Amount, 10 Periods, 7%) $5,000  1.96715 $9,835.75

Future Value

= =

$5,000  1.0710 9,835.76*

Formula:

Calculator:** N 10

I/Y 7

PV −5,000

PMT 0

FV Compute

Solution 9,835.76*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Future Value

= = =

Investment  (FV of an Annuity, 10 Periods, 7%) $500  13.81645 $6908.23

Future Value

= =

$500  [(1.0710−1)/0.07] $6,908.22*

Formula:

Calculator:* N 10

I/Y 7

PV 0

PMT 5,000

FV Compute

Solution 6,908.22*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Present Value

= = =

Investment  (PV of a single Amount, 10 Periods, 7%) $5,000  0.50835 $2,541.75

Present Value

= =

$5,000  (1/1.0710) $2,541.75

Formula:

Calculator:* N 10

I/Y 7

PV Compute

PMT 0

FV −5,000

Solution 2,541.75

* See footnote explanation for BE A3-1.

727

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-11 (Continued) d.

Tables: Present Value

= = =

Investment  (PV of an Annuity, 10 Periods, 7%) $500  7.02358 $3,511.79

Present Value

= =

$500  {[1 − (1/1.0710)]/0.07} $3,511.79

Formula:

Calculator:** N 10

I/Y 7

PV Compute

PMT −500

FV 0

Solution 3,511.79

* See footnote explanation for BE A3-1.

E A3-12 a.

Tables: Present Value

= = =

Investment  (PV of a single Amount, 7 Periods, 8%) $1,200  0.58349 $700.19

Future Value

= =

$1,200  (1/1.087) $700.19

Formula:

Calculator:* N 7

I/Y 8

PV Compute

PMT 0

FV −1,200

Solution 700.19

* See footnote explanation for BE A3-1.

Tables: Present Value

= = =

Investment  (PV of an Annuity, 7 Periods, 8%) $1,200  5.20637 $6,247.64

Present Value

= =

$1,200  {[1 − (1/1.087)]/0.08} $6,247.64

Formula:

Calculator:* N 7

I/Y 8

PV Compute

PMT 1,200

FV 0

Solution 6,247.64

* See footnote explanation for BE A3-1.

728

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-12 (Continued) c.

Tables: Future Value

= = =

Investment  (FV of a single Amount, 7 Periods, 8%) $1,200  1.71382 $2,056.58

Future Value

= =

$1,200  1.087 $2,056.59*

Formula:

Calculator:** N 7

I/Y 8

PV −1,200

PMT 0

FV Compute

Solution 2,056.59*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Future Value

= = =

Investment  (FV of an Annuity, 7 Periods, 8%) $1,200  8.92280 $10,707.36

Future Value

= =

$1,200  [(1.087−1)/0.08] $10,707.36

Formula:

Calculator:* N 7

I/Y 8

PV 0

PMT −1,200

FV Compute

Solution 10,707.36

* See footnote explanation for BE A3-1.

E A3-13 a.

Tables: Future Value

= = =

Investment  (FV of a single Amount, 4 Periods, 10%) $15,000  1.46410 $21,961.50

Future Value

= =

$15,000  1.104 $21,961.50

Formula:

Calculator:* N 4

I/Y 10

PV −15,000

PMT 0

FV Compute

Solution 21,961.50

* See footnote explanation for BE A3-1.

729

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-13 (Continued) b.

Tables:

$13,416.80 Table Factor

= Investment  (FV of a Single Amount, 6 Periods, Unknown Interest Rate) = $8,000  Table Factor = 1.67710; Interest Rate = 9%

$13,416.80 1.67710

= $8,000  (1 + Unknown Interest Rate)6 = (1 + i ) 6

$13,416.80

Formula:

Calculator:* N 6

1.67710 = 1 + i 1.09 = 1 + i i = 0.09 = 9%

I/Y Compute

PV −8,000

PMT 0

FV 13,416.80

Solution 9

* See footnote explanation for BE A3-1.

Tables: Unknown Cash Flow  (FV of an Annuity, 9 Periods, 9%) Unknown Cash Flow  13.02104 Unknown Cash Flow

= = =

$79,428.10 $79,428.10 $6,099.98

= =

=$79,428.10 $79,428.10 $6,099.98

Formula: Unknown Cash Flow  [(1.099 − 1)/0.09] Unknown Cash Flow  13.02104 Unknown Cash Flow Calculator:* N 9

I/Y 9

PV 0

PMT Compute

FV −79,428.10

Solution 6,099.98

* See footnote explanation for BE A3-1.

Tables: $7,500  (FV of a Single Amount, n Periods, 9%) $17,755.50/$7,500 n

= = =

$17,755.50 2.36740 Table Factor About 10 Periods

$7500  1.09 n 1.09 n n

= = =

$17,755.50 2.36740 About 10 Periods

Formula:

Calculator:* N Compute

I/Y 9

PV −7,500.00

PMT 0

FV 17,755.50

Solution 10.00

* See footnote explanation for BE A3-1.

730

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-14

b. 2.

a. Tables: Future Value

= = =

pv fpv  (FV of a single Amount, 8 Periods, 3%) $12,000  1.26677 $15,201.24

Future Value

= =

$12,000  1.03 8 $15,201.24

Formula:

Calculator:* N 8

I/Y 3

PV −12,000

PMT 0

FV Compute

Solution 15,201.24

* See footnote explanation for BE A3-1.

b. Tables: Future Value

= = =

Investment  (FV of an Annuity, 8 Periods, 2%) $2,500  8.58297 $21,457.43

Future Value

= =

$2,500  [(1.02 8−1)/0.02] $21,457.42*

Formula:

Calculator:* N 8

I/Y 2

PV 0

PMT −2,500

FV Compute

Solution 21,457.42*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

731

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-15 1.

Tables: Future Value

= = =

Investment  (FV of Single Amount, 5 Periods, 8%) $8,000  1.46933 $11,754.64

Future Value

= =

$8,000  1.08 5 $11,754.62*

Formula:

Calculator:** N 5

I/Y 8

PV −8,000

PMT 0

FV Compute

Solution 11,754.62*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Future Value

Interest

= = = = =

Investment  (FV of a single Amount, 7 Periods, 8%) $8,000  1.71382 $13,710.56 $13,710.56 − $8,000 $5,710.56

= =

$1,200  1.08 7 $13,710.59*

Formula: Future Value Calculator:** N 7

I/Y 8

PV −8,000

PMT 0

FV Compute

Solution 13,710.59*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Future Value

= =

Investment  [FV of a single Amount, 20 (5  4)Periods, 2% (8%/4] $8,000  1.48595 $11,887.60

= =

$8,000  1.02 20 $11,887.58*

Formula: Future Value Calculator:** N 20

I/Y 2

PV −8,000

PMT 0

FV Compute

Solution 11,887.58*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

732

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-16 1.

Tables: Future Value

= = =

Investment  (FV of a single Amount, 9 Periods, 1 %) $70,000  1.09369 $76,558.30

Future Value

= =

$70,000  1.01 9 $76,557.97*

Formula:

Calculator:** N 9

I/Y 1

PV −70,000

PMT 0

FV Compute

Solution 76,557.97*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Future Value

= = = = =

Investment  (FV of a single Amount, 6 Periods, 1%) $70,000  1.06152 $74,306.40 $74,306.40 − $70,000 $4,306.40

Future Value

= = = =

$70,000  1.01 6 $74,306.41* $74,306.41* − $70,000 $4,306.41*

Formula:

Calculator:** N 6

I/Y 1

PV −70,000

PMT 0

FV Compute

Solution 74,306.41*

Interest = $74,306.41* − $70,000 = $4,306.41 * Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

733

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-17 a.

Tables: Present Value

= = =

Investment  (PV of a single Amount, 7 Periods, 8%) $14,000  0.58349 $8,168.86

Present Value

= =

$14,000  1/1.08 7) $8,168.87*

Formula:

Calculator:** N 7

I/Y 8

PV Compute

PMT 0

FV −14,000

Solution 8,168.87*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: $5,820  (PV of a Single Amount, n Periods, 7%) $5,820 Table Factor n

= = = =

$10,000 (10,000  Table Factor) 0.58200 About 8 Periods

$5,820  (1/1.07n ) 1/1.07n 1 1/1.71821 0.582001036 n 0.582001036 n

= = = = = = =

$10,000 1.71821 1.71821 = 1/1.07n 1.07n 1.07n 1.07n 8

Formula:

Calculator:* N Compute

I/Y 7

PV −5,820

PMT 0

FV 10,000

Solution 8

* See footnote explanation for BE A3-1.

Tables: Annual Cash Flow  (PV of an Annuity, 25 Periods, 9%) Annual Cash Flow  9.82258 Annual Cash Flow

= = =

$0 $49,113 $5,000.01

= = =

$0 $49,113 $5,000.01

Formula: Annual Cash Flow  {[1 − (1/1.0925)]/0.09} Annual Cash Flow  9.82258 Annual Cash Flow Calculator:* N 25

I/Y 9

PV −49,113

PMT Compute

FV 0

Solution 5,000.01

* See footnote explanation for BE A3-1.

734

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-17 (Continued) d.

Tables: $4,000  (PV of a Single Amount, 4 Periods, i ) i = $4,000  Table Factor i = Table Factor i

= = = =

$2,542 $2,542 0.63550 About 12%

= = = =

$2,542 $2,542/$4,000 0.63550 (1 + i ) 4

Formula: $4,000  [1/(1 + i )4] [1/(1 + i )4] [1/(1 + i )4] 1/0.63550 4

Calculator:* N 4

I/Y Compute

1 / 0.63550 = 1.12 − 1 = i =

PV −2,542

1+i i 12%

PMT 0

FV 4,000

Solution 12

* See footnote explanation for BE A3-1.

Tables: $2000  (PV of an Annuity, 15 Periods, i) $2,000  Table Factor Table Factor i

= = = =

$17,119 $17,119 8.55950 About 8%

$2,000  [1/(1 + i ) 15] {1 − [1/(1 + i ) 15 ]} {1 − [1/(1 + i ) 15 ]}/i I

= = = =

$17,119 $17,119/$2,000 8.55950 About 8%

Formula:

Calculator:* N 15

I/Y Compute

PV −17,119

PMT 2,000

FV 0

Solution 8

* See footnote explanation for BE A3-1.

735

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-18 1.

Tables: Present Value

Formula: Present Value Calculator:* N 2

= = =

Investment  (PV of a Single Amount, 2 Periods, 9%) $60,000  0.84168 $50,500.80

= =

$60,000  (1/1.092) $50,500.80*

I/Y 9

PV Compute

PMT 0

FV −60,000

Solution 50,500.80*

Debit

Credit

* See footnote explanation for BE A3-1.

Journal Account and Explanation

Date 2024 Jan.

Equipment Notes Payable (Record purchase of equipment)

50,500.80

736

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-18 (Continued) b.

Tables: Present Value = Investment  (PV of an Annuity, 10 Periods, 2%) = $75,000  8.98259 = 6,73,694.25 Journal Account and Explanation Debit Credit

Date 2024 Jan.

Building Notes Payable (Record purchase of building)

6,73,694.25 6,73,694.25

Formula: Present Value = $75,000  {[1 − (1/1.0210)]/0.02} = $6,73,693.88* Calculator:* N 10

I/Y 2

PV Compute

PMT −75,000

FV 0

Solution 673,693.88*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Journal Account and Explanation

Date 2024 Jan.

Building Notes Payable (Record purchase of building)

Debit

Credit

6,73,693.88 6,73,693.88

Tables: Interest expense for the first quarter ended 3/31/24: 0.02  $6,73,694.25 = $13,473.89 Journal Account and Explanation

Date 2024 Mar.

Interest Expense Notes Payable* Cash (Record loan payment)

Debit

Credit

13,473.89 61,526.11

75,000.00

*Cash Payment − Interest = Liability Change $75,000 − $13,473.89 = $61,526.11

Interest expense for the first quarter ending 6/30/24: 0.02  New Liability Balance 0.02  ($6,73,694.25 − $61,526.11) 0.02  $6,12,168.14 = $12,243.36

737

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-18 (Continued) Journal Account and Explanation

Date 2024 June

Interest Expense Notes Payable* Cash (Record loan payment)

Debit

Credit

12,243.36 62,756.64

75,000.00

Debit

Credit

13,473.88 61,526.12

75,000.00

Debit

Credit

12,243.36 62,756.64

75,000.00

* $75,000 − $12,243.36 = $62,756.64

Formula or Calculator Interest expense for the first quarter ended 3/31/24: 0.02  $6,73,693.88 = $13,473.88 Journal Account and Explanation

Date 2024 Mar.

Interest Expense Notes Payable* Cash (Record loan payment)

* $75,000 − $13,473.88 = $61,526.12

Interest expense for the second quarter ending 6/30/24: 0.02  New Liability Balance 0.02  ($6,73,693.88 − $61,526.12) 0.02  $6,12,167.76 = $12,243.36 Journal Account and Explanation

Date 2024 June

Interest Expense Notes Payable* Cash (Record loan payment)

* $75,000 − $12,243.36 = $62,756.64

738

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-18 (Continued) 4.

Interest expense for 2024: 0.09  $50,500.80 = $4,545.07 Journal Account and Explanation

Date 2024 Dec.

Debit

Interest Expense Notes Payable* (Record purchase of building)

Credit

4,545.07 4,545.07

*Cash Payment − Interest = Liability Change $75,000 − $13,473.89 = $61,526.11

E A3-19 1.

Tables: Present Value

= = =

Investment  (PV of a Single Amount, 5 Periods, 6%) $2,00,000  0.74726 $1,49,452.00

Present Value

= =

$2,00,000  (1/1.065) $1,49,451.63*

Formula:

Calculator:** N 5

I/Y 6

PV Compute

PMT 0

FV −2,00,000

Solution 1,49,451.63*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Investment  (PV of a Single Amount, 5 Periods, 10%) $2,00,000  0.62092 $1,24,184

Present Value

= = =

Present Value =

$2,00,000  (1/1.105) = $1,24,184.26*

Formula:

Calculator:** N 5

I/Y 10

PV Compute

PMT 0

FV −2,00,000

Solution 1,24,184.26*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

739

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-19 (Continued) 3.

Tables: Present Value

= = =

Investment  (PV of a Single Amount, 10 Periods, 3%) $2,00,000  0.74409 $1,48,818

Present Value

= =

$2,00,000  (1/1.0310) $1,48,818.78*

Formula:

Calculator:** N 10

I/Y 3

PV Compute

PMT 0

FV −2,00,000

Solution 1,48,818.78*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

E A3-20 1.

Tables: Future Value

= = =

Investment  (FV of an Annuity, 7 Periods, 10%) $4,200  9.48717 $39,846.11

Future Value

= =

$4,200  [(1.107−1)/0.10] $39,846.12*

Formula:

Calculator:** N 7

I/Y 10

PV 0

PMT −4,200

FV Compute

Solution 39,846.12*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

The interest earned at any point in time equals the excess of the future value over the total amount of cash deposits. Thus, interest earned to the point in time just after the seventh deposit is: Tables: $39,846.11 − (7  $4,200) = $39,846.11 − $29,400 = $10,446.11 Formula or Calculator: $39,846.12 − (7  $4,200) = $39,846.12 − $29,400 = $10,446.12

740

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-21 For a 10-week, S1-a week plan: $1  10.06960 = $10.07 For a 30-week, $10-a-week plan:

$10  30.67960 = Number of Deposits 10 20 30 40

$306.80 Amount of Each Deposit $5 $10 $50.35 $100.70 101.48 202.95 153.40 306.80 206.13 412.25

$1 $10.07 20.03 30.68 41.23

$50 $503.48 1,014.77 1,533.98 2,061.25

E A3-22 1.

Tables: Future Value

Loss

= = = =

Investment  (FV of a single Amount, 30 Periods, 1%) $25,000  1.34785 $33,696.25 $33,696.25 − $25,000 = $8,696.25

= =

$25,000  1.01 30 $33,696.22*

Formula: Future Value Calculator:** N 30

I/Y 1

PV −25,000

PMT 0

FV Compute

Solution 33,696.22*

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Loss = $33,696.25 − $25,000 = $8,696.22

The loss is not recorded because it represents an opportunity missed. Accountants call such losses “opportunity losses.” Although opportunity losses are not entered in the accounting records, it is important to know and understand such losses in managing a business.

741

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-23 1.

Tables: Present Value

Formula: Present Value

Calculator:** N 25

I/Y 9

= = =

Investment  (PV of an Annuity, 25 Periods, 9%) $7,75,000  9.82258 $76,12,499.50

= =

$7,75,000  {[1−(1/1.0925 )]/0.09} $76,12,499.19

PV Compute

PMT −7,75,000

FV 0

Solution 76,12,499.19*

Debit

Credit

* Differs from value calculated with the tables due to rounding. ** See footnote explanation for BE A3-1.

Tables: Journal Account and Explanation

Date 2024 Jan.

Land Notes Payable (Record purchase of land)

76,12,499.19 76,12,499.19

Formula or Calculator: Journal Account and Explanation

Date 2024 Jan.

Land Notes Payable (Record purchase of land)

Debit

Credit

76,12,499.19

742

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 3: The Time Value of Money

E A3-24

1. 2.

Tables: Present Value

Formula: Present Value Calculator:* N 30

= = =

Investment  (PV of an Annuity, 30 Periods, 1%) $50  25.80771 $1,290.39

= =

$50  {[1−(1/1.0130 )]/0.01} $1,290.39

I/Y 1

PV Compute

PMT 50

FV 0

Solution 1,290.39

Debit

Credit

* See footnote explanation for BE A3-1.

Journal Account and Explanation

Date 2024 Oct.

Notes Receivable Sales Revenue (Record Sale) Cost of Goods Sold Inventory (Record the cost of mercandise sold)

1,290.39 800.00 8,00.00

Interest Period

10/31/24 .............. 11/30/24 .............. 12/31/24 .............. Total .................. 5.

1,290.39

Interest Income

Cash Payment

Change in Receivable Balance

$12.90 12.53 $25.43

$50.00 $50.00

$37.10 37.47

The income effect in 2024 of this sale: Interest income........................................................... Gross margin: Selling price............................................................. Less: Cost of goods sold ........................................... 2024 income effect ..................................................

Ending Receivable Balance $1,290.39 1,253.29 1,215.82

$ 25.43 $1290.39 (800.00)

490.39 $515.82

743

Financial Accounting: The Cornerstone of Business Decision Making, 5e [978-0-357-13278-4], Appendix 4: International Financial Reporting Standards

FINANCIAL APPENDIX 4 INTERNATIONAL REPORTING STANDARDS MULTIPLE-CHOICE QUESTIONS A4-1.

A4-2.

A4-3.

A4-4.

A4-5.

A4-6.

A4-7.

A4-8.

A4-9.

A4-10. b

744

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